Balance Sheet Basics
It’s a beautiful day, the sun is shining (or not), and the time has come for My OC Bookkeeper to review some balance sheet basics for our dear readers. Understanding balance sheets is central to understanding the health and character of your business, and it doesn’t take a lot of work to develop a strong foundational understanding. So grab your cup of coffee, turn on some nice music, and let’s begin.
The balance sheet, income statement (also known as a profit and loss statement), and statement of cash flows combine to create a business’s financial statements. Each component of the financial statements provides a unique kind of information about a business: the balance sheet offers a snapshot of the financial condition at a given moment in time, the income statement tracks the revenues and expenses through time, and the statement of cash flows tells you how close you are to running out of cash. These statements can be used to do everything from checking last month’s profits to building complex financial models and are included in a business’s annual report or 10-K. (Check out the U.S. Securities and Exchange Commission website to see some sample public company 10-Ks.)
So What Does a Balance Sheet Tell Me?
As noted above, a balance sheet provides you with a snapshot of your business at a given moment in time. Everything your business owns, or owes, is included on the balance sheet as either an asset, a liability, or shareholder’s equity.
By looking at their balance sheet and comparing various pieces of information a small business owner can gain insights into the health of their business. Are my vendors paying off their debts quickly enough? Check the balance sheet. Do I have enough cash available to consider an expansion? Check the balance sheet. Are my assets worth more than my liabilities? Check the balance sheet. Can I afford to hire a new employee? You guessed it, check the balance sheet.
What Categories Are On A Balance Sheet?
One of the central roles of the balance sheet is organizational. By organizing a business’s assets, liabilities, and equity into easy to use categories it makes it easy to understand how the business is functioning and how all of its parts fit together. The first step is separating the assets, liabilities, and shareholders equity. The fundamental accounting equation tells us that assets = liabilities + shareholder’s equity so we use these as our three main categories. If you don’t understand this don’t worry, we will go into more detail in another post. For now just remember that the total value of a companies assets equals the combined value of its liabilities and equity, and that these are the three main categories used to organize a balance sheet.
Let’s break down a companies assets into some subcategories.
Assets are anything that a business owns that has value and represent our first category. They can include anything from a company car to a factory to a million widgets. Assets are broken down into current assets and long term assets, and then broken down again within those categories.
Current Assets, also known as short term assets, are assets that can be easily converted into cash within one year. Examples include inventory you expect to sell in the near future, cash, or accounts receivables.
Long Term Assets, also known as fixed assets, are assets of a more long term nature that you don’t expect to convert into cash. Examples include a factory, heavy machinery, and a company car.
By organizing all of your assets into categories such as these you can create a simple list of everything of value that your company owns and use this information to make decisions. Remember our discussion of an expansion? We could check our balance sheet and see how much cash we have available to do so. (To find the amount of cash we simply go to assets, then current assets, and then cash. Interested in furniture? We could go to assets, then long term assets, and then look for furniture.) But before making our final decision let’s check out the other half of the balance sheet: liabilities and shareholder’s equity. But before we do that – and we realize that’s two ‘buts’ in a row – check out this post on contra assets for a more advanced balance sheet concept.
Liabilities and Shareholder’s Equity
This is where we put everything that isn’t an asset. For the time being, let’s focus on liabilities. Liabilities represent any debt or obligation that a business holds. Examples include accounts payable, loans, and deferred revenues. (Props if you know what deferred revenues are. If not, you can learn all about deferred revenues here.)
As was the case with assets, liabilities are first broken down into current and non-current (long term) liabilities and then broken down into subcategories. If they are due within a year, then they are current. If not, they are non-current.
So if we are still interested in a possible expansion, we could check how much cash we have on the assets side of the balance sheet, and then get an idea of how much we have to spend on debts on the liabilities side. By looking at all of our assets and all of our liabilities together we are starting to get a good idea as to the biology of our company.
There’s just one piece left: shareholder’s equity. Equity can be a bit more confusing than the other parts of the balance sheet, but is still pretty straightforward. Just remember that equity is the difference between assets and liabilities. (As per the fundamental accounting equation: assets = liabilities + equity.) So if you have more assets than liabilities, hooray, you will have positive equity.
Advanced Balance Sheet Training
Those are the basics. Let’s quickly summarize: a balance sheet is a snapshot of a company that enables you to examine all of its financial pieces in an organized manner. This information can be used to do all kinds of cool things, from the very basic to the very advanced.
If you are interested in some advanced balance sheet training you have come to the right place. We will be posting an advanced balance sheet tutorial in the near future, so stay tuned.
Are you a small business owner looking for some accounting and tax expertise? My OC Bookkeeper provides the best small business bookkeeping and tax assistance available in Orange County.
To learn more about balance sheets check out the cool video below.