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How Do I Read A Balance Sheet and Why Is It Important?

How Do I Read A Balance Sheet and Why Is It Important?

This is Part 6 in our “All About Bookkeeping” series.

If you missed our first four articles check them out here:

What Is Bookkeeping and Why Do I Need Bookkeeping For My Business?

What Are Bookkeeping Debits, Credits, and Chart of Accounts?

What Is Cash and Accrual Accounting?

What Is An Income Statement vs Balance Sheet?

How Do I Read An Income Statement and Why Is It Important?

Last week we discussed the Income Statement (AKA Profit and Loss), now we are going to dive into its counterpart, the Balance Sheet.

1. What Is a Balance Sheet Recap?

Shows the financial condition of your business on a specific date in time.

  • Account Types: Assets, Liabilities, and Equity
  • Time Frame: One specific date in time
  • What Does the Balance Sheet Tell You? What you own, what you owe, and what’s left over

2. What Are the Different Parts of A Balance Sheet?

Assets, Liabilities, and Equity

SAMPLE BALANCE SHEETBalance Sheet Example

  • Assets: This area represents the things you own. This can include: cash on hand (checking accounts, savings account), office equipment, accounts receivable (what others owe you), investments, machinery, inventory, etc.
  • Liabilities: This area represents what you owe. This can include: credit cards, accounts payable (people you owe), loans, sales tax still owed, employee benefits, etc.
  • Equity: This area shows what you have invested or what’s left over. This can include: current year earnings, owners contribution (money you put into the business), owners draw (money you took out of the business), retained earnings (profit you have earned over the years less distributions), etc.
  • Remember Accounting Equation: Assets = Liabilities + Equity
  • Short-Term vs Long-Term
    • Short-Term (AKA Current): You can have both short-term assets or liabilities. Typically items classified as short-term are a year or less.
    • Long-Term (AKA Non-Current): Again you can have both long-term assets or liabilities and this typically means holding for more than a year.
    • Example: You purchase $10,000 in office furniture and take out a 6 month loan. You would book that initial purchase as a Non-Current Assets for the office furniutre along with a short-term or current liability since you expect to pay the loan off in less than a year.

3. Why Is A Balance Sheet Important? What Can I Do With the Information From a Balance Sheet?

It is important to not just complete bookkeeping and then move on, but to actually take the data that comes from the bookkeeping, including the balance sheet and utilize that to see the health of your business!

  • Get a Full Understanding of the Health of Your Business: You cannot tell how well your business is doing simply by looking at the income statement. The balance sheet will give you deep insights as to how liquid you are. If you were to shut the door today, where would you be? Would you have money left over? Would you owe money to others? If another pandemic or other industry disaster hits, how long can you business survive with revenues at 50% or less?
  • Utilize Comparative Periods: It is best to compare periods to prior periods. This can help show how you are progressing over time. Are the things you own getting bigger and things you owe getting smaller? Are you paying loans off or bringing more on?
  • Utilize Ratios: There are so many different ratios you can run but basically you can utilize them to see your performance and health. Examples are:
    • Current Ratio: Current Assets / Current Liabilities : Can your business pay its debts? The higher the ratio the better.
    • Quick Ratio: (Current Assets – Inventories – Prepaid Items) / Current Liabilities : This ratio basically tells you how capable you are to pay off your short-term liabilities with basic cash and cash equivalents.
    • Debt-to-Equity Ratio: Liablities / Shareholders Equity : This ratio tells you how much your business depends on debt to continue vs equity (current opeartions/owners). In this one you are looking for a lower number. The higher it gets the more it tells you that you if you had to pay back your debt it would likely use up your earnings/cash flow.
  • Analyze and Consult: You want to be sure to have a good grasp on your balance sheet. For clients doing their own bookkeeping, this is where we see the most errors. Making a profit is no doubt important, however just as important is understanding what you own and who you owe. If you are looking to make an investment into a piece of equipment or marketing plan you will want to analyze your balance sheet to ensure you can take on additional debt (if needed). For some simpler businesses the ratios may not mean as much but they can still help get a full financial picture and come in handy in the event of a sale. If you feel like you are flying by the seat of your pants when it comes to assets, loans, etc, do not be afraid to reach out to someone that can reel that in for you.

4. Final Items Related to the Balance Sheet

Some additional things to consider.

  • Accrual vs Cash: Remember in a previous article we discussed cash vs accrual accounting. You can run a balance sheet using both methods. As a refresher, cash basis is when you record activity as cash is interchanged. On an accrual basis you report activity as it occurs (regardless of when money is received or spent). Therefore if you run a cash basis balance sheet you will see no accounts receivable or accounts payable.
  • Asset Purchases/Depreciation: Major asset purchases go to the balance sheet and then they are depreciated which is when they move to the income statement and you get the actual expense. This is often something that happens during tax season. Lets say you purchase a new truck for $50k you will book that initially to the balance sheet as an asset. Then, depending on the depreciation method you you will expense it over time, taking depreciation expense (income statement) and offsetting the asset with accumulated depreciation (balance sheet, asset section). The value for that truck on the balance sheet will be the original asset less accumulated depreciation.
  • Owner Draws/Distributions: If you are taking money from the business as an owner that is not processed through payroll, generally this would be considered an owners draw, distribution or dividend and this it NOT an expense to the business, instead it shows on the balance sheet in the equity section. Same as when you contribute money to the business, this is not income to the business instead it would be an owners contribution.
  • Loans: When you take out a business loan that goes directly to the balance sheet as a liability item. Then when you make payments against that loan it will reduce the balance of that loan on the balance sheet and the interest portion of payments will be the only thing to hit the income statement.  
  • Simple Balance Sheet Example
    • 1) Open a bank account with $1,000 you put in of your own money.
    • 2) Take a loan out to buy a $7,000 piece of equipment.
    • 3) Receive income of $15,000 and spend $5,000 in expenses, profiting $10,000
    • 4) You take $2,000 out of the business to cover personal expenses.
    • Effect on Balance Sheet:
      • Assets: $16,000
        • Cash: $1,000 (1) + $15,000 (3) – $5,000 (3) – $2,000 (4) = $9,000
        • Equipment: $7,000 (2)
      • Liabilities: $7,000
        • Loan Payable: $7,000 (2)
      • Equity: $9,000
        • Owners Contribution: $1,000 (1)
        • Owners Draw: ($2,000) (4)
        • Current Year Earnings: $10,000 (3)
      • Note: Assets ($16k) = Liabilities ($7k) + Equity ($9k)

This article was meant to give you a deeper look into the balance. Next week we are going to be diving into some final financial statements that you may run into.

If you don’t have an accounting or tax advisor (or you need assistance with anything discussed), click here to book your complimentary strategy session with JETRO.

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