A balance sheet prepares you for wisely choosing your next moves. How? The direction you take and the initiatives you implement are highly dependent on what’s happened in the recent past, and that information is rooted in the balance sheet of your business.
The balance sheet is an important financial tool for business ventures of any size. Operators of small enterprises frequently overlook it, usually because they don’t fully understand how useful it can be.
Effectively, a balance sheet represents the overall status of your business and presents warning signs that don’t appear on a profit & loss (P&L) statement, which is more a statement of revenue and expenses. Lenders are keenly aware of the value of a borrower’s balance sheet, and will scrutinize it to uncover the real picture of the business.
The balance sheet reveals bookkeeping mistakes. Contrary to what many business owners believe, the use of accounting software does not automatically ensure accurate financial records.
Among the potential errors are incorrect inventory, overstated customer invoices, and understated vendor bills. These result in glaring errors on the balance sheet that skews the profit shown on the P&L statement.
Balance sheets are snapshots of account balances on given dates, such as month-end or year-end. The three sections are: (1) what you own (assets), (2) what you owe (liabilities), and (3) the difference between these two-which is your business net worth (equity).
The asset section begins with current assets-cash or assets easily converted to cash, such as accounts receivable and inventory, but also employee advances and similar amounts incoming in the short term. Each current asset account should reconcile to a financial institution statement or other corroborating record.
Fixed assets-equipment, furniture, computers, leasehold improvements, etc.-are items with a useful life beyond one year, and more than nominal cost.
The balance in each fixed asset account is your original cost for acquiring the assets in that category. Accumulated depreciation is a negative fixed asset account in which your original cost eventually ends up as it’s expensed over time.
Liabilities can be current-due in less than one year-or long term. Accounts payable, payroll taxes accrued but not yet remitted, credit card balances, and sales tax collected but not yet paid are examples of current liabilities.
Long-term liabilities are loans payable in more than a year. Each account balance should match other records-payroll reports, credit card statements, lender summaries.
The equity section shows sources of funds that make total assets differ from total liabilities. Types of equity accounts depend on whether the business is a corporation, partnership, or proprietorship. The most common reason for unequal asset and liability balances is the accumulation of business profits, which appear in the retained earnings equity account.
Current year profit is separately indicated, which matches the bottom line of the P&L. Other supplies of equity are capital from shareholders, partners, or a sole owner. Healthy businesses are profitable and have plenty of equity-and use the balance sheet to get the real picture.