Understanding Financial Statements – The Balance Sheet: Part 1

A guide for small businesses

In order to make better business decisions and seek out opportunities to grow a company, it is crucial to have a solid understanding of your financial statements. Most small business owners typically only have accountants or bookkeepers prepare financial statements during tax season. However, to maintain a successful business, it would be advisable for owners to have an accounting professional analyze and interpret the statements a couple of times of year.  This will allow transparency into the business and would provide guidance if the company is operating efficiently, managing past due receivables, paying off its’ debts in a timely fashion and providing insight on new revenue streams.

The Balance Sheet

The Balance Sheet represents a fixed point in time such as a month-end date or fiscal year-end date. It is often compared with other month-end dates (or fiscal year-end dates) which can reveal trends and help identify increases and decreases of accounts.  Another effective strategy is to compare the financials to a competitors or industry standards to get an idea of how well the company is matching up to other businesses in the industry.  The Balance Sheet includes assets, liabilities and equities, where assets=liabilities plus equities.  It can help an owner of the company determine if he or she has positive equity or net assets in the company.

Assets are items that the company currently owns or is owed to the company.  Assets are separated out by their liquidity.  Liquidity refers to the assets ability to convert to cash which eventually puts money back into the company’s business. Current assets are the most liquid and mature in less than one year.  They include cash, accounts receivable, inventory, prepaid expenses, etc.  Long term assets are items that mature greater than 1 year.  These include fixed assets such as land, equipment, buildings etc.

Liabilities represent debt obligations that the company owes. Like assets, they are separated based on when the liability would be liquidated.  It represents disbursement of cash from the company. Typically assets need to be liquidated to pay for liabilities.  Current liabilities such as account payables, wages, taxes, unearned revenue are settled within one year. Long term liabilities settle longer than a year. Examples of long term liabilities are long term notes payables to owners or shareholders, bonds payable, capital lease obligations, deferred income tax etc.

The last section of the Balance Sheet is the equity section. This section consists of common stock (if the company is a corporation and issues stock to shareholders), retained earnings, capital and drawing accounts (for small businesses).  Retained earnings might be the most important item on the Balance Sheet.  It is made up of accumulated profit and losses from the company’s inception to the current period.  The net income from the Profit and Loss statement rolls into retained earnings after each fiscal year-end.  This number is analyzed often by investors and owners as it shows if the company is operating consistently through the years at a loss or a profit.  Capital accounts represent the initial investment that the owner contributed or subsequent contributions after inception of the company.  Drawing accounts are designated for withdrawals by the owner.

Analyzing the financial statements will benefit a business in many ways and it is important that an owner takes the time to understand what the numbers mean.  The financial statements can assist a company in knowing its’ debt structure and if it has excess cash.  This will help a company decide if it should pay down its’ debt or invest in the company. It can help determine which account receivable items are uncollectible and if a fee should be assessed to those specific balances.  And most importantly, it can help determine if the company is consistently making a profit, which in the end is the ultimate goal.