Be honest, how closely do you look at your balance sheet when your accountant produces a report for you? Do you glance at it, check you’re in profit and then carry on with what you were doing, assuming that if there was anything really worrying going on that someone else would point it out to you?
It would be an easy assumption to make, but if you’re not careful could lead you into dangerous territory. Understanding your balance sheet is a critically important part of running your business and one that you can’t afford to ignore.
If you’ve been burying your head in the sand about your financial statements, here’s our easy to digest guide to show you what you’re looking at and why it’s important.
Firstly, you need to know the difference between your Balance Sheet and your income statement.
The two reports share some similarities. They’re both reporting on revenue and expenses. But whilst an income statement (also known as a profit and loss, or P&L, report) focuses on a specific period of time (e.g. monthly), the balance sheet gives you a broader view of your financial situation. Thus it gives you a better overview of how your business is performing (and its financial value).
Your balance sheet shows you your assets (what you own), your liabilities (what you owe), and the shareholder equity (what you’re worth).
If the company owns something of value, that’s an asset. Assets can be sorted into two categories: current and non-current.
Current assets are listed first on the balance sheet and are defined as cash, or cash equivalents that can easily be converted to cash. These can include accounts receivable (money owed to you), inventory (goods sold for profit), marketable securities (easily bought, sold or traded investments) and prepaid expenses (goods or services paid for in advance).
Non-current assets (or long-term assets) are things owned by the company that will take longer than a year to reach their full potential value, like land, property or equipment.
A liability is any money owed to a third party (whether they’re a creditor or a supplier). Your Balance Sheet will list both current, and long-term, liabilities. A current liability is anything that can be paid inside a year (for example, portions of debt, overdrafts, interest, wages, taxes, overheads such as rent or utilities, and accounts payable).
Long-term liabilities cannot be paid off within a year, such as long-term debts and interest.
Equity is the value amount left over when the liabilities are subtracted from the assets, and is made up of three major parts:
Common stock – a share of ownership, which will go up or down in value according to the business performance.
Preferred stock – stock similar to the above, however the shareholder has priority over a common stockholder.
Retained earnings – income left after the business has paid dividends to its shareholders. Profit can be paid out to the shareholders but can also be reinvested back into the business.
What if my Balance Sheet doesn’t balance?
Your total assets have to equal your liabilities plus equity – if your sheet doesn’t balance it can point to something wrong in your accounting system, or a serious problem that could lead to insolvency, like a cash flow issue.
As previously stated, your Balance sheet is a crucial report to give you an accurate overview of your business performance, but it can also be a useful tool for potential investors to evaluate past and potential performance.
If you need advice when it comes to understanding your financial reports, get in touch today. We’re here to make your life easier!