Most business owners understand the idea that their Profit & Loss report (also known as an Income Statement) shows the revenue that flows into the business and the expenditures the business makes.
But many business owners have only a vague idea of what a Balance Sheet is and how to use it. This post will help you make sense of that report.
The balance sheet tracks three things, generally known as “what you own” (assets), “what you owe” (liabilities), and equity. (Equity is the trickiest concept: it’s everything that the owner has invested in the business, minus everything the business owes to anyone.)
Let’s start with assets. These include anything in the business’s name that has cash value. Bank accounts (checking or savings), equipment or vehicles or other property, loans that the business made to someone else (which represent money that will be paid to the business in future)… you get the idea.
Note that for the property-type assets, we don’t include little things, like paper clips, that get used up quickly; we just include property that will last a while (typically more than a year) and is worth a reasonable amount (typically more than $1,000). So, things like cars, not pencils. Things we could expect to sell if we needed some cold hard cash.
Next, liabilities are what the business owes. Credit card balances go here; so do debts, such as a mortgage on a building that the business owns, or a car loan on that vehicle that’s listed up in the asset section as a company asset.
Understanding equity – a practical example
Speaking of cars, that’s an easy way to understand equity. If the business bought a car last year, it has an asset (the car) on the balance sheet; let’s say it’s worth $20,000. And the business also has a car loan with $15,000 outstanding, which is in the Liabilities section.
So if the business had nothing else at all, the equity would be $5,000 (the car asset minus the car loan liability). The Equity section does this calculation for the whole business: it takes the value of all the assets minus all the liabilities and tells you what’s left.
How does the balance sheet data get updated?
Every time you enter a transaction in your bookkeeping software, the system actually makes two entries. (This is why it’s known as “double-entry bookkeeping”.) Here are a couple of simple examples.
If I buy some pens for my office, that’s a business expense. I enter it in the “Office Supplies” category, which is in my Profit & Loss set of accounts.
Although I may not pay much attention, while entering my expense, I’m also indicating to the system that I paid for the pens with my debit card (from my checking account). In the background, the system uses this information to reduce the balance of my checking account (in the Assets section of my Balance Sheet) by the amount I just spent on pens, so that the checking account balance on my Balance Sheet matches my bank’s records.
If I had used my credit card to buy the pens, the system would increase my credit card balance (the amount I owe the credit card company) in the Liabilities section of the balance sheet, instead of decreasing my checking account balance in the Assets section.
On the other hand, if I buy a valuable piece of equipment (like a car or a computer server), using my checking account, then I would enter the purchase as buying an asset (in the Assets section) instead of as an expense (like the pens that went in Office Supplies on the Profit & Loss). The system will automatically reduce my checking account balance or increase my credit card balance for the amount of the purchase, just as with the pens example. This type of entry (purchase of an asset) is usually for items that will last more than a year and that cost more than $1,000 or so.
When I pay my credit card bill, my checking account balance (in Assets) decreases and so does my credit card balance (in Liabilities). So I have less cash on hand, but I also owe the credit card company less.
What about the revenue side? When I deposit revenue from sales into my checking account, I enter the revenue as income in my bookkeeping system, and the system will automatically increase my checking account balance in the Assets section.
Because the system is automatically updating your balance sheet’s Assets and Liabilities accounts as you deposit sales revenue and spend money on business expenses, your balance sheet is an up-to-date snapshot of the current moment; so you run a balance sheet “as of” a particular date, to see your asset and liability balances as of that date. This is different from the Profit & Loss, which shows all your revenue and expense transactions for each month during the year.
Why is a balance sheet relevant?
OK, you may say, but why should I care about this, as a business owner? Well, it’s a very good idea to know what your business owns and owes. That way you can make sure that you don’t overextend your business’s money and get in trouble. Most business owners focus on making sure they’re operating at a profit, but your business can still get into a cash flow crisis, even when profitable.
Even when you understand your balance sheet and profit & loss reports, planning for the future can be overwhelming. Contact Dunathan Consulting to help you make sure you understand your reports and to help you think through major business decisions more effectively.
In our next post, we’ll take a look at a specific example of using the balance sheet, together with the profit and loss statement, to make good business decisions.