In our last post, we reviewed the three parts of a balance sheet: assets, liabilities, and equity. That is a little dry, so let’s take a look at a real example to show you how you can use your balance sheet to make better business decisions.
We’ll continue the theme of our bakery example from our first post on the Chart of Accounts. In today’s example, we’re looking at a bakery that’s just starting up. To keep it simple, we’ll assume this bakery only makes pies.
In parentheses, I’ve indicated how each transaction affects balance sheet accounts (assets, liabilities, equity) and profit & loss (P&L) accounts (income, expenses). Where I say “checking”, it’s the checking account in the assets section of the balance sheet.
In January, the owner invested $10,000 in the business. (Increase checking, increase equity due to her investment in the business.)
She also borrowed $2,000 from a friend for the business. (Increase checking, increase liabilities because now she owes her friend money.)
Using some of this money, she bought ovens. (Decrease checking, increase valuable equipment.)
She also bought pie pans and pie ingredients. (Decrease checking, increase P&L expenses.)
And she made her first pie sales. (Increase checking, increase P&L income.)
She also made her first loan payment ($100) to her friend (decrease checking, decrease liabilities), and took a small amount out of the business for personal use (an owner’s draw; decrease checking, decrease equity).
The profit & loss shows the purchase of pie ingredients and pans, and receipt of money from pie sales; everything else described affects the balance sheet. You can see that the balance sheet at the end of January shows:
- the checking account balance
- the ovens (valuable equipment asset)
- her investment (deposited into the checking account)
- the loan (deposited into checking; the balance owed is shown as a liability)
- the owner’s draw.
Each balance is the net result of all the transactions that hit that account. So the checking account balance is: 10,000 + 2,000 – 5,000 – 500 – 200 + 700 -100 – 500 = 6,400.
In February, the owner got a small bank loan of $2,000 (increase checking, increase liabilities); she again bought ingredients (decrease checking, increase expenses) and sold pies (increase checking, increase income); she made loan payments (decrease checking, decrease liabilities); and she took a draw (decrease checking, decrease equity).
The February profit & loss shows the revenue and expenses only for February; the balance sheet at the end of February shows the cumulative effect of all activities from January 1 to the end of February. It’s a snapshot of the business’s assets, liabilities, and equity as of the end of February.
It also includes the net profit from the profit & loss as the final line in the Equity section.
During the month of March, the owner begins to get into risky territory. She decides to buy a stand mixer, since she’s making a profit. But this ties up quite a bit of her available cash (decrease checking, increase valuable equipment in Assets). On the balance sheet, you can see that the checking account is down to $600, although the net profit is growing.
Before she bought the mixer, perhaps she should have looked at her balance sheet and waited until she built up a bigger checking account balance before buying more equipment. She won’t have much money to buy ingredients in April, which will reduce her sales just when she is building up her customer base. And she still needs to make her loan payments for April too, which are $100 to the friend and $500 to the bank. (You can see that the loan amount is decreasing by $600 from February to March, due to these monthly payments. Note that I’ve left out loan interest to keep things simpler.)
Now that you’ve seen this example of how an owner could use their balance sheet to monitor their business’s health, I hope you’ll try looking at yours! If you look at your profit and loss by month, and your balance sheet (always cumulative) for the end of each month, and think about the activities you did in each month, you will start to see how the pieces fit together, and have a little more information for managing your business.
Don’t hesitate to contact Dunathan Consulting if you’d like to trust your company numbers and be able to use your reports to help you run your business.