Purpose of a Balance Sheet
The balance sheet boldly declares where a business stands at a given moment in time. From the balance sheet, a financially sophisticated reader can learn an immense amount of valuable information about a business and its viability. That is why potential investors and lenders will almost always ask you for a copy of your financial statements, including the balance sheet, income statement, statement of retained earnings, and statement of cash flows. This is also why you, as a savvy entrepreneur, need to understand the information presented on them.
Why It Is Important
The principal reason your business’s balance sheet is so important to you and to any potential investors or lenders is that it is like a photograph of your business. It tells how the business is put together, what its principal resources are and where any potential dangers lie. Like any portrait it is incomplete, in that it only shows one fleeting moment in time, and therefore is most useful in conjunction with the income statement and by comparing several balance sheets over a period of time. Ahh, this is where the real story begins to unfold! The clever entrepreneur becomes the Sherlock Holmes of the balance sheet and astutely looks for trends over time and checks ratios and balances to see which direction the company is headed in and to look for any potential to cut costs or perform more efficiently.
Why Small Businesses Are Different
If you are a small business owner or entrepreneur then you need to be able to read and understand your balance sheet because, first, it is through your financial statements and other numerical data that you collect that you really get to know your business. Michael Gerber, the best selling author of the E-Myth Revisited, says it much better than I ever could as “because without the numbers you can’t possibly know where you are, let alone where you’re going. With the numbers, your business will take on a totally new meaning. It will come alive with possibility.” The very first step you will ever take down that road to really knowing your business is through examining and understanding your own balance sheet.
Second, your balance sheet is how anyone that you will ever want to do business with will understand your business. Think about getting a loan, the first thing your banker wants to see are your financial statements and the first page of your financial statements is your balance sheet. Why is it first? Perhaps because it is the most important. Now think about your situation; you’re applying for a loan or a grant or you want to do business with the federal government or an investor is thinking about either coming on board or buying you out and you present your financial statements to them. They open them up, turn to page one, and there is your company laid bare, open to them. And they ask you questions; “why is this line a negative number, how did you arrive at the valuation of that line, what are the terms of this liability.” Don’t you want to be able to confidently look them in the eye and answer those questions?
What Makes Up a Balance Sheet
Hopefully, you have been exposed to some basic accounting and understand the concepts that some numbers in accounting are recorded as debits and some numbers as credits. These numbers are often represented as positive and negative numbers and the balance sheet, as its name suggests, must balance, i.e. the negative and the positive numbers must total zero. In addition, the basic formula for accounting is Assets = Liabilities + Equity, and any US balance sheet will be organized into exactly three sections with at least two subtotals, for assets and for liabilities and equity. Using the basic algebra that we learned in Ms. Arithmatic’s 6th grade class, we can shrewdly deduce that the two subtotals must be exactly equal. So far no problem, because if your balance sheet doesn’t balance then you have much bigger problems then simply worrying about understanding your financial records.
How Assets Are Valued
Great! you’re thinking, let’s start with the assets! Well, I love an enthusiastic learner and so I will oblige. To put it very briefly, assets are the total of everything your business has that has some sort of value to the business. This could be cash or real estate or stocks and bonds or machinery and equipment or accounts receivable or other moneys due to you. It could also include inventory, which is product that you have produced but not yet sold. So to summarize assets are usually either cash, something that you have bought, something that you have made and that you expect to sell, or something that is owed to you.
Clearly then, if you want to make your balance sheet you must have a list of your assets and how much each is worth. The rub lies in the worth, or valuation of the assets. “Hmm, you think, I bought this asset ten years ago at 10 grand, I added 5 grand in improvements to it, it would cost me 20 grand to replace it and I could get about 18 grand on the open market for it, so what value should I put down for it?” Clever question, my dear reader! Well, as you may have assumed, we accountants have put a great deal of thought into these issues and we continue to think about and tweak the ways we value things to this very day. If you want the exact answer to just about every accounting question then it is there for you, for free but in techno-accountant babble, at asc.fasb.org. However, most of you don’t want to do all that work, you want a quick and easy rule of thumb that works 90% of the time without you having to leave this article, and that is exactly what you will get. The key here is conservatism, we are much more worried about overvaluing an asset then we are at undervaluing. Therefore, the rule of thumb is that assets are valued at the lessor of cost (what you paid for it) or fair market value (what you could get if you sold it right now). Now, there are additional considerations, like depreciation for buildings, machinery, and equipment, and the value of receivables and other moneys owed to you, but that is the general rule.
How Liabilities Are Valued
The next step is to make a list of items that your business owes or obligations that it has. This could be money that you owe to your suppliers for products and services or money that you owe to your employees for services performed or money that you owe to the government for taxes or or money that you owe to the bank or another lender. It could even be money that the business owes to you, as an owner.
Remember what I said before about conservatism? Well, this counts for liabilities as well, only in this case the concern is that liabilities are undervalued or, even worse, unrecognized and unrecorded. The general rule of liabilities is that they are included at amortized cost which should be equal to the amount owed on them at that moment in time. This usually presents less of a challenge than the valuation of assets because most long term assets, like loans, have explicit terms that spell out exactly how much you owe on them at any given moment in time.
How Equity Is Valued
Depending upon the type on entity (Corporation, S-Corp, LLC. etc.) that you use the equity portion of the balance sheet can use different terms, but really there are two kinds of equity: capital that you put into the company (stock, contributed capital, etc.) and the earnings of the company (retained earnings). The capital that you contribute is usually pretty straightforward. If you contributed something other than cash, such as real estate, machinery, or your interest in another business then use the rules for the valuation of assets, the lessor of cost or fair market value.
Retained earnings is a whole different ball game. Remember what I said back in the beginning about the formula for the balance sheet? That Assets = Liabilites + Equity? Well, if you’ve filled everything else out you only have retained earnings left, and, using a little bit of algebra and adding some detail to the preceding formula, retained earnings absolutely must equal Assets – Liabilities – Contributed Capital.
Now, it’s fine to do the math and plug the number to get started, but as you go forward your retained earnings will develop a new relationship, with the income statement (also commonly called the profit and loss statement). Basically, the relationship is net income + any contributions to capital – any distributions of capital (dividends) = the change in retained earnings for the period. So retained earnings becomes the bridge between the balance sheet over two consecutive time periods (usually a year). For more information on calculating retained earnings see the link to my blog below.
What the CPA or Auditor Does
You’ve done a fantastic job getting your balance sheet set up and keeping it going, but at some point you’re going to show it to someone, a banker, a supplier, a potential business partner, and they are going to take one look at the work that you have so proudly and lovingly put your heart into and they will say, “what the Hell is this crap?” Don’t take it personally (you need their money, after all) just understand that there are standard ways to present present financial statements and set rules to follow. In order to make your statements comply with these rules and to give them an air of authority you will have to hire a Certified Public Accountant, or C.P.A., and have them compile, review, or audit your financial statements. What this means is that the C.P.A. takes your statements and then makes some cosmetic changes in order to present them in the form proscribed by US Generally Accepted Accounting Principles or, if appropriate, one of a number of alternate forms, and then issues an opinion on them. The opinion will vary depending upon the type of engagement you hired them to do. The standard opinion for a compilation is “we took this pile of crap and made it pretty, but we’re not saying that it makes any sense” while the standard opinion for an audit is “sure, we took a look and everything seems OK, but please don’t sue us if we’re wrong!” while a review falls between the two.
If you’ve watched the news at all over the past five years then you are aware that not all balance sheets are what they are painted to be. Enron and WorldCom are the biggest examples of out-and-out fraud, but more recently the big Wall Street firms, like Lehman Brothers, have come under fire for inadequate or questionable accounting practices. How does this all happen? Well, let’s go back and revisit the assets and liabilities sections of this article and rethink what I said about conservatism. If assets are valued at higher than they should be, or liabilities lower, the difference must come through retained earnings in the form of income. So, most accounting frauds are a resulting of overstating assets, usually inventory for industrial firms or investments for banking and Wall Street firms, or by not including certain liabilities on the balance sheet.