Most business owners can understand a profit and loss statement but are very confused when it comes to balance sheets.
Let’s start with a couple of definitions.
Assets are the things you own and are divided into current assets and fixed assets. A current asset is something you own that will be used in the next twelve months. Examples include; cash, accounts receivable, notes receivable, inventory.
Fixed assets are those things that will last longer than twelve months. Examples include; vehicles, house, room additions, and equipment. Assets are used in the production of income.
Liabilities are the obligations of the business and are divided into two groups, current and long-term. Current assets are those obligations that will come due in less than twelve months and long-term are those that are longer than twelve months. Examples include: accounts payable, payroll tax liabilities, and lines of credit.
Long term liabilities include bank loans and loans from owners. These are obligations that the business must pay for the operation of the business or the funding of the infrastructure to run the business.
Equity is the worth of the business. The current earnings and all earnings since the start of operations less any monies that the owners have distributed make up the equity.
These are the basics of accounting and my time is spent constantly reminding myself and others the golden rule. If every number on the balance sheet is correct all other numbers will be correct, both on the income statement and the tax return. You may be asking yourself why this would be so. The reason is that every entry that is made, is made up of two sides.
Don’t get lost now.
I know I am hitting you with lots of information. Here are the examples of how this all comes together.
Accounts Receivable which we discussed in part two directly affects sales of your business, so if accounts receivable is correct sales is correct. Accounts payable which we discussed in section three directly affects all of your expenses, so if accounts payable is correct all of your expenses are correct. Finally if your cash is correct we know that you have included all of the payments for liabilities and the accumulation of other assets.
The whole point of this discussion is to explain the importance of understanding the basic building blocks of your business’s financial foundation.
We as accountants spend a great majority of our time producing these documents and very few business owners take the time to understand their meaning. Once you start to look at these things you will have a much clearer understanding of the health of your business.
There are many tools that help in the automation of generating these reports. Once these reports are generated it is so very important for you the business owner to understand them. It is your job to continue to learn more and question more about the operation of your business and the balance sheet is the perfect starting point to understand the health of your business.
(c) CG Groth