You own or work at a small business.
You work hard at your trade.
You probably never thought you’d ever want to know anything about financial statements.
You probably don’t even know what financial statements are.
And rightly so. We don’t blame you one bit.
A balance sheet is one of the main financial statements in bookkeeping, and one of the most important.
Your balance sheet monitors the health and success of your business. It shows investors and banks if they should loan you money.
Most importantly, it shows you, as a business owner, how well, or poorly, you’re performing.
And the best part is, it’s not hard to learn how to properly prepare and read a balance sheet.
In layman’s terms, a balance sheet is a breakdown of the assets (what you own), liabilities (what you owe) and equity (the difference between what you own versus what you owe) in your business.
Within each of these, is separate, more individualized, accounts. Each account has a balance of its own.
A balance sheet lists your (1.) Assets (cash, buildings, equipment) by category with a total dollar value of all your assets.
Then it lists your (2.) Liabilities (loans/mortgages you owe, money you owe to vendors) with a total.
The difference between your assets and liabilities is your (3.) Equity. Basically, equity will show you whether you own more than you owe to people, or whether you owe more money out than you actually own.
1. What is an asset?
An asset is anything of value in your business that can be converted into cash. This can be furniture, vehicles, materials, products, accounts receivable, etc. The assets are typically listed in order of how quickly they can be converted to cash. Cash being the most liquid, is always listed first.
To make this a little easier to understand, here’s a quick list of your most important asset accounts:
- Accounts Receivable – this is the money owed to you by customers who have received your service or product but have yet to pay. They may have payment terms such as 30 days to pay so while you are waiting for the actual cash, you record the transaction right below cash as an account receivable. Once you actually get paid, you increase your cash account (because you actually received the cash) and reduce your accounts receivable account (because you are owed less money now).
- Inventory – Inventory is the goods you have for sale and the materials used to make those goods. If you own a bakery, for example, your inventory is not only your donuts, but also the flour, sugar and eggs to make the donuts. Once you sell your products, you increase your cash account and reduced your inventory account.
- Prepaid Expenses – These are expenses that are paid in advance of their due date. If you pay your electric bill 2 days before it’s due, you do not have to record it as a prepaid expense. That can get to be a little crazy and overwhelming. However, if you pay your insurance premium for the entire year at one time, this is a prepaid expense. You record this as an asset and then reduce the value of the asset each month that you use the insurance premium.
- Property and Equipment – This is the land, buildings, equipment, furniture and vehicles that your business owns. These are typically items of value. A calculator for $10 is not technically an asset. This is a disposable item. Property and equipment are items of greater value and therefore counted as assets.
That’s about it for assets. Not too bad, right?
Now you should be able to categorize the assets of your business into the categories listed above.
Let’s move on to the next section: Liabilities.
2. What is a liability?
A liability is your business’ financial debts or obligations that come up during the course of regular, day-to-day business operations.
Ok, so what does this actually mean? The best way to learn is through examples, so let’s dive right in to give you a better understanding of what the various liability accounts are.
- Accounts Payable – In a nutshell, these are your bills. You name it, electric, rent, insurance, materials, payroll, gas, taxes, etc. When you receive these, they are immediately added to your “accounts payable” account because they are debts that you owe that are not due yet. Your list of account payable is basically a list of the bills you owe and their due dates.
- Notes Payable – This is the current portion of all of your loans, meaning the amount of your payments due within the next 12 months. Anything due beyond 12 months is considered long-term debt which we will discuss in more detail later in this article. Examples of notes payable are car loans, loans for equipment or a loan from a person. You record these by adding the total principal owed on the next 12 loan payments to the notes payable account. This is a great way to monitor the current balance owed on all of your loans.
- Accrued Expenses – You’re probably saying accrued what??? These are the opposite of prepaid expenses. These are expenses that you incurred already but have yet to pay, such as salaries. Let’s say you pay your employees every other Friday. At the end of the first week your employees earned their pay but they will not be paid for another week. You should record the wages for that first week as an accrued expense, increasing the amount in your accrued expense account, because it is a liability of the company as you are required to pay these wages. Once you actually pay the wages on the second Friday, you reverse the amount in the accrual account. It’s kind of like earmarking the funds to pay at a later time.
- Deferred Revenue – Deferred revenue is pretty simple. If someone pays you before services are rendered, then you add the amount to your deferred revenue account. It is a liability on your books because you are now liable to provide the service or provide the goods for which the customer already paid. Once your render the service or provide the goods, you reverse the deferred revenue amount and add the amount to the actual revenue account instead because you have now earned it.
- Long-Term Debt – This is any debt that you have that is due more than 1 year from now. Let’s say you buy a van for your business and you take a 5 year loan. The payments for the first 12 months are recorded in the notes payable account and the payments beyond 12 months are recorded in the long-term debt account. So every payment that you make reduces your long term portion until you are down to your last 12 payments, then the balance in your notes payable account (or current debt) is reduced.
Now onto the last section of your balance sheet: Equity.
3. What is equity?
The quick and easy way to calculate your equity is by subtracting your liabilities from your assets. Let’s say you have $100,000 of assets and $75,000 of liabilities. Your equity would be $100,000 – $75,000 = $25,000.
There are various accounts under the equity umbrella, but for you as the small business owner, your equity is primarily going to consist of a “Retained Earnings” account and an “Owner’s Equity” account.
- Within your “Retained Earnings” account is the net income you generate each year after all of your expenses are paid. Your retained earnings are adjusted up or down each year depending on if you have a net profit or a net loss that year.
- Within your “Owner’s Equity” account is the value of any funds you personally contributed to the business. If you spent $10,000 of your own personal money to start your business, this would be added to the Owners’ Equity account.
Let’s say at the end of your first year in business, you have a net income of $15,000 (Retained Earnings). You also have that $10,000 of your own moo-la you contributed yourself (Owners’ Equity).
In total, you would have equity of $25,000 ($10,000 in the Owners’ Equity account + $15,000 in the Retained Earnings account).
Let’s say at the end of Year 2 you had a net loss of $5,000, this would reduce your Retained Earnings by $5,000, leaving you with total equity of $20,000.
Hopefully now you are able to see how your equity is a running balance that increases or decreases over time based on your net profit or loss.
Well, that about wraps it up for our quick and easy lesson of the balance sheet.
Now if you see a balance sheet, or want to prepare one on your own, you will recognize all of the necessary accounts.
We hope you’ll be able to use this report as a meaningful tool in the success of your small business.
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