Ask any accountant and they’ll spout off the balance sheet equation (Assets = Liabilities + Owner’s Equity). Ask most everyone else, and they’ll either look at you blankly or have a hard time remembering what goes where in that equation. It’s simple, really, if you just picture it.
The balance sheet is nothing more than a pie graph where half is always “assets” and the remaining half is divided between “liabilities” and “equity”. The proportion of equity to liabilities will change, but the total of the two must be equal to the dollar value of your assets.
Now you know how to visualize the balance sheet. If you can hang on for a few more minutes of reading, I’ll tell you what it means to your business. First let’s define the terms:
Assets will be divided between current and long-term assets on your balance sheet. These are either cash or items you own that have cash value. Examples include: accounts receivable, investment accounts, inventory, equipment, etc. You’ll also find things like “prepaids” in your assets. Prepaids are simply expenses you have paid in advance, so they don’t belong on your income statement yet (theoretically you could get them refunded if you don’t actually use them…hence cash value).
Liabilities are things you owe. Like assets, liabilities are divided into current and long term liabilities. The most common liability accounts are: accounts payable, credit card debt, loans, lines of credit, etc. Similar to prepaids, you’ll also find deferred taxes, deferred wages, accrued payroll, etc. Customer deposits are also liabilities. Revenue is recognized when it is earned, not when the customer pays you. So, if the customer pays in advance, you record it as a liability until you have actually earned the revenue.
Equity is essentially what your business is worth. Equity is reduced by dividends and distributions and increased by your net profit, capital investments, etc.
Now that I’ve defined what’s on the balance sheet, let’s review what that means to your business. Essentially, the balance sheet holds the keys to how well your business has functioned throughout its lifespan. The income statement covers a period of time, while the balance sheet is an accrual of your business history. Bankers are more concerned with how your balance sheet looks because it shows how well you’re running your business.
Don’t get me wrong, the income statement is important too. The balance sheet and income statement together tell the story of your business. Too often, I see owners concerned only about the profit and loss and there are many problems with that approach.
If you ignore that balance sheet and work under the assumption it is correct, you are setting your business up for failure. The accuracy of the balance sheet is directly tied to the accuracy of your income statement. The asset and liability accounts on the balance sheet hold income statement account items until the period they impact the income statement. If you don’t move things to/from your balance sheet from/to your income statement in a timely manner, then you’re managing an incorrect income statement too.
Once you have an accurate balance sheet and income statement, the next step is to set up a dashboard and monitor your financial ratios (things like debt to equity, current ratio, receivables turnover, etc). Ideally, you’ll determine the right ratios for your business in your industry and start utilizing all of this data to make decisions.
Personally, I like to set up visual dashboards for the income statement, ratios, and other trend data. The whole idea here is to become proactive with your financial data and keep (or make) your business healthy. I find the easiest way to understand what is happening in a business is to make it visual.