This week we’re sticking with the reboot and doing a five-minute finance lessons on the basics you need to know about your balance sheet.
Since I work with first-time entrepreneurs who don’t typically have any background in business management, I spend a lot of time talking with my clients about financial statements and getting them up to speed on what’s what. Now, clearly, nobody is going to become an accountant overnight – nor should you try to – but every business owner should have enough knowledge to understand what an accountant is telling you about the financial state of your business and to be able to read basic financial statements yourself and get the pulse of your business’ health. So, as step one towards that goal I’m giving a series of 3 five-minute finance lessons to give you a brief overview of the three basic financial statements: the income statement, the statement of cash flows, and the balance sheet. This week, we’re covering the balance sheet.
The balance sheet gives a picture of a company’s assets, liabilities, and shareholders’ equity (i.e. what a company owns, owes, and who owns it) at a specific point in time. It’s a static picture and will be dated accordingly: Company X Balance Sheet as of December 31, 2013, for example. The balance sheet is based on the following equation:
assets = liabilities + shareholders’ equity
The two sides of that equation must ALWAYS equal each other, so once you start building your financial statements you need to double check that the equation balances. If it doesn’t, you know you’ve made a mistake somewhere. Think of it like this: everything the company owns (its assets) had to be paid for somehow and companies pay for things by either borrowing money (liabilities) or getting the money from shareholders (shareholders’ equity). When you look at the balance sheet in this way, it’s easy to understand 1) why it must balance and 2) what should go where.
The exact items that will be on a balance sheet differ from industry to industry and company to company, however, there are some basics that will show up on almost every company’s balance sheet. On the assets side, you should include items like cash and cash equivalents, accounts receivable, inventory, property, etc. Additionally, assets are broken down into current assets and long-term assets. Current assets are those assets that are considered most liquid, meaning that they either are cash or can be exchanged for cash quickly, and that may come and go quickly. Long-term assets are those that have monetary value but that can’t be exchanged for cash as readily and tend to be held for longer periods of time. For example, accounts receivable would be included under current assets because you can either collect the payment from those who owe you or sell it to a factoring or collections company almost immediately and have access to cash. Additionally, the balance of your accounts receivable is constantly changing. An office building owned by the company, on the other hand, would be included under long-term assets because you can’t convert its value into cash so readily and you’ll likely continue to see it on the balance sheet for years to come. Putting the building up for sale, finding a buyer, negotiating the terms, closing, collecting payment, and transferring title will take a significant amount of time, so this asset is considered illiquid and long-term.
On the liabilities and shareholders’ equity side you’ll also break liabilities down into current versus long-term debt. Current debt is that which must be paid within one calendar year of the date of the balance sheet. Long-term debt is debt which will be due more than one calendar year from the date of the balance sheet. For example, if your company has a mortgage on that office building that we discussed above, the amount owed on the mortgage for the next 12 months will be listed in current liabilities while the amount that will remain on the mortgage after those 12 months will be listed in long-term debts. In addition to the current and long-terms debts, this section of the balance sheet also lists shareholders’ equity.