I have written from time to time about the Balance Sheet. This is one of the two main financial reports used by businesses to monitor financial health. In that, it facilitates better informed predictions for both Income and Expenses, profits and the development of net worth. The formula Assets - Liabilities = Equity represents the fundamental accounting equation. It essentially means that a company's assets are financed by either liabilities or the owners' equity. Equity represents the net assets of a business, or what's left over after all liabilities are paid off. The accounting equation can also be expressed as Assets = Liabilities + Equity.
When a business begins, the investment of the shareholders, partners or even a sole proprietor becomes the Capital Account and coincidentally is owner equity. Think of owning a house where you paid a down payment of 20% on a $400,000 house. The 20% equates to $80,000 which is the equity, or the part of the house's value owned. The rest of course is debt financed through a mortgage. Businesses are much the same. Whereas a house changes value over time whether up or down, a business also fluctuates in value. That fluctuation is monitored by the Balance Sheet.
What is on a Balance Sheet depends on certain factors but the basics are:
- Investment of Capital by shareholders, partners or the sole proprietor
- furnishings owned
- real estate owned
- Cash in the bank or investments
- receivables
- Inventory
Also…debts or Liabilities are shown like
- Loans
- Accounts payable
- Credit Card balances
- Leases
This is not an exhaustive list but adequate for our discussion here.
A household like a business can use a Balance Sheet to watch the Net Worth go up or down as various plans/decisions are made and/or implemented. Ideally you want the new worth to rise over time and conversely when it goes down you want to inspect why and try to revert it. This is a basic responsibility of management. Management that ignores it is as they say, is asleep at the wheel.
To improve a Balance Sheet income can be increased resulting in more cash in the bank, debt paid down resulting in fewer Liabilities, more capital infuse raising owner equity, less cash removed as distributions etc. and other prudent maneuvers. In times of expansion, it is common to take on debt in order to finance growth. In doing so, the liabilities will increase but if the funds are applied well the cash can increase and any equipment etc. purchased becomes an additional Asset on the Balance Sheet.
The single biggest “sin” against a healthy Balance Sheet in small businesses is ownership taking out too much cash through “profit” distribution. I say profit with some caveat because there are owners who take out cash because they need it at home regardless of whether it is profit or retained earnings or not. That is not a good situation and can result in available Capital becoming too low and starving the life blood which is of course cash. Bill go delinquent, taxes too which is dangerous and the business becomes insolvent and go bankrupt if not handled appropriately and reversed. For more on Balance Sheets start here: https://www.investopedia.com/terms/b/balancesheet.asp
If you need help initiating or maintaining a Balance Sheet, contact me. If you don'y want one, just realize you are to that degree flying in a fog.
Best,
Donn Marier
DM-Your Own CFO