WHY BALANCE SHEET IS A VALUABLE TOOL FOR SMALL BUSINESS
A balance sheet is a financial report that provides a summary of a business’s position at a given point in time, including its assets (economic resources), its liabilities (financial debts or obligations), and its total or net worth. A balance sheet does not aim to depict ongoing company activities. Its purpose is to depict the monetary value of various components of a business at a moment in time. Balance sheets are also sometimes referred to as statements of financial position or statements of financial condition.
Balance sheets are typically presented in two different forms. In the report form, assets accounts are listed first, with the liability and owners’ equity accounts listed in a sequential order directly below the assets. In the account form, the balance sheet is organized in a horizontal manner, with the assets accounts listed on the left side and the liabilities and owners’ equity accounts listed on the right side.
The term “balance sheet” originates from this latter form, for when the left and right sides have been completed, they should have equal monetary amounts. In order words, they must balance.
Contents of the balance sheet
Most of the contents of a business’s balance sheet are classified under one of three categories: assets, liabilities, and owner equity. Some balance sheets, though, also include a “notes” section wherein relevant information that does not fit under any of the above accounting categories is included. Information that might be included in the notes section would include mentions of pending lawsuits that might impact future liabilities or changes in the business’s accounting practices.
Assets are items owned by the business, whether fully paid or not. These items range from cash, the most liquid of all assets, to inventories, equipment, patents, and deposits held by other businesses. Assets are further categorized into the following classifications: current assets, fixed assets, and miscellaneous or other assets. The list of assets starts with cash and ends with the least liquid fixed assets. For instance, if you have an item labelled “goodwill” on your balance sheet, you’ll have to sell the business itself to turn that particular asset into liquid cash.
Current assets include cash, government securities, notes receivable, accounts receivable, inventories, prepaid expenses, and any other item that could be converted to cash in the normal course of business within one year.
Fixed assets, meanwhile, include real estate, physical plant, leasehold improvements, equipment (from office equipment to heavy operating machinery), vehicles, fixtures, and other assets that can reasonably be assumed to have a life expectancy of several years. It is recognized, however, that most assets, although not land, will lose value over time. This is known as depreciation. When determining a company’s fixed assets, then, a business owner needs to make certain that depreciation is figured into the final value of his or her fixed assets. The net fixed asset value of a company’s holdings is calculated as the net of cost minus accumulated depreciation.
Finally, businesses often have assets that are less tangible than securities, inventory, or high-speed printers. These are classified as “other assets” and include such intangible assets as patents, trademarks, and copyrights, notes receivable from officers or employees, and contracts that call for them to serve as exclusive providers of goods or services to a client. Intangible assets are any expenditure that adds value to the company but cannot be touched or held.
Liabilities on the other hand, are the business’s obligations to other entities as a result of past transactions or events. These entities range from employees (who have provided work in exchange for salary) to investors (who have provided loans in exchange for the value of that loan plus interest) to other companies (who have supplied goods or services in exchange for agreed-upon compensation).
Liabilities are typically divided into two categories: short-term or current liabilities and long-term liabilities). Liabilities that qualify for inclusion under the short-term or current designation include all those that are due and payable within one year. These include obligation in the areas of accounts payable, taxes payable, notes payable, accrued expenses that are supposed to be paid off (such as wages, salaries, withholding taxes, and federal agencies taxes) and other expenses that are supposed to be paid off over the next year. Such obligations include the portion of long-term debt that is scheduled to be paid off during the course of the coming year. Long-term liabilities are those debts to lenders, mortgage holders, and other creditors that will take more than one year to pay off.
Once a business has determined its assets and liabilities, it can determine owners’ equity, the book value of the business’s assets once all liabilities have been deducted. Owners’ equity, which is sometimes called stockholders’ equity, is in essence the net worth of the company.
Balance Sheet and Small Businesses
A comprehensive, accurate balance sheet can be a valuable tool for a small business owner or entrepreneur seeking to gain a full understanding of his or her operation. Studying current assets and current liabilities, for instance, can reveal significant information about a company’s short-term strength. If current liabilities exceed current assets, the business may have difficulty meeting its payment obligations within the year.
Some experts feel that in a well-run company, current assets should be approximately double current liabilities. Indeed, balance sheets, if produced on a monthly or quarterly basis and compared with earlier statements, can provide entrepreneurs and small business owners with valuable information on operating trends and areas of developing strengths or weakness.
By analyzing a succession of balance sheets and income statements, managers and owners can spot both problems and opportunities. For example, could the company make more profitable use of its assets? Does inventory turnover indicate the most efficient possible use of inventory in sales? How does the company’s administrative expense compare to that of its competition? The balance sheet can be an immensely useful aid in an analysis of a company’s overall financial picture.
Given a balance sheet’s value in providing an overview of a company’s financial standing at a given point in time, it is understandably one of the primary financial documents demanded by prospective lenders, investors, and business clients. Small business owners, then, need to recognize that the investment of time necessary in compiling balance sheets (which is minimal in most instances because of the proliferation of business software available on the market) is decidedly worthwhile.