Best Bookkeeping Practices: How To Read & Understand A Balance Sheet
by Dan Wywrot, on Jun 2, 2016
When it comes to managing business finances, the crowd favorite is typically the income statement. How much money are we making? What are my margins? How does last month compare to the month before it? The income statement gets all of the immediate attention but sitting quietly in an Excel tab next to it is the underappreciated balance sheet. You might think it’s not vital to your business, but why then are investors and banks always asking for it?
Your balance sheet is a report that shows your assets, liabilities, and equity as a snapshot in time. On it, you’ll find how much your company owns, owes, and where the equity and retained earnings lie at that moment. This report balances based on the formula: Assets = Liabilities + Equity. Determining the financial stability and strength of a company starts with its balance sheet and an accurate balance sheet starts with good accounting. Here are a few reasons why you should keep an eye on your balance sheet.
Not every dollar you spend or collect goes on your income statement
You rely on more than income to fund your business. Partner contributions and distributions, capital injections from investors or banks, and conversions from notes to equity are all recorded on your balance sheet - and only your balance sheet. Other common balance sheet items include capitalization of computer equipment, furniture and fixtures, and lines of credit (LOC) or debt, all of which impact your P&L over time by way of depreciation or interest expense.
Is your money even yours?
Let’s move down to the sometimes frightening section of the balance sheet: the liabilities. Investors’ eyes are drawn to your liabilities to find what (and who) you owe in outstanding bills (accounts payable), whether you received capital by a line of credit from a bank or other financial institution, and who else has invested in the form of convertible notes (for those curious, convertible notes sit in the liabilities section prior to conversion, and in the equity section typically as common stock post-conversion).
Judging your liquidity
So you have a lot of cash. Great! Cash is king, but let’s run a “Quick Ratio” to determine how well a company is prepared to fulfill its short-term financial liabilities. This can be done by subtracting your current liabilities from current assets. Now how do things look? Hopefully, the number is still very positive. While “current” may have varying timeframes in society, on a financial statement it means assets that can be converted to cash within 1 year, or liabilities that are due within 1 year. Investors want to know how much is leftover (if anything) after all money owed is paid off.
What was your net income?
Have you ever wondered the connection between the balance sheet and income statement? Down at the bottom of your balance sheet you’ll see a line item called “Current Year Earnings”, or more likely “Net Income”. This is your year-to-date (YTD) net income, and the period over period difference represents how much net income you made (or lost) during those two dates. Any bottom-line change to your income statement will affect your balance sheet. You booked revenue when you collected cash - cash increases, net income increases (it balances!). Maybe you booked revenue but haven’t collected it yet -accounts receivable increases, net income increases. You buy coffee for the team on your company credit card -liabilities increase, net income decreases.Always keep in mind that your balance sheet is a moment in time. You never sum your balance sheet horizontally, but rather judge all balances for what they are in each column. The movement in any balance sheet account period to period is the difference between one column (time period) and the one immediately before or after it.