Uncovering Business Health With the Balance Sheet

A balance sheet makes you smarter about where you stand as a business. It prepares you for wisely choosing your next moves. The direction you take and the initiatives you implement are highly dependent on what’s happened in the recent past. That information is rooted in the balance sheet of your business.

The balance sheet is an important financial tool for business ventures of any size. Operators of small enterprises frequently overlook it, usually because they don’t understand the report or believe it reveals nothing about profitability. This belief is entirely remote from reality.

Why It’s Important

The balance sheet represents the overall status of your business. It presents warning signs of problems that don’t appear on a P&L, which is merely a statement of revenue and expenses. Lenders are keenly aware of this and closely examine a potential borrower’s balance sheet.

A most important use of the balance sheet is that it reveals bookkeeping mistakes. Using accounting software – like QuickBooks – does not automatically assure accurate financial records. Among the possible problems are incorrect inventory, overstated customer invoices, and understated vendor bills. Any of these issues result in glaring errors on the balance sheet that produce prodigious contortions of profit stated on the P&L.

What It Conveys

Balance sheets are snapshots of account balances on given dates, such as month-end or year-end. The three sections are (1) what you own (assets), (2) what you owe (liabilities), and (3) the difference between these two – which is your business net worth (equity).

The asset section begins with current assets – cash or assets easily converted to cash, such as accounts receivable and inventory, but also employee advances and similar amounts incoming in the short-term. Each current asset account should reconcile to a financial institution statement or other corroborating record.

Fixed assets are items with a useful life beyond one year and more than nominal cost – equipment, furniture, computers, leasehold improvements, etc. The balance in each fixed asset account is your original cost for acquiring the assets in that category. Accumulated Depreciation is a negative fixed asset account where your original cost eventually ends up as it’s expensed over time.

Liabilities are current – due in less than one year – or long-term. Accounts payable, payroll taxes accrued but not yet remitted, credit card balances, and sales tax collected but not yet paid are examples of current liabilities. Long-term liabilities are loans payable in more than a year. Each account balance should match other records – payroll reports, credit card statements, lender summaries.

The equity section shows sources of funds that make total assets differ from total liabilities. Types of equity accounts depend on whether the business is a corporation, partnership, or proprietorship. The most common reason for unequal asset and liability balances is the accumulation of business profits, which appear in the Retained Earnings equity account. Current year profit is separately indicated, which matches the bottom line of the P&L. Other supplies of equity are capital from shareholders, partners, or a sole owner. Because healthy businesses are profitable, they have plenty of equity. Thus making balance sheets a destination for knowledge about business health.

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