The value of your balance sheet
The last issue began this series in which we sequenced the three most important financial documents for your business. We began with this writer stating that every business has a need for the three documents – a projectionary cashflow statement, a profit and loss statement, and a balance sheet. With the three articles in the series it was announced that the documents would be covered in a sequence with the least important coming first and the most important coming last.
The first article had the profit and loss statement as the first and least important document. In the opinion of this writer, the profit and loss statement was first because it was purely historical and because it covers such a brief period of time.
Our second most important document in the sequence is (surprise) the balance sheet. The balance sheet is selected as second most important document because of the advantage it has over a profit and loss statement. While the balance sheet is historical, just like the profit and loss statement, it provides additional information in that it tells you the likely hood of the business being able to continue going forward.
The balance sheet consists of not two, but three important components. Often thought of as a statement where the assets equal the liabilities, there is both accuracy and inaccuracy in that statement as one of the liabilities is the stockholder’s equity position in the ownership of the business.
Beginning with the top section of the balance sheet, we will first see the assets. This section lists everything the business owns, regardless of whether or not it has been paid for. The assets are divided into two sections – current and long term. The distinction is easy to explain. Assets that fit into the current category are those the business anticipates will be changed into cash within the next 365 days.
Current assets would include all funds in company checking accounts, the accounts receivable, inventory and other funds such as CDs and savings accounts.
The long term assets are the rest of the assets. Examples would be a building, fixtures, computers, vehicles and land. Assets can move between current and long term, but only if they fit within the definition of the 365 days.
Liabilities follow a similar definition in that they also have current and long term. Your liabilities are all those that you anticipate paying within the next 365 days. Liabilities have a difference in that some of them can be both current and long term. Perhaps your business has a loan for the building you occupy. If the loan is for 15 years, the total of principle payments (not principle and interest) for the next twelve months would be considered a current liability. The total of principle payments to be made after the next twelve months would be considered a long term liability.
A similar scenario could be made for payments on vehicles, a computer system, and even a note for buying the business from the previous owner could all have amounts in current liabilities and long term liabilities.
The liabilities have a section that we previously mentioned – the stockholder’s equity. Depending on how the ownership of the business is established for accounting purposes, there can be variations of how the numbers are arranged. As a generalization, there are three parts. The first is the money that the owner of the business put in when they first bought the business. This is sometimes referred to as initial capitalization.
The second part is called the current income. During the current year of the business, as a monthly profit and loss statement is created, the net profit moves into the current income. Over the course of a year, the current income would have twelve entries. At the end of the year, as the term ‘current’ comes to a close, the current income then moves into the retained earnings. ‘Retained earnings’ is exactly what the title implies; earnings of the business that the business continues to hold and has not paid to the owner.
Add these three together, - capitalization, current income and retained earnings – and you have the owner’s (or stockholder’s) equity in the business.
The assets, current and long term, are equal to the liabilities, current and long term, and the owner’s equity. The larger the owner’s equity the stronger the business is likely to be, because the liabilities to others constitute a smaller percentage.
In the next issue we will conclude the series by looking at a projectionary cashflow chart at which time we will explain why we think this is the most important financial document of a business.