How to Understand Your Balance Sheet
If you can’t read your balance sheet you don’t know the health of your business
One of the biggest mistakes a lot of small business leaders make is ignoring their balance sheet. For some silly reason, they think that it’s irrelevant or something only their accountant needs to understand.
Unfortunately, when it comes to the balance sheet, ignorance is far from bliss. In fact, it’s bloody irresponsible and can get the company - and its directors in particular - in some very hot water.
But the balance sheet is also a very powerful source of information and therefore even more important that it’s understood.
Balance sheet 101
Being forever the optimist, I’m betting there’s a lot of small businesses out there who actually want to understand their balance sheet – it’s just they’ve never got round to it.
This post is therefore my stab at helping a few of those folks break through the barrier of ignorance and get a good handle on their balance sheet.
What actually is the balance sheet and why does it matter?
The balance sheet (sometimes referred to as the Statement of Financial Position) reveals the financial health of a company, at a particular point of time.
So, unlike the Profit & Loss (P&L) which looks at your historic revenue and cost performance over a period of time, your balance sheet is all about the here and now.
And whilst many see the P&L as more interesting, there is no doubt that the balance sheet is more important.
Fundamentally, the balance sheet is measuring the current health of your business and how much stress it’s under. It is also vital in determining the company’s capacity to deal with change and take on even more risk. Now call me old-fashioned but that sounds pretty important to me – especially if you own and/or run that business!
To get a better understanding of its importance, let’s consider the following statement…
Just because you once ran a marathon in under 3 hours, doesn’t mean you’re healthy today.
Hopefully you get the point - that your past fitness doesn’t determine your current health. And so the same is true in business – just because your P&L has historically been strong, doesn’t mean your company (as evidenced by your balance sheet) is currently in good shape. Sure, the two things are somewhat related but, just like individuals, once-fit and healthy businesses can go down the old gurgler quicker than we like to believe.
Understanding your balance sheet
OK, now for some good news … all balance sheets are basically the same. So look at any balance sheet and you’ll see it’s made up of 3 main components: Assets, Liabilities and Equity.
And the even better news … as its name suggests, a balance sheet always balances!
Here’s the formula:
Assets = Liabilities + Equity
Now let’s work through a simple example and we’ll see why the above formula makes perfect sense.
Let's buy a house
If you’ve ever applied for a mortgage, chances are you were asked for a bunch of information related to your personal finances. And whilst you might not have realised it at the time, essentially what you gave the bank were the items that make up your personal Profit & Loss and (more importantly to the bank) your Balance Sheet (i.e. your assets, liabilities and equity).
It is this information the bank needs to determine your risk profile and therefore your ability to repay that big slug of money you’re asking them for.
OK, so let’s say you want to buy a house for $500k (clearly not in Auckland!) and you’ve got $100k of savings that you’re going to use to partially fund it. So you go to the bank, fill in all those horrible forms and, hey presto, they approve a $400k loan.
Now what does your balance sheet look like after you’ve purchased the house?
Easy. Your assets are now represented by the value of the property – in this case, $500k. However your liabilities – the amount you owe someone else – have shot up from zero to $400k. And in terms of equity, because you put down a cash deposit, you’ve got $100k of equity in your new home.
See, I told you it was easy: Assets ($500k) = Liabilities ($400k) + Equity ($100k).
Assets, liabilities & equity – that’s all there is
Chances are your balance sheet looks a little busier than the above example but, again, there’s nothing to fear because each line is either an asset, liability or equity item.
Let’s take a look at these items in a bit more detail…
Assets – the value of things you own or can use
Before we get into the nitty gritty, let me quickly explain why above I’ve described assets as things you own or can use.
Contrary to popular belief, your assets aren’t necessarily the things you own. Sure, you might own most of them but what goes on the balance sheet is the value of the assets you have a legal right to use. It may seem a trivial point but think about the house you bought earlier. Legally, when you took out the mortgage, you transferred the title of the property to the bank but you retained the right to use it. And that’s why the asset value on the balance sheet is $500k.
This is an important enough concept to repeat: financial ownership doesn’t matter. If something is in possession of a company, it’s considered an asset.
Now that key point is clear, let’s look at some specific asset examples.
Of course, most people have a good understanding of some basic asset types – things like cash, office equipment (computers, chairs, etc.) and stock. But what else might we typically see? The best way to answer that question is to look at how assets are categorised.
Current vs. Fixed Assets
When you look at the assets section of your balance sheet you’ll no doubt see it split between current and fixed assets.
All this is doing is helping to differentiate between those assets that can be turned into cash within a year (i.e. current assets) and those that can’t (i.e. fixed assets).
Of course some of your current assets – like money in the bank – may already be cash but others will take a little bit of time to convert to cash. Obvious examples here are your debtors (i.e. accounts receivables) and any inventory you’re carrying (so not quite cash but relatively easy to convert).
Fixed assets on the other hand – things like machinery and buildings - are non-current as they can’t be turned into cash easily.
Further, you’ll often see fixed assets that are intangible – things like goodwill and patents. While these assets are not physical in nature, they are often the most valuable and should therefore be included on the balance sheet.
Next, because the value of your assets will change (typically reduce) over time, you’ll often see line items on the balance sheet that are reducing the asset’s original value. The obvious one here is depreciation which has the effect of reducing an asset’s value over time so, in theory at least, it is never over- or under-stated.
And that’s about it for assets, except to mention that any asset costing less than $500 shouldn’t find its way onto your balance sheet. Instead it should be expensed to the P&L immediately.
Liabilities – the value of your debts and obligations
The next section of your balance sheet captures the financial obligations your company has to other parties. Examples of liabilities are accounts payable, accrued expenses, wages payable and taxes. These obligations are eventually settled through the transfer of cash or other assets to the other party.
And just like assets, your liabilities should be split between current and long-term.
Current liabilities are those obligations that will come due, or must be paid, within one year. This includes both shorter term borrowings, such as credit card balances and accounts payables, along with the current portion of longer term borrowings. For example, consider the $400k mortgage we discussed earlier where a portion of it would be recorded as a current liability (to cover those payments due in the next 12 months).
Long-term liabilities are debts and other non-debt financial obligations, which are due after a period of at least one year from the date of the balance sheet. Typical examples are long-term loans and debentures, etc.
Equity – your net worth
And so we come to the third and final section of the balance sheet – equity.
With your assets and liabilities hopefully now making more sense (and not forgetting the magic formula we learnt earlier) getting a handle on your equity is easy.
As we saw with our simple example earlier, the equity value was the portion of the property that you own free and clear. And so the same is true in business – equity is the value of all your assets after you’ve paid off all your financial obligations. That’s why equity is also known as net worth, even though it may bear very little resemblance to what your business is actually worth (but that’s another story!)
Now in order for a business to have any equity, it must have come from somewhere in the first place, i.e. it must have been introduced or the business actually generated it. And that’s where we see the typical equity line items like: shareholders’ funds introduced and earnings (which is just another way of saying profit after tax).
But let’s say you then decide to distribute some of those profits to the shareholders. In this case the dividend paid is money being taken out of the company and will therefore reduce total equity.
So another way of defining equity is that it’s the net amount of funds invested in a business by its owners, plus any retained earnings.
Hopefully you’ve now got a better understanding of how the balance sheet works and why it’s important.
However, if you’re hungry for more, please look out for a future post where I’ll explain how you can really use your balance sheet to make better, faster business decisions.
In the meantime, if you’ve got any questions, please don't hesitate to contact us direct.