Your income and cash flow statements detail your company’s activity over a specific period of time. Alternatively, your balance sheet details your financial position at a specific point in time. It tells investors how much you owe, own and have declared to your shareholders. This can be a powerful pool if you know its limitations.
The balance sheet reports assets, liabilities and equity in dollar amounts as of a specific day in the past. In accordance with Generally Accepted Accounting Principles (GAAP), assets are typically recorded at or below cost. Common categories include accounts receivable, cash, inventory, land and equipment. Notes payable, accounts payable and unearned revenue are liability accounts or existing obligations. Finally, stockholders equity reports the book value of shareholders’ interest and is the difference between your total assets and total liabilities.
What the Balance Sheet Tells You
At its core, the balance sheet reflects the two-sided accounting equation. As a business owner, you pay for what you own by either taking on liability or issuing stock. The equation must balance with every single transaction. Any excess revenue over liability goes right to the equity account.
- Leverage: A consolidated sheet lets you quickly calculate working capital when you divide your total debt by total equity. This shows how leveraged you are. Financing with debt is very common, but it doesn’t come without risk. In theory, highly leveraged companies carry more debt and thus more risk. If you buy an asset that neither appreciates nor generates income, you may experience a loss when your market shifts. On the flip side, risk can also multiply your profits.
Consider an airline where high fixed costs are constant regardless of passenger volume. Once ticket sales cover the cost to fly the plane, any surplus is easy revenue. History shows airlines thriving when oil prices are low and tanking to near bankruptcy when costs increase. If you’re highly leveraged, you’re competing for a bigger payout, but you’re also at risk for a bigger loss. Conversely, low-leveraged companies tend to be more stable through change. Losses are small, but so are payouts.
- Liquidity: A classified balance sheet further categorizes your assets as long-term or short-term. Your receivables account is a highly liquid asset that can quickly convert to cash if needed. The acid-test ratio is a good way to gauge how you might respond to an event like an abrupt drop in sales. Divide your total liquid assets by your total current liabilities. A ratio lower than 1.0 might mean you’re unable to properly cover your current expenses. Or, it might not. Retail stores, for instance, rely on inventory. Wal-Mart has an acid-test ratio of 0.2, which is no indication that the company is in danger.
What the Balance Doesn’t Tell You
Of course, every statement has drawbacks. Here are two things that your balance sheet ignores:
- True value: Assets go on your books at historical cost. Therefore, the balance sheet ignores appreciation and may not reflect current market value.
- Non-monetary assets: Your balance sheet records only those assets that you acquire in transactions. Perhaps you buy out a successful competitor for $10,000. Net assets total $4,000. The $6,000 excess that you paid for the name is called goodwill. While it’s recorded as a number, it may bear no connection to the actual market value of the purchase. Likewise, assume you’ve built up a talented team of loyal contractors. This creates definite value for your company, yet it goes unrecorded. Other intangible assets, including brand names, reputation and customer loyalty are also ignored.
The balance sheet is a necessary tool for any small business owner, but every industry is unique. Just remember to analyze all of your statements collectively. This gives you a clearer view of your financial position and your ability to adapt to change.
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