No accounting term generates more fear and confusion for business owners than the words “balance sheet.”
Most owners review their profit-and-loss statement regularly but only give their balance sheet a cursory and often confused look if they look at it at all.
A profit-and-loss statement shows income and expenses over a defined period of time. A balance sheet on the other hand shows a compilation of activity related to assets, liabilities and equity “as of” a certain date. A balance sheet is created by the first transaction recorded by a new business and includes virtually every transaction the business ever makes.
A balance sheet is comprised of three main sections: assets, liabilities and equity. Assets represent things owned by a business. They might range from cash to real estate. Assets are always put on the books at cost not value. Liabilities include vendor payables, loans and other items that represent what a business owes to others.
The final section of the balance sheet is equity. Equity represents the owner’s stake in a business. It represents the difference between what is owned and what is owed. A balance sheet always balances. Assets are equal to liabilities plus equity.
While the terminology and layout of balance sheets can be confusing, the information they can provide to business owners is of great value. All owners should learn how to measure and manage both the liquidity and leverage of their business by using their balance sheet.
The term liquidity refers to a business’s ability to cover its short-term financial obligations. Does it have enough cash to pay its bills and expenses? This can be determined by comparing the short-term assets to the short-term liabilities listed on a balance sheet.
These short-term assets include cash, checking, inventory and accounts receivable. In turn, short-term liabilities include vendor payables and upcoming debt payments. Be careful while reviewing these numbers as sometimes inventory cannot be quickly turned into cash.
The term leverage refers to an owner’s investment relative to the level of debt in the business. This relationship is often a good gauge of the risk of the business failing. Generally, highly leveraged businesses are more likely to fail than those that are not.
If you have to use much of your resources to pay back debt, you typically have less cash and flexibility to battle your competitors. This can be determined by comparing your debt and equity, both of which are found on your balance sheet. Lenders especially watch this number closely.
Next time you review your financials make it a point to look more closely at the balance sheet. Make it a point to analyze your liquidity and leverage. It should help you when making critical business decisions such as adding debt, conserving cash and purchasing inventory. Your ability to manage cash shortages and control debt levels will be greatly improved if you take the time to regularly review your balance sheet.
You will be glad you did.
David Lewis is the area director of the Brunswick office of the Georgia Small Business Development Center Network and he may be contacted at firstname.lastname@example.org.