Financial Statements 101: Your Current Position Reflected in the Balance Sheet
28 November 2016
This is part 1 of a 3-part series on financial statements. Please stay tuned for the remaining posts.
The balance sheet is one of three major financial statements in which is used as a tool by business owner’s to review their financial position and health of their company (The other two statements: Income statement; and Statement of Cash Flows). A balance sheet summarizes a company's assets, liabilities and owner’s equity at a specific point in time, such as year or quarter end. The balance sheet may also be referred to as a Statement of Financial Position- because it provides a snapshot of your assets and liabilities at a single point in time.
The balance sheet gets is name for a very simple reason: a balance sheet MUST balance. In essence, the balance sheet is set up as an equation: Assets = Liabilities + Owner’s Equity. Assets must equal liabilities + equity; if the three balance sheet segments do not equal, there is a problem with the balance sheet. It may seem easy, but the devil is in the details.
To simply put: a company has to pay for all the things it owns (assets) by either borrowing money (taking on debt/liabilities) or taking it from investors (issuing or obtaining equity).
In greater detail below, we discuss the assets, liabilities and owner’s equity of a business and how they are presented on the balance sheet. These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by shareholders.
Assets are goods or items that the company owns. Whether tangible or not, assets are the resources of the company that have been acquired through transactions, and have future economic value that can be measured and expressed in dollars. On a balance sheet, assets are typically presented in order of liquidity: cash, marketable securities and accounts receivable will be listed first, followed by assets which are less liquid, like equipment and buildings owned by the business. Depending on the objective for the balance sheet, the creator of the financial statement may also use sub categories for assets, such as current and non-current assets.
As previously noted, the devil in the details- for assets such as accumulated depreciation and accounting for prepaid liabilities (which are actually an asset), it’s best to discuss these complexities of your financials with your accountant to make sure you are presenting all of your assets correctly.
On the other side of the equation, a liability is a company's financial debt or obligation that materialized from business operations. Liabilities can be thought of as a source of the company's assets. A sure and easy way to identify a liability is if an account title is labeled as a “payable”, such as: notes payable, accounts payable, interest payable etc.
Businesses sort their liabilities into two categories on the balance sheet: current and long-term. Current liabilities are debts payable within one year, while long term liabilities are debts payable more than one year.
The devil in the detail for liabilities: Loan amortizations can cause many financial woes for a business owner when constructing their balance sheet. A common mistake is to reduce your loan balance on the balance sheet by your monthly payment amount; however there are two transactions. Only a portion of each loan payment will go toward the principal of the loan and the rest will go to interest. Your interest will only show up on your income statement and cash flow statement, not the balance sheet.
Lastly, Owner’s Equity—along with liabilities—can be thought of as a source of the company's assets. When sourcing a company's assets, the company can make a decision to finance via a loan (liability) or thorough the owners (Owners equity). Equity accounts track owners’ contributions to the business as well as their share of ownership. Owner's equity is also referred to as the book value of the company, because owner's equity is equal to the reported asset amounts minus the reported liability amounts (everything that is left over after liquidation).
Owner's equity can look very different across various structures of business. A sole proprietorships’ owner’s equity will look much different than a C or S Corp. For a corporation, ownership is tracked by the sale of individual shares of stock because each stockholder owns a portion of the business. In smaller companies, equity is tracked using Capital and Drawing Accounts.
The devil in the detail for Owner’s Equity: Non-accounting professionals have a difficult time in understanding the Owner’s Equity section of the balance sheet, especially fully understanding the dreaded retained earnings line item. Retained earnings of a corporation is the accumulated net income of the corporation that is retained by the corporation at a particular point of time, such as at the end of the reporting period. A common misconception about retained earnings is that it is a “catch all” or “slush bucket” to balance the books at year end; this is improper bookkeeping and will provide an inaccurate picture to your firm's financial position. Contact your accountant to fully understand the proper details within your balance sheet.
This article is brought to you by GMAC Accounting, LLC, a full service cloud accounting and bookkeeping firm. With over 30 years of experience in the business of banking, accounting and project management, GMAC assists small and mid-sized businesses with all their financial needs. For more information on GMAC Accounting, please visit: www.GMACAccounting.com