Formulating a balance sheet: Assets, liabilities, and equity
Preparing balance sheets can help to attract investors and paint a clear picture of your small business financials.
The basic equation
A balance sheet represents the financial state of your business in an easy-to-digest format. It's often used as a report card of your company's value to help attract investors.
"The best way for [investors] to know how you’re going to treat their money is how you treat your money," says Emily Chase Smith, Esq., author of The Financially Savvy Entrepreneur. "It’s similar to the way a traditional mortgage lender looks at a credit report. An investor looks at your financial statements, including your balance sheet and your income statement, to see what's going on historically and what's going on right now."
The structure of a balance sheet is built around a basic financial accounting equation:
Assets minus Liabilities = Owner’s Equity
Here’s a breakdown of those terms as well as valuable tips, resources, and examples to help you create a snapshot of your business financials.
Assets: What's owned
Assets include the value of everything owned and what's owed to the business. Assets on a balance sheet are usually further split into current and non-current assets.
Current assets are cash and those items that are likely to become cash in one year or less. In other words, you'll likely recoup those assets in 12 months or less. Current assets include:
Cash: The dollars you have on hand or in a bank or other financial institution
Accounts receivable: What's owed to you by customers
Inventory: The value of products purchased by the business to be sold to purchasers
Notes receivable: Outstanding loans made by the company, typically represented by promissory notes from customers, employees, or officers of the business
For purposes of the balance sheet, assets will equal the sum of your current and non-current assets — less depreciation of those assets.
On the other side of the equation are your liabilities, both short- and long-term, which are the monetary obligations you owe to banks, creditors, and vendors. Short-term liabilities include accounts payable, such as short-term obligations accounts payable owed to vendors and creditors, and notes payable to others within the next 12 months. Long-term liabilities, due more than a year away, include a mortgage balance payable beyond the current year.
The last component of the balance sheet is owner's equity, sometimes referred to as net worth. This is your net investment in the company. It's equal to total assets minus total liabilities.
The financial statement should balance, showing assets equaling liabilities plus owner's equity.
Income statement: Profits minus losses
In addition to drafting a balance sheet, it's important to prepare an income statement. The income statement will show how well your company is currently performing. Each report presents income and expenses over a set period. Overhead expenses typically are comprised of many items, including utility bills and payroll.
"[Business owners] need to understand, in terms of an income statement, what that cash vision looks like today and what it looks like projecting out tomorrow and the next day," says Chase Smith. "[For example,] a restaurant owner has to go out and buy all [his or her] products, has to hire [his or her] staff, has [his or her] overhead in the building, and hasn't sold any food yet."
While all balance sheets follow the same equation, the types of accounts listed will vary based on the type of business. Product-based companies, such as retailers, sell goods to consumers and have expenses like inventory and real estate that are overhead. Service-based companies, like hair salons or law firms, on the other hand, sell services, not goods to customers, so they do not typically have inventory or raw products on the balance sheet. The method and time period in which payment is accepted may also change what's listed in the balance sheet.
"For example, a merchandising company may have an account payable to a wholesale company for the purchase of its products," writes Mallory Otis of Demand Media. "A service company may have a service revenue receivable account for expected payment for services already provided."
Timing your statements
Balance sheets are usually drafted at the end of accounting periods: monthly, quarterly, or yearly. Accurately analyze these financial statements for a clear picture of your cash flow.
"Business owners really need to understand how the balance sheet is reflecting what's actually going on in their business, because [it] can look a lot more rosy than what's going on cash-wise in the business," says Chase Smith. "Let's say you're in a product-based business and you sell to Costco. You may provide that product to Costco in January but not get paid for it until March." The balance sheet in isolation does not reflect this delay in the collection of cash. Profit and loss statements and cash flow statements therefore are key to obtaining a complete picture of your small business finances.
Balance sheets can be created with ease, even if you're not an accounting professional. The U.S. Small Business Administration (SBA) offers a free 30-minute "introduction to accounting" course. SCORE provides a downloadable balance sheet template listing the categories in the financial statement.
Bookkeepers and Certified Public Accountants (CPAs) also can be invaluable. Chase Smith recommends enlisting a bookkeeper for day-to-day accounting, but suggests tapping a CPA to prepare and analyze statements to help plan your financial future.