How To Read The Balance Sheet
For The Work From Home Business Owner

The balance sheet reveals your business finances! So careful who you show it to.

Do you ever feel confused about the balance sheet? You are soooooo not alone! I hope your tea is hot because ...

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... this chat is going to be divided into two separate discussions:

We’ll begin with the basics of reading and understanding this financial statement.

Then we’ll go beyond the basics to ratio analysis which uncovers interesting stuff about your business like how:

• Liquid (ready cash) you are;
• To quickly measure long term operating results;
• Efficiently your business runs;
• Solvent (do you have too much debt) you are;

and more …

Let the fun start now ... as you discover the relationships between the numbers and begin to understand how they affect your business.

Balance Sheet Essentials

The balance sheet explains the financial health of your business and its future growth prospects.

• ... How much cash is in the bank;


• ... What your business owns;


• ... What your business owes;


• ... How much you have invested in your business; and


• ... How much money your business has made ... or lost ... since inception.

It reveals how your business finances its operations and what your business purchased with your financing. When we crunch a few numbers in the next section, some very interesting stuff is uncovered - such as how efficiently run your business is.

This report gets its name because all the accounts must sum to zero ... soooooo the sheet balances! Get It? Here's how it does it.

Restated in accounting language

or you could rearrange it like this

or perhaps like this

This means that the assets you have in your small business were obtained through any or all of three different sources:

(1) debt - someone else’s cash;
(2) capital contributions - your cash; or
(3) reinvested profits - the business’s cash.

If we put this into a formula, it would look like this

or we could say

What's Your Point Lake?

The idea I want you to see is that the balance sheet is relevant to you as a business owner. You can play around with the formula and rearrange it or rename the parts to something you remember and understand. It doesn't have to be in accounting language.

The balance sheet is usually presented in one of two formats.

In Canada, the balance sheet format lists each group directly under the other in the order shown.

Assets
Liabilities
Owner’s Capital

If you are a visual learner, this sample financial report of a very basic balance sheet may be helpful to you. You can get a look at what an actual balance sheet looks like ... just in case you have never seen one before.

Another format used in various parts of the world is listing Assets down the left hand side of the page and Liabilities and Owner's Capital down the right hand side.

Let's Chat About ...

Just so you know ... Canada switches from GAAP (Generally Accepted Accounting Principles) to IFRS (International Financial Reporting Standards) effective in 2011. I am not up on the new reporting standards except for a few articles I've read.

With the "new" balance sheet, you will no longer be able to see at a glance if it balances ... it is my understanding that it will change to look like this:

BUSINESS
Operating assets, net
Investing assets
Net Business Assets

FINANCING
Financing assets
Financing liabilities
Net Financing Assets

INCOME TAXES
DISCONTINUED OPERATIONS

NET ASSETS
EQUITY

Source: Knowledge Plus Business Training and Consulting

The new reporting changes will apply mostly to publicly traded companies or companies requiring international financing.

The Accounting Standards Board (AcSB) has developed a "made in Canada" financial reporting standards for private enterprises call Accounting Standards for Private Enterprise (ASPE). You can find out more information on their web page Strategic Planning - Private Enterprises.

The CICA website also has a great resource page dedicated to ASPE. You'll find it at www.cica.ca/privateenterprises/resources.

The goal was to release "final standards in time to permit their use for the calendar year-end 2009 financial statements". This goal was met as the standards were released in December, 2009.

As a result, you will find notes throughout this site whenever the new standards affect your financial reporting system.

We'll briefly review each component of the balance sheet then move on to the ratio analysis.

Timing - Remember This

When you look at the balance sheet, keep in mind that the information is for a specific date in time. Think of it just like a photograph of how your business looked at that moment in time ... a snapshot frozen in time.

The income statement is more like a video. It represents activity in your business over a particular period in time. The period varies and you have to read the heading to figure it out. It could be a month, a quarter, a year.

The results (whether you made a profit or loss for the period) of the income statement show up in the owner's equity section of the balance sheet.

This concept gets answered incorrectly most often in my accounting test. So here is a summary:

• Income statement - activity during a specific time period
  ... Balance sheet - value on a particular day
• Income statement - is like a video or a movie
  ... Balance sheet - is like a snapshot or a photograph.
• Income statement - calculates net profit or loss
  ... Balance sheet reports the profit or loss from the income statement in the Owner's Equity section.

There are five basic categories of assets however the three main categories that probably affect your business are ...

Current Assets
Capital Assets (Fixed Assets or Capital Outlays)
Other Assets

Current assets list things the business owns that are liquid (can be turned into ready cash within one year). This would include:

• cash in your bank account(s)
• petty cash
• any temporary investments
• your accounts receivable (money customers owe you)
• your inventory (recorded at cost not sales price), and
• any prepaid expenses such as insurance or rent.

continued below

If your record keeping isn’t up-to-date, where do you go to see if you have enough cash on hand? You certainly can’t be relying on your financial statements. You haven’t kept the information up-to-date.

I’m guessing your bank statement or online balance? Are you sure that’s an accurate account of your cash balance?

Ask yourself, "What information is missing when you look at your bank statement or online balance?"

It's easy to forget but ... what about those cheques you put in the mail yesterday or the online bill payment you setup to be paid at the end of the week? How about that bank deposit you have that hasn’t made it to the bank yet? And this one is my own pet peeve, the person who deposits a cheque you wrote four months ago! They couldn’t get to the bank before then?

It is pretty important that you make time to balance your bank statement to your books monthly because every decision you are making is based on the cash you have on hand. A monthly bank reconciliation is a good bookkeeping practice.

What is a bank reconciliation?

A bank reconciliation is simply the act of making sure your accounting ledger has recorded all the transactions (deposits and withdrawals) the bank has processed.

There is the possibility of charge backs (NSFs) and interest on lines of credit or demand loans that the bank could have processed on your account.

Don't forget the bank service charges have to be recorded in your ledger when the bank statement is received.

The purpose of reconciling the bank statement each month is to ensure you have caught and recorded all bank transactions in your ledger. If you find transactions that haven't been posted, then part of the reconciliation process is to post those transactions.

Even if you have the bookkeeper prepare the bank reconciliation, you as the owner need to review the bank reconciliation regularly to ensure fraud or embezzlement is not occurring ... not to mention checking that good bookkeeping practices are being followed by your bookkeeper.

By keeping tabs on your bank account balance showing on your balance sheet, you will have the confidence to know it is accurately reflecting your cash position and ...

... one of the things you are aiming for is to have accurate and timely financial statements from which you can make sound business decisions.

Then follow up with monthly statements if the account is outstanding. If you are using a bookkeeper, ask that it be part of the regular routine. I use QuickBooks software and it is very easy to go in and run statements to send out to customers.

Consider requesting a customer deposit. If you do receive customer deposits, learn how to book the entry correctly the first time in How to Record and Apply a Customer Deposit or Prepayment.

The sooner you get your cash, the less likely you are to run into cash flow problems.

You should perform an inventory count as close to the last day of your fiscal year-end as possible. If a portion of your inventory contains large dollar value items, you should try to do a quarterly inventory count on these items.

The bookkeeping entries to record after you have performed your inventory count are found in The Income Statement - You Want To Understand Profitability.

Let's Chat About ...

A basic principle in accounting is to generally (there are some exceptions) record purchases at their actual cost instead of their current market value. This eliminates guesswork and bias which leads us to an accounting constraint.

The constraint of conservatism states that accounting should be fair and reasonable. Some accounting entries require judgments, estimates, opinions and a choice of different methods of reporting. When making these decisions, try to never overstate or understate the transaction. Always lean towards the conservative choice.

The general rule is ... when you are uncertain about two choices of values ... book the entry that records the lesser asset amount and/or the lesser profit amount.

Please note: In Canada, the cost principle will be modified with the new Accounting Standards for Private Enterprise (effective in 2011) which moves in part towards International Financial Reporting Standards (IFRS) ... which is either historical cost or current valuation (IFRS IAS 16).

Under IFRS rules, revaluation to the current value is used when the fair value can be measured reliably ... and revaluations on method, useful life and residual value are reviewed annually. See GAAP Updates for more information on the new standard for the booking of temporary investments and plant, property and equipment. The U.S moves towards this standard in 1014.

Capital assets are things you own that have a life longer than one year such as your tools, equipment, office furniture, computers and computer software. It can also include land (and improvements), buildings and vehicles.

You will also see capital assets referred to as Fixed Assets. (Read about why here.)

Formally on the balance sheet, they are usually referred to as Plant, Property, and Equipment (PPE).

As a general rule, if the capital outlay (fixed asset) is under $500, you can expense it instead of capitalizing it.

If you look at your chart of accounts, you will probably also see accounts in the capital asset section called amortization.

The amortization accounts are used to allocate a portion of the original cost of your capital outlay to your expenses on the income statement. We'll talk more about this account when we look at the income statement.

For our purposes here, and to keep it simple, other assets is going to include anything else you own that doesn't fit into current assets or capital assets.

For our purposes, there are two basic categories of liabilities that affect your business. They are ...

Current (Short Term) Liabilities
Long Term Liabilities

Current liabilities list debts the business owes that are due and payable within one year. This would include:

• bank overdrafts
• credit card balances
• lines of credit
• accounts payable (money owed to others like your suppliers)
• payroll payable
• most types of taxes payable, including HST/GST Payable and income tax payable
• dividends payable, and
• customer deposits

You will also find in this section (if applicable):

• accrued liabilities, and
• the current portion of your long term debt

Long term liabilities are debts you owe that have a life longer than one year such as:

• bank loans
• capital lease obligations
• money due to related parties

Let's Chat About ...

When entering a loan payment to the books, always remember that only the principle portion gets booked to the loan account (on the balance sheet). The interest portion of the payment is expensed (on the income statement).

The entry looks like this:

Debit Bank Loan - principal only (on balance sheet under long term liabilities see The Bookkeeper's Tip below)

Debit Interest Expense (on the income statement)

   Credit Cash in Bank (on balance sheet under current assets)

The bank will be more than happy to provide you with an amortization (depreciation) schedule … or you can run your own. It will show you the split between your principal and interest expense.

If you get a monthly statement, you could reconcile the account to the statement each month. It is a good bookkeeping practice to verify any of your balance sheet account balances to third party sources.

Each year end, you will look at your loan statement for the year (you may have to request a copy) and make any needed adjustments to the loan balance ... booking the difference to interest expense.

The Bookkeeper's Tip - Each year-end, your accountant will make an adjusting entry for the current portion of your long term debt. The adjusting entry reclassifies the amount of principle due in the coming year to a current liability account. You don't need to concern yourself with this entry or this account during the year except when you are balancing your loan to the banks records. You will need to remember to add the current liability account and the long term liability account together when balancing your loan balance. Book the principal portion of all your loan payments during the year to the long term liability account.

How to account for your business loan proceeds can be found in the article How to Record Common Bookkeeping Entries.

The package contains 80 forms developed by a CPA / MBA. The section on depreciation includes worksheets for straight line, double declining balance, sum of the years' digits and units of activity methods along with instructions on how to use an amortization schedule to book your current portion of long term debt. You will receive:

• Depreciation and amortization worksheets
• Financial ratio and analysis worksheets
• Break even, contribution margin and cost-volume-profit worksheets
• Financial statement worksheets
• General business forms

This package saves you the time from creating these worksheets yourself. It will reduce the likelihood of a calculation logic error (but not necessarily clerical errors). Click here to view more details.

----Equity--
The owner’s investment in the business -- The business’ cash -- Source of funds to purchase assets for the business

In this section of the balance sheet, you will find your cash investment in the business (Owner’s Equity) along with your owner's draws, and current year net income or loss.

Owner’s equity is also referred to as owner’s investment or owner’s capital. Have you noticed I've been switching the terminology? When you see any one of these terms on a balance sheet, you know the business in not incorporated. It will be a sole proprietorship or a partnership.

If the business is incorporated, this section of the balance sheet would contain a line for share or stock capital and for retained earnings.

Professionally prepared financial statements normally have just one line showing called Owner’s Capital. All the categories discussed above still exist in separate accounts in their general ledger. However, for financial reporting purposes, they have consolidated the accounts into one line.

It is also worth noting that the net income (loss) amount reported should match the net income (loss) on the income statement.

I'll chat a bit more on this section of the balance sheet during the Income Statement discussion coming up shortly.

What I'd like to mention right now is that equity means how much you have invested in your business. But don't confuse it with the worth of your business. ... Why?

Remember the cost principle says to record assets at the original cost (in most cases). This means that you cannot look at the equity section of your balance sheet and think that is how much your business is worth.

To do a very rough determination of the current worth of your business, you would have to adjust your assets to their market value. That would give you a better idea of your business' worth.

However, to determine the real value of your business, you will have to factor in growth potential, quality of your assets, your market position ... just as an example.

The point I really wanted to make is that your equity does not represent the worth of your business.

This concludes the first discussion on the balance sheet. Before we move on to ratio analysis, we’ll look at the income statement.

I know, I know. I said earlier we'd do ratio analysis next but ... I've changed my mind! You get to do stuff like that when it's your own website. :O)

However, before we do that, I thought I’d take a sec to see if you are ...

… confused about all the debits and credits being thrown around?

Every accounting transaction must have a debit and a credit. It’s why you will sometimes hear it referred to as double entry accounting.

It can be confusing because while every account can have a debit or credit posted to it, different types of accounts normally have a debit or credit balance. Clear as mud right?

I really like the way Jack Sands, retired CA and CPA explains debits and credits. He says,

• Debits are what you received or what you bought (assets or expenses).


• Credits are where the money came from or what you gave (liabilities, ownership, revenues).

Expenses are also debit balances because you received something whether it was phone service or photocopy paper.

Liabilities and equity would normally have a credit balance as this is where the money came from to purchase the things we have.

Sales revenue would also have a credit balance because you received cash (the debit side of the transaction) in exchange for a product or service (the where side of the transaction, in this case what you gave or sold).

Once we have that figured out, the following must be true:

Tutors like feedback. :O)

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