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 ...
We’ll begin with the basics of reading and understanding this financial statement.
Then, in a separate article, we’ll go beyond the basics to ratio analysis which uncovers interesting stuff about your business like how:
and more …
Let the fun start now ... as you discover the relationships between the numbers and begin to understand how they affect your business.
Tools for the Home Based Business Owner
Basic Sample Financial Statements
How To Read Your
How To Read Your
How To Read Your
It shows you:
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.
What you own - (What you owe + Your capital contributions
+ Cumulative profits since inception) = Zero
Restated in accounting language
Assets - (Liabilities + Owner’s Equity) = Zero
or you could rearrange it like this
Assets - Liabilities = Owner’s Equity
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
Source of Assets = Debts + Capital Investments + Reinvested Profits
or we could say
Source of Assets = Someone else's cash + Your cash + The business's cash
I can see you thinking ... What's my point?
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.
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.
Just so you know ... Canada revised / updated their GAAP (Generally Accepted Accounting Principles) to IFRS (International Financial Reporting Standards) and ASPE (Accounting Standards for Private Enterprise) in January 2011. Effective January 2012, there is also a standard for not-for-profit organizations. I am not up on the new IFRS reporting standards, except for a few articles I've read, as they don't affect my clients.
With the "new" IFRS balance sheet, you will no longer be able to see at a glance if it balances ... it is my understanding that it changed to look like this:
Operating assets, net
Net Business Assets
Net Financing Assets
Source: Knowledge Plus Business Training and Consulting
These new reporting changes 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 keep up to date on annual changes to ASPE on their web page Standards for Private Enterprises.
The CICA website also has a great resource page dedicated to ASPE. You'll find it at www.cica.ca/privateenterprises/resources.I find their information much more user friendly than the AcSB website.
The standards were released in December, 2009 and went into effect January 1, 2011. As a result, you will find notes throughout this site whenever the new standards affect your financial reporting system.
Now that we've covered why balance sheets can look differently from one business to another, we'll briefly review each component of the balance sheet then move on to the ratio analysis.
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:
There are five basic categories of assets however the three main categories that probably affect your business are ...
Capital Assets (Fixed Assets or Capital Outlays)
Current assets list things the business owns that are liquid (can be turned into ready cash within one year). This would include:
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 was modified with the new Accounting Standards for Private Enterprise (effective in 2011) which moved 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.
For most small businesses without investors, using historical cost is the easiest method to use. Unless there is a valid reason to switch to the current valuation method, stick with historical cost reporting.
continued from above
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
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. (Since the repair regs came into effect in 2014 in the U.S. this amount is generally $200.)
If you take a close 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:
You will also find in this section (if applicable):
Accounts payable are created when you purchase goods and/or services on credit ... meaning your supplier allowed you to take the item without paying for it at the time of purchase.
As noted above, the accounts payable account is found in the current liability section of the balance sheet. To locate Accounts Payable on your Trial Balance, you need to become familiar with your Chart of Accounts, as it is your blueprint to your accounting system. If you can't find Accounts Payable in your chart of accounts, it may be called Trade Payables.
Accounts Payable is not part of the income statement. However, when you initially book your account payable (you buy supplies or services on credit), your purchase may show as an expense on your income statement. I say "may" because if you purchased a capital asset, the expenditure will not show up on your income statement.
A good practice to get into is to use your Aged Accounts Payable Report to help you manage your cash flow.
Long term liabilities are debts you owe that have a life longer than one year such as:
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.
How to account for your business loan proceeds can be found in the article How to Record Common Bookkeeping Entries.
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.
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?
You'll like my "cheat" table which should unscramble the confusion for you. But first ...
Every accounting transaction you see on your balance sheet and income statement 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,
Every time you prepare a transaction, figure out what you received (debit) and where it came from (credit).
So following that logic, we now know that assets would normally have a debit balance as they are things we have like the computer.
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:
What was received
Where it came from
|Debit (+)||Assets||Increases Account||Decreases Account|
|Credit (-)||Liabilities||Decreases Account||Increases Account|
|Credit (-)||Equity||Decreases Account||Increases Account|
|Credit (-)||Sales Revenue||Decreases Account||Increases Account|
|Debit (+)||Expenses||Increases Account||Decreases Account|
*Examples of where various items belong:
Before you go, why don't you test your balance sheet knowledge.