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Updated: February 16, 2023
According to CPA Practice Advisor, a whopping 57% of small business owners have less than $5,000 cash on hand for unforeseeable — or unavoidable — expenses that can arise during the year. This can pose a big financial risk to businesses, but the good news is that a few operational changes can help you make sure you’re prepared. Keeping track of your assets, liabilities, and equity can go a long way to ensure money is set aside should you need to address any financial surprises that might rear their head. That’s where a well-thought-out balance sheet can be a difference maker because it captures a snapshot of your company’s financial health, based on its assets, liabilities, and equity.
Moreover, having a better understanding of these numbers allows you to see any budget discrepancies and make better fiscal decisions for your company. In this guide for business owners, we’ll get into the details on what you need to know about balance sheets, the difference between assets and liabilities, and some common myths surrounding these aspects of running a company.
To begin with, a balance sheet shows what your business owns (assets), what it owes to others (liabilities), and your stake in the business (equity). It all adds up to the bigger picture of your company’s financial health, says Logan Allec, a CPA and owner of tax resolution firm Choice Tax Relief with over 10 years of experience working with small businesses. “Keeping an accurate balance sheet is critical,” he says. “You need one so you can see the state of your business at a glance and make informed decisions.”
On a balance sheet, assets are listed in the left-hand column while liabilities and equity form the right-hand column. To see how the numbers typically come together on a balance sheet, check out the example below:
In a nutshell, assets always equal liabilities plus equity — a concept that is commonly referred to as the basic accounting equation and forms the basis of modern bookkeeping and accounting.
It can help to think of it as a simple math problem: your business’s resources (assets) equal what it’s borrowed from others (liabilities) plus what you’ve put into the business (equity).
This formula is frequently turned around by business owners — and their accountants — to say that assets minus liabilities equals equity.
This is mathematically equivalent to the basic accounting equation and another way to think about the numbers. What your business owns (assets) minus what it owes (liabilities) equals your value in the business (equity).
Keeping all of these figures up-to-date can also make a difference during tax season. Logan Allec offered some additional insight: “Without an up-to-date balance sheet, you may not be able to prepare your business’s annual income tax returns accurately. Many businesses (though not all) are required to report their balance sheet on Schedule L of their tax return.” So thorough recordkeeping could prevent Uncle Sam from paying you an unwanted visit.
Now let’s turn our attention to the common financial terms that appear on a balance sheet and have a lot to do with your company’s bottom line.
Without an accurate balance sheet, fraud is more difficult to detect since you’re not keeping track of various accounts that are common targets for fraud, such as cash and accounts receivable.
Assets are your company’s resources, and they include anything that can help your business generate value or meet its obligations. Assets come in two broad categories, and these are commonly referred to as current and long-term.
As you get more familiar with the concept of assets, there’s a simple rule to follow: Anything you expect to convert into cash within a year is classified as a current asset. Some examples include:
On the other hand, assets you’ll likely not convert into cash within a year are commonly referred to as long-term assets, such as:
Next, let’s talk about some scenarios when a business owner might have liabilities: financial obligations to suppliers and service providers.
Liabilities include anything (such as debts) your business owes to suppliers, banks, employees, customers, or anyone else you acquire goods and services from to keep operations running regularly. When preparing a balance sheet, it’s a good idea to distinguish between current and long-term liabilities, which have some differences.
For example, liabilities due within a year count as short-term liabilities. Some common short-term liabilities you’ll come across when running a business include:
Liabilities due after more than a year — called long-term liabilities — include:
Now that we covered some of the ins and outs of how financial obligations line up on a balance sheet, let’s talk a little bit about equity.
Equity represents an owner’s stake in their business. Funds owners put into the business, such as common stock (for a corporation) and partnership contributions (for a partnership), count as equity. This section also includes the accumulated profits of the business, which are called retained earnings. Any funds taken out of the business, such as dividends and partnerships, also affect the owner’s equity.
With an understanding of how assets, liabilities, and equity work together (and some balance sheet fundamentals under our belts), next, we’ll cover how they make a difference to a business’s bottom line.
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The main reason it’s so important to accurately account for assets and liabilities on a balance sheet is because it shows a company’s liquidity and solvency — and both are key measures of financial security. Simply put, liquidity means your company is going to be able to pay its bills within the next year — and your short-term assets and liabilities are a big influence on liquidity. So, what are businesses losing out on if they are not paying attention to each? Again we tapped CPA Logan Allec for his insights.
“The data should help you discern year-over-year trends. Ideally, a business’s assets should be increasing at a faster pace than its liabilities. In addition, you should keep track of upcoming payments due: If you’re not keeping track of your liabilities, it’s difficult to forecast future payable needs.”
Here are some additional examples from Allec of what else a business could lose sight of by not paying close attention to the dollars and cents.
The balance sheet also allows you to calculate several important liquidity ratios, including:
Solvency measures your company’s ability to pay its obligations over a long period of time because it has more assets than debt. Some solvency ratios require an income statement, but the balance sheet alone allows you to calculate the following:
We’ve covered a lot of ground, but before we wrap up we’ll highlight some pieces of fact — and fiction — about assets and liabilities that business owners sometimes mix up.
After you’ve finished reading about assets and liabilities, learn about the key differences between invoices vs. receipts and why they’re important for cash flow and collections.
At the end of day, you need a balance sheet so you can see the state of your business and make informed decisions. As we wrap up, CPA Logan Allec has some final words on the subject.
“Simply put, you want to understand what your business owns and what it owes. Relying on your memory or random notes is problematic for a host of reasons.”
While there is no shortage of things for a business owner to keep track of, keeping close tabs on assets and liabilities is a critical step in keeping your business prepared for the future. You will not only have a better understanding of your spending, but you will also feel empowered to make more proactive rather than reactive decisions.
Please note all material in this article is for educational purposes only and does not constitute tax or legal advice. You should always contact a qualified tax, legal or financial professional, in your area for comprehensive tax or legal advice.