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.
Balance sheet basics
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.
What is an asset?
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:
- Cash. This usually includes highly safe and liquid investments — called cash equivalents — like Treasury bills and bank CDs.
- Accounts receivable. These are the dollar amounts owed to you by customers. As we touch on above, if it’s going to be converted to cash within the year, they appear on this list.
- Inventory. Items that appear on this list include goods for sale, including finished goods, partly completed products, and raw materials.
- Prepaid expenses. Think of these as any expenses your business pays before receiving the benefit of what you’re paying for. For example, a lease paid for the full year on January 1st would have half its cost as a prepaid expense on a June 30th balance sheet.
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:
- Property, plant, and equipment. These are major physical assets with a long life span, other than inventory. Examples include machinery, vehicles, buildings, and land. These items are also commonly referred to as fixed assets.
- Intangible assets. Significant non-physical assets you’ll likely hold onto for the life of your business, such as patents and trademarks.
Next, let’s talk about some scenarios when a business owner might have liabilities: financial obligations to suppliers and service providers.
What are liabilities?
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:
- Accounts payable. These are the dollar amounts your company owes to suppliers.
- Accrued expenses. Expenses your business has already benefited from but not yet paid for. For instance, accrued wages include amounts due to employees for work already performed as of the balance sheet date.
- Current portion of long-term debt. Long-term debt is mostly a long-term liability, but any payments due within a year are current liabilities.
Liabilities due after more than a year — called long-term liabilities — include:
- Long-term debt, net of current portion. Examples include bonds and bank notes. The “net of current portion” means that the company subtracts the amount included in current liabilities because it falls due within a year.
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.
What is 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.
Why assets and liabilities matter
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.
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.
- Visibility into the business’s long-term growth trajectory
- Visibility into the business’s short-term obligations
- Visibility into the business’s attractiveness to outsiders — You may think your business is doing well but no one else does unless you can show a strong, growing, and accurate balance sheet. So it can impact how lenders view your business when seeking a loan — or to prospective buyers should you decide to sell your company.
The balance sheet also allows you to calculate several important liquidity ratios, including:
- Current ratio. To determine this number, you look at your current assets divided by current liabilities.
- What to know: The current ratio tells you whether your business could pay its bills if all your current assets became cash at balance sheet value — and all your current liabilities become due immediately.
- Like other liquidity ratios, the current ratio helps a company understand when it might have trouble meeting its obligations in the near future — sometimes within a year. You can then look at options to improve your business’s liquidity, such as negotiating or refinancing liabilities, raising additional capital, selling long-term assets, and earning more cash from operations
- A current ratio of one means current assets cover current liabilities exactly. Current ratios considered safe vary across industries. That said, usually a number below one usually indicates trouble — you might have to raise funds to survive another year.
- Quick ratio. To determine the quick ratio, you’ll need to divide quick assets by current liabilities.
- What to know: Quick assets include cash and equivalents, marketable stocks and bonds, and accounts receivable. Similar to the current ratio, the quick ratio lays out whether your business could pay its bills if current liabilities became due immediately.
- The key difference though is that the quick ratio assumes your business can’t sell any of its inventory — it can only use cash and assets that convert very quickly and easily to cash. And since not all businesses have inventory, acceptable quick ratios vary even more than current ratios.
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:
- Debt ratio. This number is total liabilities divided by total assets.
- What to know: This shows how much of your business’ assets would go to creditors — including suppliers, banks, employees, and others — if the business sold everything at the balance sheet value. A debt ratio of one means everything would go to creditors, while a debt ratio over one shows negative equity and an inability to pay all creditors.
- Debt-to-equity ratio. This number is total liabilities divided by total equity.
- What to know: This shows how much your business owes compared to the owner’s stake in the business. A debt-to-equity ratio of one means your assets come from creditors and owners equally. A lower debt-to-equity ratio means more financial safety.
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.
Common misconceptions about assets and liabilities
- Myth: A balance sheet shows assets and liabilities over a certain period of time.
- Fact: The balance sheet provides a snapshot of assets, liabilities, and equity on a specific day.
- Myth: The balance sheet shows assets and liabilities at fair market value.
- Fact: The value of an asset or liability on the balance sheet, called book or carrying value, often differs from fair market value. Under Generally Accepted Accounting Principles (GAAP), the balance sheet usually reflects unfavorable changes to FMV, but not favorable changes. However, many exceptions apply.
- Myth: Anything that reduces the value of an asset, such as accumulated depreciation, is a liability.
- Fact: Accumulated depreciation represents a contra-asset, not a liability. Contra accounts, which also exist for liabilities and equity, offset a related account. Most fixed assets wear out or become obsolete over time, so accumulated depreciation partially offsets the value of fixed assets. Recording accumulated depreciation as a liability wouldn’t make sense — it doesn’t cause your business to owe anything.
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.
Understand your assets vs liabilities and how they affect equity
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.