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Understanding Balance Sheet

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What am I looking at?

What do these numbers mean?

What’s my bottom line and how did I get there?

Do any of the above questions sound familiar? Do you spend time with your bookkeeper/accountant going over your financials but when you leave you still don’t feel like you know what you talked about? When I started out in the business industry, it was as a Business Manager/Controller for a company and I never believed that I would be able to understand financials let alone prepare them and analyze them for other people.

In my experience, I have found that far too often when individuals start their own businesses, they do so because they have a very clear specialty in the product or services that they are providing. This doesn’t always mean that they are experienced business men and women and understand everything there is to know about starting a business especially when it comes to the bookkeeping and financials. For most people, we understand income and expenses but what is usually foreign to us, is the balance sheet and how to understand the assets and liabilities etc. When I was just starting out, I would look on the balance sheet and the only things that I understood was the bank account balance and the credit card balance. I certainly didn’t understand what “pre-paid expenses” were and forget trying to understand my assets and depreciations of said assets. I remember looking it all over and feeling so overwhelmed, I didn’t know what to do. It was then that I found an accountant (now friend) that could explain my financials in such a way that I not only understood what I was reading but I also knew where everything came from, how the numbers got to where they were! It was amazing! I felt like a kid in a candy store (I know that I am a little weird, but hey, I love numbers now).

In this article I am going to try and explain the very basics of basics for bookkeeping and some important areas to look at when going over your financials with your bookkeeper/accountant. So let’s dive right in. I will use easy round numbers for the sake of simplicity.

First let’s start with what I believed to be the hardest document to understand when I began; that is the Balance Sheet.

The Balance sheet is not the most important financial statement, but it is the second-most, the most important being the income statement (or Profit and Loss). The Balance sheet gives a reporting on a business’ assets, liabilities, and owner contributions of capital at any given point in time.

  • The Assets shown on the balance sheet are items that are owned by a business in which have value and that money was paid for.
  • The Liabilities that are shown on the balance sheet are those amounts that a business owes to other businesses, government agencies and/or people (Credit Cards, HST etc.).
  • Owner’s Contribution to Capital is any amount that an owner, shareholder or partner has paid into the business. This can be in the form of investment or have reinvested in the business by leaving profits inside the company.

The most important thing to understand about the balance sheet is what the assets and liabilities are. This will make understanding the statement easier and help you interpret what it is saying. The following table will show you a very simple balance sheet. Let’s assume that this balance sheet shows the condition of a side street vendor that sells food. This will show the balance sheet at the beginning of the day before there are any sales. The first section of the balance sheet shows the totals the two assets of the business; $1,000 cash in the lock box under the counter and the $3,000 worth of food that has been purchased to sell during the day.

A Simple Balance Sheet:

Assets

Cash $1,000

Inventory   3,000

Total Assets $4,000

Liabilities

Accounts Payable $2,000

Loan Payable   1,000

Owner’s Equity

S. Nelson, capital $1,000

Total Liabilities and Owner’s Equity $4,000

Note:

Balance sheets can use various categories to report assets (eg. Accounts Receivables, Investments, Fixtures, Equipment and Long-Term Investments). With a small business owner, not all of these asset categories will show up. If you look at the Balance Sheet of a much larger business/corporation you will see more of these categories.

The liabilities section of the balance sheet states the amounts that the business owes to other businesses; think of them like IOUS. Liabilities are not necessarily a bad thing. After all, companies have to spend some money to make money. They only become a problem when a company is consistently spending more than it’s earning and has no clear and viable strategy to reduce that trend.

Shareholder/Owner Equity

Subtract the total liabilities from the total asset, and you end with the company’s net worth, also known as shareholder equity – the shareholders’ ownership stake after all the debts are paid. (That’s why stocks are also called equities.) Common stock, preferred stock, and retained earnings comprise the three major parts of shareholder equity. They ultimately determine how much each share receives in dividends.

I understand that this is a lot to take in and for some of you, it may not be vital information for you to know however, I believe that if you understand even a portion of the Balance Sheet, it will help you in the long run. We all have great people in our lives that help us run our businesses and do our bookkeeping etc. The trick is to find someone that you trust and that will work WITH you and communicate openly with you. Once you have this person or company, you will be set and you will notice a lot of stress will be released.

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Scott Caslick