Dealing with your company’s financial reports is probably not the most enjoyable part of your job. But here’s a prediction: If you avoid this less enjoyable responsibility long enough you’ll end up with a whole lot more unenjoyable things to deal with later. But if you let your financial documents speak to you they can become great advisers. They won’t ever just “tell you what you want to hear.” In this regard the balance sheet (in contrast to profit and loss, and cash flow) is the most objective of your financial tools.
But here’s the thing about balance sheets: Their messages become clearest only when you evaluate them regularly and compare them to previous statements. That’s because a balance sheet is a summary or “snapshot” of the total value of your company at any given point in time. And the bottom line can change somewhat from one day to the next. So it’s best to run and review your balance sheet after reconciling your bank statements and processing all you monthly payables and receivables. That way you can compare a series of balance sheets all run under similar conditions in order to make the best comparison and to observe trends.
What is a Balance Sheet
A balance sheet shows the theoretical cash value of your company at any given time. If you could “cash out” on the day you ran the report, your “total equity” would essentially be the cash you would walk away with. Of course in real life you can’t liquidate all your assets in one day, but the “total equity” is most accurate and consistent measure of the true cash value of your business. Suffice to say, this number should be going up over time. If you see a declining trend you need to ask some hard questions.
The Two Main Parts
The balance sheet is made up of two main parts, or two ways of looking at the cash value of your business. When compared to each other these two parts should match, or as the name of the report indicates–balance. The balance sheet starts by tallying your assets (cash, receivables, property–anything with value) and calculating their total worth. But this is not the worth of your business! To get to the real cash value, of course, you have to first subtract your liabilities (loans, accounts payable, mortgages and the like).
The assets part of the report does not account for this. But the second part, the liabilities and equity section, does. It is in this section that you will find the theoretical cash value of your business.
But this is the section that often produces the most confusion. That’s because it’s adding together what intuitively seems like a negative number (your liabilities) and something that intuitively seems like a positive number (equity in the company). It’s usually here that you might start feeling a little dizzy, and if you’re like me you may have had to ask your accountant to explain it to you several times–and not to disparage accountants but often their explanations are just as dizzying. Have you ever said to your accountant, “Can you explain that again?” “Sorry, let me see if I understand?” “No? How would you explain that in normal English”? “I’m still a bit confused, can you dumb it down a little?” “Ohhhh, I see. (No, I don’t but this is getting way too embarrassing).”
The reason the liabilities and equity section is often a little confusing is because it is not as intuitive as the assets. The liabilities part is fine, except notice that the total liabilities is expressed as a positive number in the report. You might expect the liabilities to be a negative number–since we know we need to subtract out our liabilities from our assets to get to the real cash value of our company. But this is not how a balance sheet works. Instead the balance sheet is taking two different views of the financial status and comparing them to make sure they are in balance. The liabilities and equity section should equal the assets section to demonstrate that the financial accounts are indeed balanced. If they are not, it means you have some account errors somewhere in your books.
So in order to confirm that your accounts are in “balance,” the two ways of looking at your finances sheet ultimately need to show the same number. So if the assets report a positive number, then the liabilities and equity view also needs to show that same positive number.
The key to the liabilities and equity part is understanding what goes into the equity numbers. (This is where it gets a little murky–if you don’t understand don’t worry, I’ll point you to the main point in the end.) Your equity is made up of your retained earnings and your net income (including owner draws). Retained earnings is the amount of profit accumulated at year end and added to all the previous years retained earnings. Since this is a yearly tally the retained earnings number will stay the same throughout the year. At the end of the current year your net income will be added to your retained earnings and the balance sheet will then be updated for the following year. So the equity section is all the value your business has accumulated in the past plus the net value being accumulated so far this year.
But in order to compare the assets and equity to see if they balance you need to add back into the equity (thus the positive liabilities number) your current liabilities. By doing this you bring both views into balance.
Now if you can’t quite get your head around how that works out, don’t worry, the key to using your balance sheet is mostly in tracking your total equity. Total equity is the number we really care about. This is the theoretical cash worth of your business.
The Second to Last Bottom Line
So the bottom line of your balance sheet–the number you really want to watch and track and compare over time–is not the literal bottom line of your balance sheet. It’s the second to last bottom line, your total equity. (The literal bottom line is the combination of liabilities represented with a positive number and the remaining equity entered back in to bring the balance sheet into balance in order to match the other part–the list of assets.)
So it’s the second to last bottom line, in the section called “Equity,” which is typically made up of “retained earnings” and “net income” which are the lines you want to highlight and compare month by month. If you are profitable the total equity line will be trending upward. If you are losing money it will trend downward. If you are breaking even it will stay the same. But again the trends are important. Any given month might have a spike or a dip. Maybe you made a big deposit on a new project the day before running your balance sheet–well that month might show a decent increase in total equity. Or maybe you decided to spend, oh let’s say $5,000, to hire a consultant and paid it out the day before you ran your balance sheet–well that month might show a little dip on your net income (but certainly a worthy investment to get that total equity line trending back upward!).
You don’t have to remember all the ins and outs of your balance sheet to make good use of it. Just run it (or have your bookkeeper run one) at the end of every month, note the total equity line, pull out your folder of previous months reports, and compare the total equity lines to make sure the numbers are moving upward. If they are going down for several months in a row–call me, let’s figure out why that might be happening and what we can do about it.