It's a tool for looking inside your business to outline what it's really worth.
- A balance gives insights into a company and its operations. It reveals a company's liabilities, assets and owners' equity net worth.
- A balance sheet gives interested parties an idea of the company's financial position in order to allow them make informed financial decisions.
- The primary reason for business is to make profits. The balance sheet indicates whether the business is making losses or profits for directors to determine future steps to take. The balance sheet acts as a decision-making tool.
A balance sheet offers a way to look inside your business and outline what it is really worth. A balance sheet is different from a measure of profit and loss. It's a list of assets and liabilities. Any good balance sheet includes some basics:
- What the business owns (real estate, vehicles, office equipment, etc.)
- Revenue you expect to take in (accounts receivable)
- Expenses you expect to pay out (accounts payable)
Getting into the details can be daunting for many people, who when they start a business might be doing it as a hobby that makes money. That can be a mistake.
If you want to claim tax deductions, for instance, it's important to note how fast and by how much your assets are depreciating (losing value with age). Balance sheets also include the costs of labor, which is also important for tax calculations. Keeping records of all these is essential.
Also, if you ever want to sell the business, you have to be able to say what the real value of the asset is – and that often has little to do with its potential, however good it is.
The Small Business Administration has a sample balance sheet; it shows some basic things anyone starting out should have on it. But the statement of assets and liabilities will differ, sometimes widely, for different businesses, and some of it falls under state or federal laws.
Bill Brigham, director at the New York State Small Business Development Center in Albany, New York, notes a big mistake people make is trying to do it themselves even as their business grows. While commercial accounting software such as Quicken is fine, it's a good idea to go to a professional accountant the first time you set a balance sheet up.
"It will save you money down the road," Brigham says.
The cost of hiring an accountant for a one-time job is a few hundred dollars; the cost of paying fines to the IRS, or the potential lost money in tax breaks is often much more.
Brigham also notes a balance sheet is a good reality check. "Everybody thinks their business is worth more than it really is," he said. If you are planning to sell your business or incorporate it, the total worth is vital information. If you're applying for a small business loan, it helps to have something to show the bank that you've done your homework.
Drew Gerber started three businesses of his own, and now runs a Georgia firm that helps small business market themselves. Gerber says a common pitfall of many entrepreneurs is to try and do everything themselves. Delegating balance sheet creation to a professional (or a friend who is an accountant) avoids that problem. In addition, a balance sheet tells you if your business is really profitable to your household or not. He notes that oftentimes business owners just guess at profitability, without really calculating the carrying costs of many assets.
Real estate, for example, has to appreciate faster than both inflation and the interest cost of the loan in order to turn a profit. If your business owns a piece of property and that price appreciation doesn't happen, that asset is actually worth less.
A vehicle loses value every year, and that can count against the total worth of an enterprise because maintenance costs go up, not down, over time. But depreciation isn't all bad. It can add up to big tax deductions in some cases, but unless you know how much, you can't claim those breaks.
What to include on a balance sheet
A balance is divided into two parts: a company's assets and liabilities and the shareholders' equity. The assets or means to operate balance against companies' financial obligations, equity investments and retained earnings.
There are two types of assets: current assets and noncurrent assets. Noncurrent assets refer to assets that cannot liquidated within a year. These assets have a longer life span as compared to current assets. They refer to tangible assets such as machinery, computers, the building your business operates in and the land. Noncurrent assets can also be intangible assets such as patents, goodwill and copyrights. These assets are not physical in nature, but they can determine whether a market makes it or not.
These are the financial obligations that a company owes other entities. They are categorized into two, current and longtime liabilities. Long-term liabilities refer to long-term debts and nondebt financial obligations due after a period of more than one year.
Current liabilities must be paid within one year. They include short-term borrowing, such as account payables or monthly interest payable on loans.
Shareholders equity is the initial amount of money invested in business. Where retained earnings are transferred from the income statement, into the balance sheet, they form the company's net worth.
How to create a balance sheet
Use the following accounting equation to make a balance sheet:
Assets = Liabilities + Owners' equity
Ensure that the value of total assets is equal to the total of liabilities and owners' equity. The asset account should have all the goods and resources that a company owns, while equity represents all the contributions by the owners of the company and past earnings. Most assets of companies are financed through borrowing. Check out some balance sheet examples.
Choose the date for the balance sheet.
It is essential for an organization to determine when the financial year ends. This is different for most companies with most financial years ending between the month of March and June. Collect enough data during the year to ensure you have the right representation of the company's position. The date should always be indicated on the balance sheet. See here for an example.
Have a header for the balance sheet.
Always have the title balance sheet at the top of your balance sheet.
Prepare the assets section.
Assets may include, account receivables, inventory and prepaid expenses, among others. List both the current and noncurrent assets.
Include the liabilities and owners' equity section.
The liabilities should be categorized into both long-term and current liabilities. Sample liabilities include pension plan obligations, interest on loans and bonds payable, among others.
Balance off the assets against liabilities and owners' equity. These should tally.