Here is a guide to the contents of a balance sheet and how to use it in a business.
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a company. It’s a financial statement that summarises a company's assets, liabilities and shareholders' equity at a specific point in time.
These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by the shareholders. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year.
A balance sheet is often described as a snapshot of a company's financial condition. Of the four basic financial statements, the balance sheet is the only statement which applies to a single point in time of a business' calendar year.
The balance sheet must follow the following formula:
Assets = Liabilities + Shareholders' Equity
An asset is anything the business owns that has monetary value. Accounts such as cash, inventory and property are on the asset side of the balance sheet. Liabilities are the claims of creditors against the assets of the business.
On the liability side there are accounts such as accounts payable or long-term debt. It's called a balance sheet because the two sides balance out. This makes sense: a company has to pay for all the things it has (assets) by either borrowing money (liabilities) or getting it from shareholders (shareholders' equity).
Each of the three segments of the balance sheet will have many accounts within it that document the value of each. The exact accounts on a balance sheet will differ by company and by industry, as there is no one set template that will accommodate the different types of businesses.
Why does a business need a balance sheet?
Balance sheets, along with income statements, are the most important records in an entrepreneur's financial reporting system. A balance sheet helps a small business owner quickly get a handle on the financial strength and capabilities of the business. It lets you know whether the business is in strong position to grow and evolve financially.
Balance sheets and income statements have to be provided to potential lenders such as banks, investors, and vendors who are considering how much credit they should give to your business.
Balance sheets show trends in payables and receivables, and what, in turn, should be focused on. A business with a long payment cycle may look at its balance statement and see how things could be adjusted, or it may notice that the payables have slowed down in frequency in order to deal with a potential shortage of cash.
The balance sheet should ultimately show whether can afford to take risks financially because you have made adequate provision for the normal ups and downs of running a business, or if it would be more sensible to put in measures to safeguard the financial security of the business.
Avoid common balance sheet mistakes
The balance sheet is what drives the cash flow of your business. If it is not correctly modelled, the cash flow forecast is most likely inaccurate and of no value. Here are the three most common mistakes to avoid:
1. No balance sheet projections
The most common mistake that business owners make is to leave out the balance sheet forecast from the financial model. The balance sheet represents the most complex transactions of the company and may excluded from the financial model because the company lacks the expertise of a financial officer to compile this critical part.
2. Failure to correlate operating activities and operating assets and liabilities
Operating assets include accounts receivable, inventory and pre-paid items. Operating liabilities include accounts payable, taxes payable, and other accrued expenses. When sales go up, accounts receivables go up, and cash goes down. The model must capture that.
If sales go up, your inventory will probably need to increase too. The effects of these changes are dependent on the relationship between your days’ sales outstanding and your inventory turnover. As sales increase, accounts payable usually increase as well.
The timing of your payments against your accounts payable is a major outflow of working capital. Make sure you define the relationship that payables have with your operating activities and reflect this relationship in the balance sheet.
3. Disregard for debt and equity transactions
Are you bringing in any more equity during the period you are modelling? What is your dividend policy for shareholders? Is some or all of the active shareholders’ compensation coming through equity? All of these items can have a significant impact on cash flow, even though they do not reflect on the P&L statement.
In addition to equity transactions, the structure of the company's debts and obligations must be correctly reflected on the balance sheet. An interest only line of credit will keep the same balance until more is withdrawn or some is paid back, based on the cash flow. Term loans need to show the correct amount of debt being reduced every month.
These items can seriously change your cash flow so they must be included in the financial model to enable correct forecasting.
By avoiding these mistakes, you will have a balance sheet that accurately drives the cash flow of the business. That means you can make more legitimate assumptions about the future of your business, make better strategic decisions, raise capital more easily and correct problem areas.