The ornaments have been removed from the trees and packed away for next year and the cruise ships have returned from Mexico and the Caribbean, so it’s safe to say the holidays are over. As most individuals head back to work, entrepreneurs (who may not have stopped working during the holiday) are starting the year with a clean slate, new goals and high hopes for the opportunity of 2012. If you are one of the business owners who would like to get a handle on your finances, it is the perfect time for a refresher course. This month, we are featuring a blog series on the basics of financial reporting that every business owner should know:
Week 1: Examining the Balance Sheet
There are three fields on a balance sheet – assets, liabilities and equity.
Assetsrepresent things of value that a company owns and has in its possession. For example, the equipment that produces your products, accounts receivable from customers, or inventory that you are currently holding are all considered to be assets.
Liabilities are what a company owes to others – such as bank loans, supplier invoices, taxes and accrued employee wages. Liabilities are obligations that must be paid under certain conditions and time frames.
Equity represents the retained earnings and funds contributed by its shareholders, who accept the uncertainty that comes with ownership risk in exchange for what they hope will be a good return on their investment. Or, if the company is a sole proprietorship, equity represents the funds that the single business owner has invested in the company to keep it open.
The relationship of these segments is shown in the following balance sheet equation:
Assets = Liabilities + Equity
This means what your business owns is exactly equal to what your business owes plus what has been invested and retained in the business. As a company’s assets grow, its liabilities and/or equity also grow in order for its financial position to stay balanced.
How assets are supported, or financed, by a corresponding growth in accounts payable, debt liabilities and equity reveals a lot about a company’s financial health. Depending on a company’s line of business and industry characteristics, possessing a reasonable mix of liabilities and equity is a sign of a financially healthy company.
This is a question often asked by business owners. They know sales are being made, but don’t know where the money goes. They do know that it’s not in the bank!
The answer lies in the activity in all the other balance sheet accounts.
Look at the following comparative balance sheet. Note that an increase in accounts receivable has a negative impact on cash due to more sales not being collected which ties up cash.
An increase in accounts payable means that some vendor payables have not been paid which has a positive impact on cash.
The last column becomes your de facto cash flow statement. And you know where the cash went!
Two rules to find the cash:
- An increase in any asset other than cash has a negative impact on cash and a decrease in any asset other than cash has a positive impact on cash.
- An increase in any liability has a positive impact on cash and a decrease in any liability has a negative impact on cash.