Lesson Eight
How to Use an Balance Sheet to Know Your Worth
Unlike an income statement, which looks at your business’ movement of money over a period of time, a balance sheet is a snapshot of your financial situation at a given point in time. It’s important to keep an eye on your balance sheet and understand what it’s showing you.
In lesson eight, our goals are:
- Understand how to read your balance sheet.
- Analyze your balance sheet to understand your business finances.
How to Read a Balance Sheet
A balance sheet allows you to fully understand what you own and what you owe. As the name suggests, balance sheets will always be, well, balanced–that is, the total assets will be equal to the sum of liabilities and owner’s equity.
You’ll want to understand what your balance sheet shows about your financial status because you can use your balance sheet to make sure your business is headed in a healthy financial direction. Additionally, banks and investors will use your balance sheet when considering whether or not to give your business money.
Just like we did with income statements, let’s take a look at an example of a balance sheet to really understand how to read it. The balance sheet we’ll be reviewing belongs to Jill. Jill creates beautiful clothing, which she sells in her online store along with working on commissions for custom orders. At the end of last year, this was Jill’s balance sheet:
| Balance Sheet – 12/31/2017 | |
|---|---|
| Assets | |
| Cash and Cash Equivalents | $40,000 |
| Inventory | $20,000 |
| Accounts Receivable | $20,000 |
| Equipment | $5,000 |
| Total Assets | $85,000 |
| Liabilities | |
| Accounts Payable | $10,000 |
| Notes Payable | $20,000 |
| Total Liabilities | $30,000 |
| Owner’s Equity | |
| Common Stock | $10,000 |
| Retained Earnings | $45,000 |
| Total Owner’s Equity | $55,000 |
| Total Liabilities + Owner’s Equity | $85,000 |
Balance Sheet Section 1: Assets
First, let’s look through Jill’s assets:
Cash and cash equivalents is pretty self-explanatory—it’s how much money she has in her checking and savings accounts. This can also include any investments she has made that will mature within three months.
Inventory details the value of goods she already has in stock that are ready for sale, like pieces she has created to list in her store. If you work in a service business, like writing or design, your inventory will likely always be zero. Instead, you should focus on accounts receivable, which shows how much money is due from customers for work you’ve already done. For Jill, it details her outstanding invoices for custom projects.
Finally, there’s equipment. Sometimes these are separated out into long-term assets, as they are things that cannot be readily converted into cash, like computers, owned office or studio space, or manufacturing equipment. Jill just includes her industrial sewing machines.
Balance Sheet Section 2: Liabilities
Next, we get into what your business owes, or its liabilities. This is broken down into accounts payable, which is how much you owe to suppliers for goods and services you’ve received, and notes payable, which is how much you owe for loans. Sometimes short-term liabilities such as credit card debt will also be broken out into a separate category.
Jill writes down the money she owes for some manufacturing she contracted out on a large order, as well as a small business loan she took out to help her to scale her business.
Balance Sheet Section 3: Owner’s Equity
Finally, we’re left with owner’s equity, or how much of the business you own after all debts are considered. This includes common stock, which is the amount of money you and other business owners have put into the business, and retained earnings, or the sum of all of the profits you’ve made that have been kept in the business rather than paid out to yourself or other owners.
It’s important to note that retained earnings may be different than cash in the bank as you’ve likely reinvested some of those profits into other assets for your business, like purchasing equipment or creating inventory.
Additionally, when doing your bookkeeping, remember that personal funds taken out and put into your business always pass through owner’s equity. You’ll record these transactions as either an owner’s contribution or an owner’s draw. Owner’s contributions include business purchases made on a personal card as well as money invested in the business. Owner’s draws include personal expenses, which would be money withdrawn from your business for owner pay that wasn’t run through payroll.
Analyze Your Balance Sheet
When reviewing your balance sheet, you’ll want to pay attention to a couple of things. First, you’ll want to make sure you’re keeping up with everything and that balances are correct. If the sum of your liabilities and your equity doesn’t add up to the same amount as your assets, then your sheet isn’t balanced. If that happens, you’ll want to look back at your bookkeeping to make sure everything is recorded accurately.
This equation must be true: Liabilities + Equity = Assets
Next, you’ll want to keep an eye on how your assets and liabilities compare. If your liabilities ever surpass your assets, then your business is losing money and could be headed towards bankruptcy.
It’s also valuable to look at your balance sheet over time to understand if and how the company is growing. For example, let’s compare Jill’s year-end balance sheets from the past two years.
Balance Sheet
| 12/31/2021 | 12/31/2022 | |
| Assets | ||
|---|---|---|
| Cash and Cash Equivalents | $30,000 | $40,000 |
| Inventory | $5,000 | $20,000 |
| Accounts Receivable | $15,000 | $20,000 |
| Equipment | $2,000 | $5,000 |
| Total Assets | $52,000 | $85,000 |
| Liabilities | ||
| Accounts Payable | $5,000 | $10,000 |
| Notes Payable | $15,000 | $20,000 |
| Total Liabilities | $20,000 | $30,000 |
| Owner’s Equity | ||
| Common Stock | $10,000 | $10,000 |
| Retained Earnings | $22,000 | $45,000 |
| Total Owner’s Equity | $32,000 | $55,000 |
| Total Liabilities + Owner’s Equity | $52,000 | $85,000 |
By comparing the total on these two balance sheets, Jill can see that things appear to be going well. Even though her liabilities are higher because she took on a small additional loan in 2021, the investment seems to have paid off in increasing her assets and equity over the past year.
Though balance sheets can seem a bit technical and intimidating at first glance, by learning the basics, you can be proactive in determining the financial health of your business.
