What is the Role of the Balance Sheet?

by Evan Carmichael

5 min read

Intuit recently ran a survey which found that the single biggest reason that most small businesses don’t succeed is that they lack the financial literacy skills needed to navigate the obstacles in front of them.

Only 51% of companies that start up today will still be around 5 years from now.

In order to change that we’re creating a new series of posts on financial literacy to help you make sense of the information in front of you.

Today we’re going to look at what the role of the balance sheet is and how it can be used to help you grow your business.

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What is the role of the balance sheet?

At a very high level, the balance sheet represents what resources your company owns  (assets) versus how much you owe to others (liabilities).

The difference is your owner’s equity in the company.

Assets

Using my QuickBooks Online account I’m going to check out a sample balance sheet for you to have a look at.

This is data from a sample company, Craig’s Design & Landscaping Services.

The assets are split into Current Assets and Fixed Assets.

Current Assets are cash and things that can be converted into cash in a relatively short amount of time.

In Craig’s case he has a few bank accounts, accounts receivable, and some undeposited funds.

Fixed Assets are permanent investments that are used to run the business but are not actually for sale by the business.

In Craig’s case his only fixed asset is his truck but it can also include equipment, buildings, land, patents, etc.

Liabilities

Now let’s look at Craig’s Liabilities and Owner’s Equity.

Liabilities are split into Current Liabilities and Long Term Liabilities.

Current Liabilities are what your company owes and has to pay off within a year from the balance sheet being created.

In Craig’s case he has accounts payable, credit cards, loans, and sales tax to pay.

Long Term Liabilities are everything else that your company owes that is due beyond one year from the balance sheet being created.

In Craig’s case his only long term liability is a note payable.

Equity

Now a balance sheet has to, well, balance so the different between your assets and liabilities is your equity.

If we look at Craig’s complete balance sheet you’ll see that he has $30,275.04 in liabilities and only $26,684.69 in assets which gives him a negative equity of $3,590.35.

So How Does This Help?

Now that you know what the numbers mean and their values, you can start making important business decisions from them.

Here are a few to consider:

1) Current Assets to Current Liabilities

Also known as Working Capital, you want to have more Current Assets compared to Current Liabilities.

This will help ensure that you have enough money to fund your short term debts as well as the day to day operations of your business.

If your Current Liabilities are more than your Current Assets then you’re going to feel a major cash crunch within the next year.

Your options could be to make more sales, sell some inventory, restructure your loans, or apply for short term financing.

If we look at Craig’s data he has $13,239.69 in Current Assets and only $5,275.04 in Current Liabilities so he doesn’t have to worry.

2) Fixed Assets to Long Term Liabilities

You also want to have more Fixed Assets than Long Term Liabilities.

This will help ensure that you have enough in the business to fund your longer term debts.

Ideally you want your Long Term Liabilities to be around 50% to 70% of your Fixed Assets.

If your ratio is higher, remember that the value of Fixed Assets like land, buildings, patents, etc. often increase with time and your best bet would be to try and refinance and pitch your lender that it’s better to have them keep you around and making payments rather than force you into liquidity.

Looking at Craig’s data we see he’s in trouble.

His Fixed Assets total $13,445 and his Long Term Liabilities are $25,000.

This means that if he can’t turn his business around he’s going to be in a serious cash crunch after the year is up.

3) Raising Capital

Finally let’s look at the story a balance sheet shows to potential investors.

If you want to raise money any investor or lender will want to see your balance sheet.

They’re going to look at your Working Capital (see if you can survive in the short run) and they’ll compare your Fixed Assets to Long Term Liabilities (see if you can survive in the long run).

They’re also going to look at your equity.

They want to see how much you have in the business.

If you don’t have much equity it’s going to make it hard for them to give you any kind of money because you’re very high risk.

Looking at Craig’s data, again he’s in trouble.

He has negative equity of $3,590.35.

He took out $25,000 as a loan and spent $13,495 on a truck.

Where did the other $11,505 go?

While Craig’s company has some positive signs in that it has $3,327.99 in net income (which means the company earned more in revenue then it spent in expenses) it would be very hard for Craig to convince someone to give him more money without proving he can do better or providing a personal guarantee.

Wrapping Up

It all starts with the tools.

76% of entrepreneurs who use financial software or a solution their accountant provided feel confident that they have a strong grasp of financial management principles.

If you know where the problems are ahead of time you can plan for them so you’re not constantly putting out fires as they happen.

Next Step

Starting a business can be empowering, but it also demands a level of financial understanding to make sure your business succeeds.

To help address this need for financial expertise, Intuit is offering free one-on-one consultations for small businesses with their Intuit ProAdvisors.

Learn more by visiting my website, EvanCarmichael.comYou can also check out my Worksheets for Entrepreneurs.

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