Understanding Your Small Business Balance Sheet

(Balance Sheets for Dummies)

 

 

I learned how to do balance sheets from an ex-Israeli special ops soldier turned CPA.  (Go ahead, take a minute and morph Judd Hirsch and Arnold Schwartzenegger, it’s more fun than math.)  Although my balance sheet training was a little “intense,” this is just a brief overview to help you understand your balance sheet.

 

The basic accounting equation (there I go with the math, don’t get scared off yet)  for a balance sheet is:

 

Assets = Liabilities + Owner’s Equity

 

Assets are the good things like cash and equipment.  A more politically correct accounting definition is “Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.”

 

Liabilities are the stuff you owe like credit card bills and loans.  You could also say liabilities are “probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

 

Owner’s Equity is what’s left over (assets minus the liabilities).  On your tax return, owner’s equity is referred to as “Retained Earnings.”  Another technical definition is “the residual interest in the assets of any entity that remains after deducting liabilities.

 

So let’s take a simple balance sheet.  A small business runs on a cash basis.  It has no equipment and no debt.  There’s $2,000 in the bank account.

Assets                   =             $2,000 cash in the bank

Liabilities              =             $0

Owner’s Equity                 =             $2,000

 

In this simple example, as cash comes into the company, the owner’s equity goes up.  As cash goes out, the owner’s equity goes down.

 

Here’s the important part: When the owner takes the money out of his company for his own use (which he does because it’s his money) the owner equity in the business goes down because he took the cash out of the company.

 

For example:  Sarah and Peggy have a Partnership.  They started the year with $2,000 in their checking account.  After expenses, they netted $100,000.  Now if they kept all of that money in the company, their balance sheet balances would read:

Cash:                     $102,000

Owners Equity:                 $102,000

 

But Peggy and Sarah like to eat and pay their rent so they each took $45,000 out of the company (that’s $90,000 altogether) so at the end of the year, the balance sheet balances would have looked like this:

Cash:                     $12,000

Owner’s Equity:                $12,000

 

This is important to know because many software programs will just plug a number into owners equity to make it tie out.  Sometimes the plug goes into cash.  If Sarah and Peggy didn’t check their balance sheet, in a few years it could look like they have half a million dollars of equity sitting in their company that’s just not there.   I’m not joking about that.

 

I once had to amend ten years worth of tax returns for a business owner trying to sell his company.  His balance sheet had $2 million dollars worth of equity but the figure should have been closer to $200,000.  For ten years his tax preparer had let the program “adjust” his balance sheet.  The taxpayer didn’t know any better (and clearly that preparer didn’t either.)  Sadly, the owner had quite a bit of a “smack down” when he tried selling his $2 million dollar company that was really only worth $200,000.

 

That’s why it’s so important to be able to read your balance sheet.  If you own a business, you need to know what’s on there and why it’s there.

 

My next post will add some common balance sheet items so you can see a more complete picture.   The bottom line is—your balance sheet should tell you what your company is worth.  If the “owners’ equity” doesn’t jive with what you think your company is worth—then it’s time to start asking questions.