Why Small Business Owners Should Know About Assets, Liabilities and Equity
Running a business in itself a balancing act. But there’s one more task every small business owner should be doing that actually includes the word “balance:” Creating a balance sheet.
A balance sheet is a financial snapshot of your company during a certain period of time. It takes into account your company’s assets, liabilities and equity and tells you what the business owes and what it owns. And a balance sheet can tell a very different story from day to day.
“Depending on the timing, it can look really good one day, a little different the next,” Catherine Derus, CPA and founder of Brightwater Accounting in La Grange Park, Ill., said. “For example, if that’s the day you just paid off the company credit card, that will have an effect.”
Understanding your business’s assets, liability and equity is important, and that’s the story the balance sheet tells. In fact, the equation for a balance sheet is:
Assets – Liabilities = Equity
The balance sheet is a powerful partner to another common document business owners use: the profit and loss statement. Also called an income statement, the profit and loss statement is calculated by looking at another formula:
Revenue – Expenses = Net Profit
What are assets, liabilities and equity?
Before you can create useful income statements and balance sheets, you need to understand the meaning and determination of assets, liabilities and equity — and how they relate to one another. Use this crib sheet for a handy reference.
These are tangible things you own and that have value, Derus said. Examples of assets can include:
- Bank accounts
- Accounts receivables and inventory
- Fixed assets (things a business needs to operate, but aren’t for sale, such as property, equipment, computers and furniture)
- Construction and contractors
Current — or short-term — assets include cash, plus inventory and accounts receivable that you expect to turn into cash in one year or less. Fixed assets are physical assets that have an expected life of more than a year, such as buildings, vehicles, machinery, computer equipment and tools.
Tangible assets are touchable items for which you can easily factor worth, such as buildings and equipment. Intangible assets, which don’t appear on a balance sheet, and include items such as client lists, franchise agreements, brand names, patents and supplier contracts. For some companies, intangible assets can still make up a large part of the company’s asset value.
These are debts or obligations you owe other people. Examples of liabilities include:
- Credit card debt
- Mortgages and other loans
Liabilities might be broken out into short-term — those that you’ll pay off in 12 months or less, such as payroll and credit lines — and long-term liabilities, such as mortgages and bonds.
Other examples of short-term liabilities include:
- Credit lines
- Dividends payable (dividends that a company’s board of directors has determined is payable to its shareholders)
- Customer deposits (cash the company has received from a customer before the company delivers the purchased good or service)
- Short-term debt (a loan with a term of one year or less)
Some examples of long-term liabilities include:
- Long-term leases
- Capital leases (agreements in which the lessors agree to transfer ownership of the property to the lessees after the lease expires)
- Employee stock options
“You do get some benefit out of liabilities, maybe you get some cash to operate your business,” Derus said. “But you’re going to eventually owe that money to someone else, and probably with interest.”
Equity is assets minus liabilities — it essentially measures what your company is worth. Equity is made up of three parts: contributions, or money you’ve invested in the business; distributions, or money you or any other business owner has taken out of the company; and retained earnings, or the cumulative profit the company has made since its founding. Equity is essentially where the profit and loss statement and the balance sheet come together, Derus said.
Your equity also increases based off the net income of the business, Derus said, and it can decrease if you pull out money from the business for personal use.
A balance sheet gives you a more current snapshot than an income statement regarding where your money is coming from and where it’s going, Derus said. It also includes outstanding revenue and expenses, which can help guide spending decisions.
For example, if your assets column shows that you have $10,000 in your checking account and your obligations column shows a $2,500 business credit card expense, you know you can easily afford to pay off that bill, Derus said.
Business owners must record their companies’ transactions in the general ledger according to the type of transaction. If you’re keeping accurate records, the left side (which typically shows assets (and the right side (which typically records liabilities) should always equal one another.
A balance sheet is more complete than a profit and loss statement because it can show how the different decisions you make — regarding things such as product pricing or marketing — affect your business’ finances over a certain period of time.
For some small business owners, the outstanding revenue and debt on a balance sheet won’t matter for their accounting books or their tax estimates. That’s because many small businesses, especially sole proprietors or those without inventory, use the cash accounting method. That means they record revenue only when they receive it and record expenses when they actually pay them. But knowing about outstanding income and debt is still very useful.
“You’re not going to recognize those sales until money has actually come in the door, but it’s still important to know what people owe you,” Derus said. “It helps you plan for big purchases. Maybe you need a new computer or you want to hire someone else.”
The profit and loss statement, meanwhile, looks at a much longer period of time. It can tell you what your profit was for the year and if your company is making a profit, breaking even or operating at a loss. You’ll want to look at a couple of factors in particular on your profit and loss statement:
Pricing. What impact does the pricing of your products and services have on your bottom line? For that, you need to know the unit cost, which includes labor and materials, for every product you sell, which is known as the cost of goods sold. You must charge more than the unit cost of the product to be profitable.
Gross margin. To find your gross margin, subtract the cost of goods sold from your product sales (net revenue). If your gross margin is less than 30 percent net revenue, that could cause financial problems for your business.
Is your business financially healthy?
When you look at your assets, liabilities and equity via your balance sheet and profit and loss statements, what should you see? “Ideally, you’d have more assets than liabilities,” Derus said.
You should also see that your revenue is outpacing your liabilities in general. At the same time, not all companies have the same profitability ratios, so Derus recommends looking at your industry averages to figure out what your ratio should be. A profitability ratio measures how well a business is able to use its assets to produce a profit.
When you have a good handle on your company’s assets, liabilities and equity — and can use profit and loss statements and balance sheets to track them — you’ll have a stronger picture of your company’s finances and where you can make improvements.