How To Read Your Balance Sheet
For The Business Owner Working From Home

Published February 2009 | Edited June 3, 2024

The balance sheet reveals how healthy your business really is. It's a bit like showing someone your private parts! So careful who you show it to.

Do you ever feel confused about the balance sheet? You are soooooo not alone! I hope your jug of lemon water is ready ...

We’ll begin with the basics of reading and understanding this financial statement.

Then, in a separate article, we’ll go beyond the basics to ratio analysis which uncovers interesting stuff about your business like how:

• Liquid (ready cash) you are;
• To quickly measure long term operating results;
• Efficiently your business runs;
• Solvent (do you have too much debt) you are;

and more …

Let the fun start now ... as you discover the relationships between the numbers and begin to understand how they affect your business.

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Learning How To Read Your Internal Financial Reports

Tools for the Home Based Business Owner

--Overview--

It shows:

• How much cash is in the bank;
• What your business owns;
• What your business owes;
• How much you have invested in your business; and
• How much money your business has made ... or lost ... since inception.

It reveals:

• How your business finances its operations, and
• What your business purchased with your financing.

When we crunch a few numbers in the next section, some very interesting stuff is uncovered - such as how efficiently run your business is.

This report gets its name because all the accounts must sum to zero ... soooooo the sheet balances! Get It? Here's how it does it.

What you own - (What you owe + Your capital contributions
+ Cumulative profits since inception) = Zero

Restated in accounting language

Assets - (Liabilities + Owner’s Equity) = Zero

or you could rearrange it like this

Assets - Liabilities = Owner’s Equity

or perhaps like this

This means that the assets you have in your small business were obtained through any or all of three different sources:

1. debt - someone else’s cash;
2. capital contributions - your cash; or
3. reinvested profits - the business’s cash.

If we put this into a formula, it would look like this

Source of Assets = Debts + Capital Investments + Reinvested Profits

or we could say

Source of Assets = Someone else's cash + Your cash + The business's cash

I can see you thinking ... What's my point?

The idea I want you to see is that the balance sheet is relevant to you as a business owner. You can play around with the formula and rearrange it or rename the parts to something you remember and understand. It doesn't have to be in accounting language.

Answers to the Quick Quiz on Critical Information. 1-D, 2-C, 3-J, 4-E, 5-F, 6-A, 7-I, 8-H, 9-G 10-B

--The Report Format--

The balance sheet is usually presented in one of two formats.

In Canada, the balance sheet format lists each group directly under the other in the order shown.

• Assets
• Liabilities
• Owner’s Capital

If you are a visual learner, this sample financial report of a very basic balance sheet may be helpful to you. You can get a look at what an actual balance sheet looks like ... just in case you have never seen one before.

Another format used in various parts of the world is listing Assets down the left hand side of the page and Liabilities and Owner's Capital down the right hand side.

Now that we've covered why balance sheets can look differently from one business to another, we'll briefly review each component of the balance sheet then move on to the ratio analysis.

Income Statement vs. Balance Sheet

When you look at the balance sheet, keep in mind that the information is for a specific date in time. Think of it just like a photograph of how your business looked at that moment in time ... a snapshot frozen in time.

The income statement is more like a video. It represents activity in your business over a particular period in time. The period varies and you have to read the heading to figure it out. It could be a month, a quarter, a year.

The results (whether you made a profit or loss for the period) of the income statement show up in the owner's equity section of the balance sheet.

This concept gets answered incorrectly most often in my accounting test. So here is a summary:

There are five basic categories of assets however the three main categories that probably affect your business are ...

• Current Assets
• Capital Assets (Fixed Assets or Capital Outlays)
• Other Assets

Current assets list things the business owns that are liquid (can be turned into ready cash within one year). This would include:

• cash in your bank account(s)
• petty cash
• any temporary investments
• your accounts receivable (money customers owe you)
• your inventory (recorded at cost not sales price), and
• any prepaid expenses such as insurance or rent.

The Bookkeeper's Tip
Improve Cash Flow

Prompt Invoicing of Accounts Receivable

Accounts receivable represents amounts your customers owe you. Improve your cash flow by invoicing promptly, no delays. Presenting the invoice at the completion of the sale is the best.

Then follow up with monthly statements if the account is outstanding. If you are using a bookkeeper, ask that it be part of the regular routine. I use QuickBooks software and it is very easy to go in and run statements to send out to customers.

Consider requesting a customer deposit. If you do receive customer deposits, learn how to book the entry correctly the first time in How to Record and Apply a Customer Deposit or Prepayment.

The sooner you get your cash, the less likely you are to run into cash flow problems. Remember you are not a bank and there are a lot of ways to accept credit card payments these days. Check out Square and PayPal as two easy solutions to eliminating the need for A/R in small businesses. The fees charged offset your labour costs for managing your outstanding Accounts Receivables.

Inventory and Delivery Charges

Record any shipping and/or delivery charges as part of your inventory cost. Do not expense it.

The cost of shipping or delivery of inventory will get expensed when the item is sold as part of the cost of goods sold.

Joanna Tompkin's book, Accounting for Big Kids which I believe is now out of print, explains that when you purchase inventory from the United States, there are Landing Costs.

The landed costs include the vendor's invoice, US exchange, duty, freight and possibly other charges. All of the landed costs get included as part of the cost of your inventory to be expensed only when an inventory item is sold.

Capital assets are things you own that have a life longer than one year such as your tools, equipment, office furniture, computers and computer software. It can also include land (and improvements), buildings and vehicles.

You will also see capital assets referred to as Fixed Assets. (Read about why here.)

Formally on the balance sheet, they are usually referred to as Plant, Property, and Equipment (PPE).

As a general rule, if the capital outlay (fixed asset) is under $500, you can expense it instead of capitalizing it. (Since the repair regs came into effect in 2014 in the U.S. this amount is generally under $200 as well as units of property with economic useful lives of, or that would be used or consumed in, 12 months or less.)

More for Americans >> Blast from the past: Tax planning with the repair regs.

I like to set up my chart of accounts so that my fixed assets are grouped by CCA group classifications ... to make tax preparation easier.

If you take a close look at your chart of accounts, you will probably also see accounts in the capital asset section called amortization.

The amortization accounts are used to allocate a portion of the original cost of your capital outlay to your expenses on the income statement. We'll talk more about this account when we look at the income statement.

OTHER ASSETS

For our purposes here, and to keep it simple, other assets is going to include anything else you own that doesn't fit into current assets or capital assets.

For our purposes, there are two basic categories of liabilities that affect your business. They are ...

Current (Short Term) Liabilities
Long Term Liabilities

Current liabilities list debts the business owes that are due and payable within one year. This would include:

• bank overdrafts
• credit card balances
• lines of credit
• accounts payable (money owed to others like your suppliers)
• payroll payable
• most types of taxes payable, including HST/GST Payable and income tax payable
• dividends payable, and
• customer deposits

You will also find in this section (if applicable):

• accrued liabilities, and
• the current portion of your long term debt

Accounts payable are created when you purchase goods and/or services on credit ... meaning your supplier allowed you to take the item without paying for it at the time of purchase.

As noted above, the accounts payable account is found in the current liability section of the balance sheet. To locate Accounts Payable on your Trial Balance, you need to become familiar with your Chart of Accounts, as it is your blueprint to your accounting system. If you can't find Accounts Payable in your chart of accounts, it may be called Trade Payables.

Accounts Payable is not part of the income statement. However, when you initially book your account payable (you buy supplies or services on credit), your purchase may show as an expense on your income statement. I say "may" because if you purchased a capital asset, the expenditure will not show up on your income statement.

A good practice to get into is to use your Aged Accounts Payable Report to help you manage your cash flow.

Long term liabilities are debts you owe that have a life longer than one year such as:

• bank loans
• capital lease obligations
• money due to related parties

How to Record Your Monthly Loan Payment

When entering a loan payment to the books, always remember that only the principle portion gets booked to the loan account (on the balance sheet). The interest portion of the payment is expensed (on the income statement).

The entry looks like this:

Debit Bank Loan - principal only (on balance sheet under long term liabilities see The Bookkeeper's Tip below)

Debit Interest Expense (on the income statement)

Credit Cash in Bank (on balance sheet under current assets)

The bank will be more than happy to provide you with an amortization (depreciation) schedule … or you can run your own. It will show you the split between your principal and interest expense.

If you get a monthly statement, you could reconcile the account to the statement each month. It is a good bookkeeping practice to verify any of your balance sheet account balances to third party sources.

Each year end, you will look at your loan statement for the year (you may have to request a copy) and make any needed adjustments to the loan balance ... booking the difference to interest expense.

How to account for your business loan proceeds can be found in the article How to Record Common Bookkeeping Entries.

In this section of the balance sheet, you will find your cash investment in the business (Owner’s Equity) along with your owner's draws, and current year net income or loss.

Owner's Equity is also referred to as owner’s investment or owner’s capital. Have you noticed I've been switching the terminology? When you see any one of these terms on a balance sheet, you know the business in not incorporated. It will be a sole proprietorship or a partnership.

If the business is incorporated, this section of the balance sheet would contain a line for share or stock capital and for retained earnings.

Professionally prepared financial statements normally have just one line showing called Owner’s Capital. All the categories discussed above still exist in separate subaccounts in their general ledger. However, for financial reporting purposes, they have consolidated the accounts into one line.

It is also worth noting that the net income (loss) amount reported should match the net income (loss) on the income statement.

I'll chat a bit more on this section of the balance sheet during the Income Statement discussion coming up shortly.

What I'd like to mention right now is that equity means how much you have invested in your business. But don't confuse it with the worth of your business. ... Why?

Remember the cost principle says to record assets at the original cost (in most cases). This means that you cannot look at the equity section of your balance sheet and think that is how much your business is worth.

To do a very rough determination of the current worth of your business, you would have to adjust your assets to their market value. That would give you a better idea of your business' worth.

However, to determine the real value of your business, you will have to factor in growth potential, quality of your assets, your market position ... just as an example.

The point I really wanted to make is that the equity section of your balance sheet does not represent the worth of your business.

This concludes the first discussion on the balance sheet. Before we move on to ratio analysis, we’ll look at the income statement.

I know, I know. I said earlier we'd do ratio analysis next but ... I've changed my mind! You get to do stuff like that when it's your own website.

However, before we do that, I thought I’d take a sec to see if you are ...

… confused about all the debits and credits being thrown around?

You'll like my "cheat" table. It should unscramble the confusion for you.

Before you go, why don't you test your balance sheet knowledge.

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