Finance 101: Understanding the Balance Sheet

In my opinion and experience, the Balance Sheet is the most neglected and least understood financial document in the small business world. Too often a small business owner will skip the Balance Sheet entirely to focus solely on the Income Statement. Even if the Balance Sheet is utilized in decision making — it is often only the Cash & Cash Equivalents line item. Two significant issues exist from ignoring the balance sheet. First, the biggest misclassification of entries occurs on the Balance Sheet. Second, a great wealth of knowledge is missed from not correctly interpreting the picture created from Balance Sheet data.

I was reminded the other day about 3D Magic Eye pictures. This was the 90’s phenomenon that drove everyone crazy. I remember checking out these horrible books from the library that contained hundreds of blurry, repeating images. Unfortunately, I wasn’t able to decipher anything. Any guesses what the picture below is?

I despised these things as a kid. I spent countless hours at the library going crossed eyed hoping to see the hidden treasures within. One day a friend, far more experienced than I at ‘seeing’ the magic pictures, described the process necessary to accurately see and interpret the image. Only then was I able to look at these images and understand the picture within. I liken the process of understanding the Balance Sheet to a Magic Eye image. It takes practice, patience, and concerted effort to understand the picture created by the financial information.

This week we review a basic example of a Balance Sheet. I have included some of the issues we see when looking at company financial statements. Here are four lessons for reviewing your Balance Sheet:

Lesson 1: Remember the Accounting Equation

Assets = Liabilities + Equity

It really is that simple. When presented in a Balance Sheet the Assets Section is listed at the top and the Liabilities and Equity Section is listed below. Whatever the company OWNS is listed as an Asset and whatever the company OWESis listed as a Liability. Equity is simply the difference between those numbers. Equity can be separated into many different categories — but remember that at the end of the day it represents the difference between what is owned and owed.

Assets = What the company owns.
Liabilities = What the company owes.
Equity = The difference between what is owned and owed.

Lesson 2: Everything is ordered

Take a look at the assets of this Demo Company:

Everything is listed in relationship to liquidity. In other words, the balance sheet is organized by how quickly things can be converted into cash. The sooner it can be converted into cash, the higher it is on the list. A checking account is entirely cash. It is the best example of cash — except for the actual currency in my wallet (But who carries cash anymore? I certainly don’t). In our example, the accounts receivable (or the money owed to the business in the normal course of events through sales invoices) is listed next. We don’t have any buildings or non-current, intangible assets listed on the statement — but the harder it is to squeeze cash out of an asset quickly — the lower its placement on the list.

The same is true for liabilities. The sooner an item needs to be paid, the higher its placement on the list. If it requires payment tomorrow (converted from cash) then it is at the top of the list. When an item does not need to be paid to the lender for 10 years, it is listed lower down.

Revenue is vanity…margin is sanity…cash is king.

Cash is King. Everything is ordered by its relationship to cash.

Lesson 3: Identify issues before comparison

You may have already noticed a few issues with the reliability of this Balance Sheet.

  1. Cash is displaying a credit (negative asset) balance of $4,946
  2. Computer Equipment is displaying a credit (negative asset) balance of $829.87
  3. An Historical Adjustment account exists with a credit (positive liability) balance $4,130.98
First, let’s discuss the problem with cash

So, cash being a negative number is ‘sorta a big deal’. This number isn’t supposed to be negative, since it is technically impossible to have negative cash in your wallet. However, accounting is like the mirror of Galadriel in the Lord of the Rings.

For [accounting] … shows many things… things that were… things that are… and some things… that have not yet come to pass.
- J.R.R. Tolkein, The Lord of the Rings

Cash is negative, in our example, because the company has already committed those funds for use. The company has properly recorded all the checks they have sent out, and all the expenses occurring on the debit card. The problem is that the business doesn’t have sufficient funds to cover those checks when they clear the bank. The business needs to deposit additional cash into tthe account, or some of those checks are going to bounce.

However, cash is not supposed to be negative on a regular basis. This is not a healthy sign.

Secondly, lets look at our negative computer equipment

Again, we have an asset that is a credit (negative) balance. I opened up the detail of this item on the Balance Sheet and found the following:

It appears that an attempt was made to reclassify equipment that had been coded erroneously to Office Equipment. However, the journal entry to fix the coding has been made in the wrong direction. The Office Equipment account should have been credited instead of debited.

This requires a simple fix to reverse and correct.

Lastly, what is this historical adjustment account?

Often, when we inherit a set of books, there are a few accounts with current balances which are not an accurate reflection of reality. In our Demo Company example, the Xero software provides an aggregator account to lump all the “unknowns” together. When this company converted to Xero the system forced the following entry:

In other words, when the person converting this file was working through the numbers, “something” didn’t add up. That “something” was $4,130.98 of “I don’t know what”. The accountant at year end needs to do 1 of 2 things. Either they need to work backwards through all the historical transactions to find that “I don’t know what”, or they need to deal with it in the current period. If the amount is large enough — the search is necessary, otherwise we can simply journal entry the $4,130.98 into the current year Income Statement as an “extraordinary adjustment”.

These issues happen in the real world, so understanding what the transactions in your “anomaly” accounts are imperative.

Identify and understand abnormal balances in accounts.
Identify and understand unusual accounts.

Lesson 4: Comparisons

I wrote an article last week about the Income Statement which contained a lesson about comparisons. The process of comparing the Balance Sheet to previous months, quarters, and years is just as important. Without a comparison, it is impossible to gauge which direction a company is headed.

Cat: Where are you going?
Alice: Which way should I go?
Cat: That depends on where you are going.
Alice: I don’t know.
Cat: Then it doesn’t matter which way you go.
- Lewis Carroll, Alice in Wonderland

Here are a few examples of comparison questions I would ask against the previous month:

  1. Has my Cash & Cash Equivalents Balance increased or decreased over last month?
  2. Have I increased my receivables? Am I collecting my outstanding receivables quick enough? (This is a lesson for another day)
  3. Have I purchased more Fixed Assets?
  4. Am I generating more expenses that I haven’t paid for yet through the Accounts Payable? Why is that balance increasing? Am I paying my bills too early or too late?
  5. Is my current year earnings increasing or decreasing?
Comparison against previous results displays the direction of the business.

The Big Picture

Just as the Cat explained to Alice, the same holds true for business. Knowing what to do next depends on where you have come from and your desired destination. The Balance sheet helps us understand where you have come from and the current direction of the business financially. When utilized effectively along with budgets, forecasts, and goals, the balance sheet can drive both long and short-term decision making. We help businesses restructure their balance sheet on paper as well as their debt, to ensure they are reducing overheads and maximizing their cash usage.

What are some of the areas of the Balance Sheet that you love reviewing on a weekly, monthly, or annual basis?