We love to increase our clients' accounting knowledge. Even though they won't ever become experts, it helps to have them have a basic understanding of accounting concepts. This basic understanding helps them to manage their business better, even when they are utilizing our services.
We usually start with the financial statements. We will walk our clients through their financials every month, explaining what we see and what improvements can be made. I will walk you through the Balance Sheet this week and we will tackle the Profit & Loss next week and the Statement of Cash Flows the week after that.
The Balance Sheet shows a business owner what they own, what they owe and what the difference between the two is. What they own is their assets, what they owe are the liabilities and the difference between the assets and the liabilities is the equity in the business.
Assets are listed by liquidity from most liquid (current assets) to least liquid (fixed assets). Liquidity refers to how easy it is to convert the item to cash. Obviously cash, checking or other bank accounts are the most liquid because they are cash! Next comes accounts receivable and they just need to be collected to become cash. Then we have inventory which must be sold first which converts it to a receivable which then needs to be collected. There are other types of current assets such as prepaid expenses (if you pay for a whole year of insurance coverage in one payment, you can have one month's worth be insurance expense and the remaining 11 month's worth will be prepaid insurance - an assets. Each month you will expense a portion until it is all gone and it is time to pay the next year's premium).
Fixed assets are the least liquid and are the things that you buy and expect to use for over a year. This includes computer and other equipment, vehicles, furniture, and real estate.
The next category on a Balance sheet is the liabilities which details all the debt the business has. This is also listed by liquidity and starts with current liabilities. Current liabilities include credit card charges, accounts payable (people who you owe money for goods or services provided which you didn't pay for at the time the service was provided or when the goods exchanged hands), payroll items (wages and taxes), the loan payments due in the next year, the balance on a line of credit, deposits or down payments you have received from customers or clients, and sales taxes are the most common types of current liabilities. If the payment has to be made within the next year, it is a current liability. Long term liabilities are the portion of loans which will not be paid in the next year.
Equity varies depending on the legal structure of the business. For LLC's it is usually Member equity (the amount of money the owner has put into the business to start it and any additional funds they provided over the life of the business) and Member draws (the money the owner has taken out of the business). For corporations (S or C) there will be a more complex equity structure which includes Retained Earnings, the current year's net income and often stock of some sort.
Ideally, the assets of a business will be larger than the debt so the business will have positive equity. The balance in a Balance Sheet comes from the equation Assets=Liabilities + Equity. This is best explained by realizing that assets must be paid for so how were they paid for? If you didn't pay cash for them, then you incurred debt so as your assets increase, usually so will the debt. All the other nuances in the equation as to numerous to detail in one blog article Balance Sheets must always balance! Modern accounting software programs have taken some of the difficulty out of this process as QuickBooks and Sage and other programs are written so that your Balance Sheet will always balance even if it doesn't always look good!