When we hear the word equation, some of us cringe with anxiety. We’re sent back to our school days when we were bombarded with theories and calculations that we were convinced we would never use.
But as a business owner, the accounting equation is one that you must understand to be able to gauge the financial health of your business. If you’ve taken a business class, you probably remember that the accounting equation is made up of debits and credits and double entries and … what?
Did I lose you?
Let’s break it down in terms that actually make sense.
There are two reports that all businesses should rely on to gauge their financial health, and you need both reports to get the full picture.
Revenue – Expenses = Net Profit
The first report is the profit and loss report. You probably already look at this report frequently to see what your total sales were for the month and how much you spent in office supplies. The profit and loss report includes the total amounts recorded in your income and expense accounts.
At the end of the year, our total expenses are subtracted from our total income to calculate our profit for the year. All business owners are familiar with the profit and loss equation because it seems to give you a clear picture of where the money is coming from and where it is being spent. But the profit and loss alone doesn’t show you everything.
Assets = Liabilities + Equity
The other report that small businesses need to understand is the balance sheet. It includes a summary of our total assets, liabilities, and equity. Many small business owners know that the balance sheet is important, but they don’t really understand what it is telling them.
While the purpose of the profit and loss is to show how the business performed over a specific time period, the purpose of the balance sheet is to show the financial position of the business on any given day. The balance sheet can tell you how much money the business has in the bank and how likely it is that the business will be able to meet all of its financial obligations. It can also tell you how much profit (or loss) the business has retained since it started.
Before we can use the balance sheet for analysis, we need to really understand the three types of accounts included on it; assets, liabilities, and equity.
Assets (or what you have)
An asset is something that the business owns, or as I like to say, what a business has. Some common asset accounts include cash or bank accounts, accounts receivable (monies owed to you by your customers), inventory, fixed assets (buildings, machinery, or furniture), investments, and intangible assets like patents, trademarks, or non-compete covenants.
Liabilities (or what you owe)
A liability is something that you owe, whether to an individual, business, or institution (like a bank or the IRS). Examples of liabilities would be accounts payable (monies owed to your vendors), a car loan, or mortgage on a building. Amounts owed to customers for gift certificates or prepaid services are also examples of liabilities.
Both asset and liability accounts are classified as either short term (meaning they will be used up or paid within one year) or long term (meaning it will take more than 12 months to use them or pay them back).
Equity (or what you really have)
Equity can be looked at as the net worth of the business. If we rewrite the equation for the balance sheet another way, it actually makes much more sense to us.
Assets – Liabilities = Equity
Just as we have different types of asset and liability accounts, we also have different types of equity accounts—contributions (money invested into the company), distributions (money taken out of the company by the owners), and retained earnings (the cumulative profit or loss of the business since its inception). At the end of each fiscal year, the net profit (or loss) from the profit and loss is added to (or subtracted from) retained earnings and the amounts in the income and expense accounts reset to zero.
Equity accounts can have many different names depending on the organizational structure of a business. For example, a sole proprietor’s equity accounts are usually called Owner’s Equity for money put into the business and Owner’s Draw for money given back to the owner. And a corporation has a Common Stock account (the initial investment into the company), Additional Paid in Capital (APIC, or additional amounts invested by the shareholders), and Shareholder’s Distributions or Dividends Paid (amounts taken out of the company by the shareholders as a return of their investment or share of the company’s profits).
Once we understand the balance sheet equation, we can use it, along with the profit and loss, to get important information about the health of a company. Some important ratios you can use to gauge the health of your business are:
Many of the financial ratios that lenders use when determining credit risk are based on balance sheet accounts, so understanding how they relate to your situation can really help you before you start to look for a business loan.
The balance sheet is also used when creating cash flow projections. A cash flow projection uses amounts in the asset and liability accounts to predict when money will be received and when payments are due. These amounts are added and subtracted from the expected net profit or loss to arrive at a projected cash balance.
When you look at the profit and loss and balance sheet together, you get the full financial picture of your business. While a company may show a profit on the profit and loss statement, the balance sheet might tell a different story.
For example, if the company is in a cash crunch, only the balance sheet would show that liabilities exceed assets and indicate a problem. In other words, business owners must get into the habit of reviewing both reports frequently in order to successfully manage their business finances.