8

Understanding Balance Sheet Basics

There’s a puzzling fact about financial statements. Maybe you’ve noticed it.

Give a company’s financials to a first-time entrepreneur, and the first thing he will turn to is the income statement. Entrepreneurs know that a company has to make a profit. Maybe he has worked in other companies and has had P&L responsibility. Or maybe this is his first business experience, and he knows revenue has to exceed expenses. He believes that the income statement is the best record of a company’s financial performance. So that’s what he looks at first.

Now try giving the same set of financials to a banker, an experienced investor, or maybe a veteran entrepreneur. The first statement this person will turn to is invariably the balance sheet. In fact, she’s likely to pore over it for some time. Then she’ll start flipping the pages, checking out the income statement and the cash flow statement—but always going back to the balance sheet.

Why don’t less-experienced entrepreneurs do what the pros do? Why do they limit their attention to the income statement? We chalk it up to three factors:

• The balance sheet is a little harder to get your mind around than the income statement. The income statement, after all, is pretty intuitive. The balance sheet isn’t—at least, not until you understand the basics.
• Company owners deal with revenue and expenses day in and day out. They monitor sales. They create and approve expense budgets, and usually the budget categories more or less align with the line items on the income statement. Balance sheet data, by contrast, rarely figures in the day-to-day management of a young company (although you’ll see why we think it should).
• Managing the balance sheet requires a deeper understanding of finance than managing an income statement. You not only have to know what the various categories refer to; you have to know how they fit together. You also have to understand how changes in the balance sheet affect the other financial statements, and vice versa.

Maybe you, too, are a bit wary of the balance sheet. But remember, what we’re focusing on here is financial intelligence—understanding how financial results are measured and what you as a company owner can do to make your business more successful. We won’t get into the esoteric elements of the balance sheet, just the ones you need to appreciate the art of this statement and do the analyses of your business that the statement makes possible.

SHOWING WHERE THINGS STAND RIGHT NOW

So what is the balance sheet? It’s no more, and no less, than a statement of what a business owns and what it owes at a particular point in time. The difference between what a company owns and what it owes represents equity. Just as one of a company’s goals is to increase profitability, another is to increase equity. And as it happens, the two are intimately related.

What is this relationship? Consider an analogy. Profitability is sort of like the grade you receive for a course in college. You spend a semester writing papers and taking exams. At the end of the semester, the instructor tallies your performance and gives you an A – or a C+ or whatever. Equity is more like your overall grade point average (GPA). Your GPA always reflects your cumulative performance, but at only one point in time. Any one grade affects it but doesn’t determine it. The income statement affects the balance sheet much the way an individual grade affects your GPA. Make a profit in any given period, other things being equal, and the equity on your balance sheet will show an increase. Lose money, and it will show a decrease. Over time, the equity section of the balance sheet shows the accumulation of profits or losses left in the business; the line is called retained earnings (losses) or sometimes accumulated earnings (deficit).

Equity

Equity is the shareholders’ stake in the company as measured by accounting rules. It’s also called the company’s book value. In accounting terms, equity is always assets minus liabilities; it is also the sum of all capital paid in by shareholders plus any profits earned by the company since its inception minus dividends paid out to shareholders. That’s the accounting formula, anyway; remember that what a company’s shares are actually worth is whatever a willing buyer will pay for them.

Here too, however, understanding the balance sheet means understanding all the assumptions, decisions, and estimates that go into it. Like the income statement, the balance sheet is in many respects a work of art, not just a work of calculation.

INDIVIDUALS AND BUSINESSES

Since the balance sheet is so important, we want to begin with some simple lessons. Bear with us—it’s important in this case to crawl before you walk. Besides, if you want to explain your company’s balance sheet to your employees or family members, you’ll probably want to begin at the beginning.

So here’s a way to go about it. Start by considering an individual’s financial situation, or financial worth, at a given point in time. You add up what the person owns, subtract what she owes, and come up with her net worth:

owns – owes = net worth

Another way to state the same thing is this:

owns = owes + net worth

For an individual, the ownership category might include cash in the bank, big-ticket items like a house and a car, and all the other property the person can lay claim to. It also would include financial assets such as stocks and bonds or a 401(k) account. The “owing” category includes outstanding mortgage, car loan, and credit card balances, as well as any other debt. Note that we’re avoiding for the moment the question of how to calculate some of those numbers. What’s the value of the house—what the person paid for it or what it might bring today? How about the car or the TV? You can see the art of finance peeking around the curtain here—but more on that in a moment.

Now move from an individual to a business. Same concepts, different language:

• What the company owns is called its assets.
• What it owes is called its liabilities.
• What it’s worth is called owners’ equity or shareholders’ equity.

And the basic equation now looks like this:

or this:

If you took any sort of accounting course in school, you learned one of these formulas. The instructor probably called it the fundamental accounting equation. You also learned that the latter formulation reflects the two sides of the balance sheet: assets on the one side, liabilities and owners’ equity on the other. The sum on one side has to equal the sum on the other side; the balance sheet has to balance. Before you finish this part of the book, you will understand why.

READING A BALANCE SHEET

First, however, find a sample balance sheet, either your own company’s or one in an annual report. (Or just look at the sample in appendix A.) Since the balance sheet shows a company’s financial situation at a given point in time, there should be a specific date at the top. It’s usually the end of a month, quarter, year, or fiscal year. When you’re looking at financial statements together, you typically want to see an income statement for a month, quarter, or year, along with the balance sheet for the end of the period reported. (Unlike income statements, balance sheets are almost always for an entire organization. Sometimes a large corporation creates subsidiary balance sheets for its operating divisions, but it rarely does so for a single facility.) As we’ll see, accounting professionals have to do some estimating on the balance sheet, just the way they do with the income statement. Remember our hypothetical delivery business? The way we depreciate the truck affects not only the income statement but also the value of assets shown on the balance sheet. It turns out that the assumptions and biases in the income statement flow into the balance sheet one way or another.

Fiscal Year

A fiscal year is any twelve-month period that a company uses for accounting purposes. Many companies use the calendar year, but some use other periods (October 1 to September 30, for example). Some retailers use a specific weekend, such as the last Sunday of the year, to mark the end of their fiscal year. You must know a company’s fiscal year to ascertain how recent the information you are looking at is.

Balance sheets come in two typical formats. The traditional model shows assets on the left-hand side of the page and liabilities and owners’ equity on the right side, with liabilities at the top. The less traditional format puts assets on top, liabilities in the middle, and owners’ equity on the bottom. Whatever the format, the balance remains the same: assets must equal liabilities plus owners’ equity. (In the nonprofit world, owners’ equity is sometimes called net assets.) Often a balance sheet shows comparative figures for, say, December 31 of the most recent year and December 31 of the previous year. Check the column headings to see what points in time are being compared.

As with income statements, some organizations (usually public companies) have unusual line items on their balance sheets that you won’t find discussed in this book. Remember, many of these items may be clarified in the footnotes. For public companies, the footnotes will appear in the 10-K right after the financial statements; in fact, the balance sheets of large public companies are notorious for their footnotes. Ford Motor Company’s 2006 annual report contained a whopping fifty-one pages of notes, many of them pertaining to the balance sheet. Indeed, companies often include a standard disclaimer in the notes that makes the very point about the art of finance that we are making in this book. Big Dog Holdings, Inc., for instance, says this in its 2006 report:

Use of Estimate

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.1

If your accountant includes notes with your balance sheet and you are unclear about what they mean, be sure to ask him. This is your business, and you should be aware of the assumptions and calculations that go into your numbers.

Since the balance sheet is new to many entrepreneurs, we want to walk you through the most common line items. Some may look strange at first, but don’t worry: just keep in mind that distinction between “owned” and “owed.” As with the income statement, we’ll pause along the way to see which lines are most easily monkeyed with.