Financial Statements: The Balance Sheet

Also called a "statement of financial position," the balance sheet represents a company's financial health. The balance sheet shows the company's assets (what it owns), liabilities and net worth (what it owes, collectively). The balance sheet, income statement and cash flow statement are different types of financial statements. The balance sheet is used as a barometer of your company's financial health by investors, creditors, partners and others involved in the venture.

While the balance sheet represents a point in time, tracking how this data changes over time is an important measure of trends within the organization. Understanding how to read and interpret a balance sheet can help you better manage inventory, collect revenues, make business investments, calculate payments to creditors and make other important decisions.

Sources of funds are represented as liabilities and net worth—cash and other material support (such as equipment) provided by investors and creditors. Assets, meanwhile, represent how funds are spent and include anything of value owned by (or due to) the business.

The following information breaks down the various elements found in financial statements.

Current Assets

Assets that mature in less than one year are referred to as current assets. They typically are grouped into the following categories:

• Cash
• Accounts Receivable (A/R)
• Inventory (Inv)
• Notes Receivable (N/R),
• Prepaid Expenses
• Other Current Assets

Cash

Cash is inarguably the most important and flexible asset a company can have, since it can be converted into anything else of value. Cash is used for payroll, bills, machinery, facilities and inventory, just to name some of the more common business expenditures. Even a company with record sales and an otherwise winning business model cannot last without adequate cash in the bank.

Accounts Receivable (A/R)

Accounts receivable represents sales that have yet to be collected. Products and services often are sold on terms that allow payment within a set period of time after delivery. For example, if a customer orders $150 worth of widgets from ABC Inc. but has 30 days from the date of delivery in which to pay, then $150 is added to ABC Inc.'s accounts receivable total.

Inventory

The goods and materials stockpiled for resale at a profit represent a company's inventory. Raw material inventory is purchased, often a company's first use of cash, and processed into finished goods inventory to be sold. Since cash is used to buy and process materials into finished goods inventory, it is important to manage this wisely. Too much inventory can negatively impact cash flow, while too little inventory can slow deliveries, negatively impacting receivables and resulting in the loss of customers.

Notes Receivable (N/R)

Notes receivable, like accounts receivable, are dollars owed the company. But notes receivable represent either a loan from the company, often to an employee or officer, or the conversion of an account receivable to a promissory note because a customer was unable to meet the payment terms.

It's best to keep notes receivable to an absolute minimum, since they represent loans that usually have nothing to do with helping the business thrive.

Prepaid Expenses

These are expenses for goods or services that are paid in advance, such as a six- to 12-month advance on rent, taxes or salaries. For example, a business paying $12,000 in rent ($1,000 per month) in advance under "prepaid expenses" in the balance sheet would deduct $1,000 from that total each month.

Fixed Assets

Assets whose life exceeds one year typically are referred to as fixed assets. This category includes such things as land, building and facilities, machinery and equipment, furniture and leasehold improvements. Other fixed assets include deposits, long-term notes and other such accounts.

A fixed asset also may be intangible, something acquired with cash that has an undetermined lifespan and may never be liquidated into cash. The value of intangibles is difficult to determined, so they usually are ignored as assets and simply deducted from net worth.

The following are examples of fixed assets:

• Market Research
• Patents
• Research and Development
• Organizational Expenses

Liabilities and Net Worth

Liabilities, as listed on a balance sheet, are sums of money the company owes to others, such as money borrowed from a financial institution, money owed to suppliers, owed payroll and taxes. A company's net worth is total assets minus total liabilities. Liabilities and net worth are listed on the balance sheet in descending order from the highest priority creditors (those who need to be paid the soonest) to the lowest priority (those who can wait the longest) and never due obligations.

The two sources of funds are lender-investors (including employees, trade suppliers and banks) and owner-investors (such as stockholders and principals who loan money to the organization). Both categories of fund sources involve entities that have invested cash or equivalent assets into the company.

Current Liabilities

Financial obligations owed within 12 months are called current liabilities, which can make a company insolvent if they outstrip available cashflow. The goal of any company is to keep current creditors happy and satisfied. Happy creditors are an ongoing source of credit for short term cash needs, such as payroll and inventory.

The following obligations make up an organization's current liabilities:

• Accounts Payable - Trade
• Accrued Expenses
• Notes Payable - Bank
• Notes Pay - Other
• Current Portion of a Long-Term Debt

It is important to use current (or short-term) liabilities only for inventory, receivables and other short-term assets.

Notes Payable

Promissory notes with maturity dates of 12 months or less, often payable upon demand (notes payable), are referred to as notes payable. Notes payable that are not demand notes usually have specific maturity dates, measured in increments of days (30, 60, 90, 180, 270, 360). Interest owed on promissory notes is listed under accruals, not notes payable (which only includes the principal debt amount).

Businesses should use the proceeds from notes payable to finance inventory, receivables and other current assets in order for the asset to mature into cash before the obligation matures.

Accounts Payable

Financial obligations due to suppliers for goods and services or inventory are referred to as accounts payable. Suppliers typically offer payment terms (in other words, credit), so it makes sense to take advantage of payment terms that provide an advantage with respect to keeping costs down.

Accrued expenses are accounts payable owed but not billed, such as payroll taxes, wages or interest on a loan. If wages are paid twice a month, for example, then accrued expenses generally should not exceed two week's worth of payroll and related taxes.

Non-Current Liabilities

Financial obligations that will mature and become payable after the coming year are called non-current liabilities. The three main types of non-current liabilities are listed below:

• Non-Current Portion of Long-Term Debt (LTD)
• Subordinated Officer Loans (Sub-Off)
• Contingent Liabilities (these are not included in the balance sheet)

The non-current portion of long-term debt is the principal part of a loan that will not be payable in the coming year. Subordinated officer loans are treated somewhat like debt and somewhat like equity. Contingent liabilities, which are not factored into the balance but are included as footnotes, are potential liabilities (such as possible lawsuits or warranties).

If your business has been sued but litigation has yet to be initiated, then it is unclear whether or not the legal action will result in a liability. Since there is uncertainty, it is not calculated as a liability (since it might not become a liability) but is added in the footnotes as a possibility.

Total Liabilities

The sum of all financial obligations (including all creditor claims) is listed as a company's total liabilities.

Equity

Total assets minus total liabilities equals a company's equity, or net worth. As the most patient and last source of funds to mature, equity represents the owners' share in the financing of a company's assets. For example, an investor might put in $50,000 in exchange for a 10 percent equity share in the company. So when this equity matures (usually after a sale or public offering of stock), the owner will have the option of cashing out his or her 10 percent share of equity.