If the income sheet shows what you’re earning, the balance sheet shows what you’re worth. A balance sheet can help an investor see that a company owns valuable assets that don’t show up on the income statement or that it may be profitable but is heavily in debt. It adds up everything your business owns, subtracts everything the business owes, and shows the difference as the net worth of the business.
Actually, accountants put it differently and, of course, use different names. The things you own are called assets. The things you owe money on are called liabilities. And net worth is referred to as equity.
A balance sheet shows your condition on a given date, usually the end of your fiscal year. Sometimes balance sheets are compared. That is, next to the figures for the end of the most recent year, you place the entries for the end of the prior period. This gives you a snapshot of how and where your financial position has changed.
A balance sheet also places a value on the owner’s equity in the business. When you subtract liabilities from assets, what’s left is the value of the equity in the business owned by you and any partners. Tracking changes in this number will tell you whether you’re getting richer or poorer.
Assets
An asset is basically anything you own of value. It gets a little more complicated in practice, but that’s the working definition.
Assets come in two main varieties: current assets and fixed assets. Current assets are anything that is easily liquidated or turned into cash. They include cash, accounts receivables, inventory, marketable securities, and the like.
Fixed assets include stuff that is harder to turn into cash. Examples are land, buildings, improvements, equipment, furniture, and vehicles.
The fixed asset part of the balance sheet sometimes includes a negative value—that is, a number you subtract from the other fixed asset values. This number is depreciation, and it’s an accountant’s way of slowly deducting the cost of a long-lived asset such as a building or a piece of machinery from your fixed asset value.
Intellectual properties, such as patents and copyrights, also fall into the asset category. For some companies, a recipe, a formula, or a new invention may actually be their most valuable asset. Of course, the actual value is often very hard to determine. Patents, trademarks, copyrights, exclusive distributorships, protected franchise agreements, and the like do have somewhat more accessible value.
You’ll also have intangibles such as your reputation, your standing in the community, and “goodwill,” which are difficult to put a value on. Probably the best way to think of goodwill is like this: If you sell your company, the IRS says the part of the sales price that exceeds the value of the assets is goodwill. As a result of its slipperiness, some planners never include an entry for goodwill, although its value may in fact be substantial.
Liabilities
Liabilities are the debts your business owes. They come in two classes: short-term and long-term.
Short-term liabilities are also called current liabilities. Any debt that is going to be paid off within twelve months is considered current. That includes accounts payable you owe suppliers, short-term bank loans (shown as notes payable), and accrued liabilities you have built up for such things as wages, taxes, and interest.
Any debt that you won’t pay off in a year is long-term. Mortgages and bank loans with more than a one-year term are considered in this class.
A Note on Land
Almost anything can lose value, but for accounting purposes, land doesn’t. As a rule, you never depreciate land, although you may depreciate buildings as well as other long-lived purchases.
Buzzword: Book Value
The book value of the business is the net worth (or owner’s equity). Most valuation methods for small and midsized businesses use the net worth plus adjusted earnings or free cash flow multiple to create a rough and ready valuation. If you are just starting out, you will probably feel that you are undervalued because you have nothing on which to base your value. Don’t fret: Value grows with time as you build your business. It’s better that the value of your business honestly reflects your business. If you recall the dot-com crash of 2000, it was largely the result of many up-and-coming dot-coms being greatly overvalued.
Tax Considerations
You always want to maximize profits, right? Savvy entrepreneurs know that managing reported profits can save on taxes. Part of the trick is balancing salaries, dividends, and retained earnings.
Tax regulations treat each differently, and you can’t exactly do whatever you want. Get good advice and be ready to sacrifice reported profits for real savings.
Personal Financial Statement
Investors and lenders like to see business plans with substantial investments by the entrepreneur or with an entrepreneur who is personally guaranteeing any loans and has the personal financial strength to back those guarantees. Your personal financial statement is where you show plan readers how you stack up financially as an individual.
The personal financial statement comes in two parts. One is similar to a company balance sheet and lists your liabilities and assets. A net worth figure at the bottom, like the net worth figure on a company balance sheet, equals total assets minus total liabilities.
A second statement covers your personal income. It is similar to a company profit and loss statement, listing all your personal expenses, such as rent or mortgage payments, utilities, food, clothing, and entertainment. It also shows your sources of income, including earnings from a job, income from another business you own, child support or alimony, interest and dividends, and the like.
The figure at the bottom is your net income; it equals total income minus total expenses. If you’ve ever had to fill out a personal financial statement to borrow money for a car loan or home mortgage, you’ve had experience with a personal financial statement. You should be able to simply update figures from a previous personal financial statement.
Because this is important only to investors or lenders, you want to be careful to include this only when necessary. For a small business looking for a small amount of funding, you may be able to draft something with your accountant verifying your net worth and/or previous year’s income.
