The Balance Sheet measures the business’ position at a point in time. It is a snapshot of the business that is often neglected by less than savvy business owners.
The American-style Balance Sheet shows the assets on the left side and the liabilities and equity on the right side. The two sides balance, hence the name of the statement. On both sides, the individual accounts are generally in their order of liquidity. That is, how quickly they can be converted to cash. That’s why, on the asset side, cash comes first, then accounts receivable and then, usually, inventory. Fixed assets and intangibles come further down the list. On the liability side, accounts payable and payroll payable usually come first since they are paid on a short-term basis. Other liabilities follow.
Most Balance Sheets are prepared on a “classified” basis. That is, there is a distinction made current items and non-current items. Current items are items that complete the cash-to-cash cycle in less than a year. For example, cash goes out for inventory, inventory is sold and cash is collected in less than a year. That’s why inventory is usually a current asset. Debt can be short-term or long-term. That portion of debt due in more than one year is considered non-current. That to be paid within the next year is current.
The distinction between current and non-current is important because it helps readers of the Balance Sheet and other financial statements judge the company’s ability to meet its obligations. The excess of current assets over current liabilities is called working capital. The amount of working capital and the company’s ability to generate working capital are important measures.
Of course, no one ever made payroll with working capital, so a more immediate concern is the ability to generate cash. Both cash and working capital are important.
The residual of subtracting liabilities from assets is Owners’ Equity. Owners’ Equity is made up of amounts invested in the business and retained profits, less losses of the business and draws or dividends paid to the owners.
A few industries have an operating cycle of more than one year. For example, timber companies and whiskey manufacturers. In this case, current is defined as more than one year. Still other industries don’t use a classified Balance Sheet format at all. Real estate is the best example of this. In this case, the accounts are just listed in liquidity order with no distinction made between current and non-current.
Every amount on the Balance Sheet must represent something real. Because these amounts carry forward from year-to-year, sometimes this is overlooked. Cash must be the reconciled amount of cash in company’s bank accounts. Accounts receivable represents amounts due and collectible from customers on specific invoices. Accounts payable represent specific amounts on invoices due to vendors. The person preparing the Balance Sheet should be able to explain, precisely, what every amount on the Balance Sheet represents. If they can’t, you’ve got a problem that needs to be addressed. In fact, if you’re the owner of the business (or the banker), you should probably be provided with a supporting schedule detailing what is behind every number on the Balance Sheet. You need to have confidence that the Balance Sheet presents an accurate picture of the business at a point in time.
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