Reading a balance sheet: 3 things business owners need to look for

A business’ financial statements are the most basic indicator of your business’ health. But they can be confusing and complicated and, truthfully, not many business owners look at them (and when they do they might not learn much). Yesterday I offered some tips on how to read an income statement. Today we are going to look at reading a balance sheet.

I hear it from business owners all the time: “My accountant says I made $300,000 last year and have a big tax bill — but I don’t have that money in my bank account. Where did it go?” I’m not going to go into the differences here between management accounting and tax accounting (except to say that you may have spent money on things that aren’t “fully deductible” like meals and entertainment); so, for tax purposes, your income is likely more than what it says on your Income Statement. But it’s crucial that you know where the money goes between the time you book a sale and when you see your bank balance rise. This is shown on the Balance Sheet.

reading a balance sheet

The balance sheet is where we record things that we are owed and things we own (Assets), as well as things we owe to others (Liabilities). The difference between these things (Assets – Liabilities) is called Equity.

When we are showing an income on our Income Statement but we don’t see the money in our checking account it is often because we’ve loaned it to someone else (usually our customers in the form of Accounts Receivable); or we’ve spend that money on an asset (like furniture or computers) that has a value for a while. Since we are going to use that asset over a period of time, we have to spread the expense over the asset’s useful life through a process accountants call depreciation.

How does this work?

If you buy office furniture you have to pay for it all now, when the furniture arrives; but that furniture is going to last more than 1 year, right? So your accountant will put that purchase on the balance sheet (as an asset) and only deduct 10% of its value (if it has a 10 year life) this year. So your income statement is now saying that you spent $1000; but your checkbook is missing $10,000. You don’t have the money in the bank, but now you have an Asset worth (theoretically) $9,000.

invoiceThis happens in other ways too. If you sell a project and send an invoice, that creates an entry in Accounts Receivable. When you receive payment for that project it moves that amount from Accounts Receivable into Sales. So if you’ve sold a lot of projects but your customers haven’t paid you yet your business could feel profitable (“Look at all the invoices I’ve sent!”) but you may not have cash in the bank.

To make matters worse you’ll likely pay your employees, contractors, vendors, rent, etc. before you get payment for the project that those employees worked on. So even though the project was profitable (assuming you charged more than it cost you to deliver), because you haven’t gotten paid yet, you have no money in your bank account.

All these scenarios can make a business owner feel like money is disappearing. If you want to look for money that’s missing from your checking account, you will usually find it somewhere on your balance sheet.

So when it comes time for reading a balance sheet for your business each month, what should you be paying attention to?

1. Did your equity go up?

The difference between your assets (things you own or are owed to you) and your liabilities (things you owe to others) is your the value of your equity. When that number goes up your business is creating value. (Don’t confuse the value of the Equity with what your business is worth, that’s a topic for another day.) Now look more closely at what Equity is made up of; it’s retained earnings (money you made in prior periods) – Shareholder Disbursements (Money you took out) + Net Income (money you made in this period).

If your Shareholder Disbursements are high (especially if they are higher than retained earnings) then your company is creating value — but you are taking out more value than it’s creating! This is not sustainable in the long-term — either you need to reduce your distributions, or you need to increase your earnings.

2. How are your receivables?

If you are running your business on a cash basis (you only recognize revenue when the cash is in the bank) your balance sheet won’t show Accounts Receivable (A/R) — but you should look at it anyway! Accounts Receivable is the money you have loaned to your customers. Money they owe you but they haven’t paid yet. This number will go up or down with your sales (e.g. if you sell more, you send out more bills, your A/R will go up). This is not a problem, it’s a normal thing when your sales rise. This makes it hard to compare one month’s A/R to another, how do I know if it’s too high?

One way to compare A/R from month to month is use A/R Days, or Days Sales Outstanding (DSO) two terms that mean the same thing. This converts the absolute value of your A/R into a ratio of Receivables to Sales so that you can compare the value of the receivables between different periods. This allows us to isolate the variations in receivable value from the variations in actual sales levels.

3. What else is changing? (Payables, Inventory, etc.)

balance sheetIf you own inventory, that’s another big place where cash hides. If you pay for inventory, that’s money out of your bank account. Even though you will sell it at a profit, until you actually get paid for that inventory, it’s money that’s missing from your bank account. Payables (or Accounts Payable) is money that you are borrowing from your vendors. It’s good to be that customer who pays on time — but if your customers are paying you in 60 – 90 days and you are paying your vendors in 20 – 30 days your business can turn into a bank — where you are loaning everyone money and you are out of cash. Try to get your payment terms with your vendors to be at least as long as your customers demand of you.

Reading Balance Sheets can be confusing, but it essential that you keep tabs on where your cash is coming from and going to. There’s only two things that a business can never run out of; customers and cash. So find a way to keep an eye on both!

BONUS: We’re giving away a free tool this month, called our Small Business KPI Reporting Tool from our Pro Member library. In it, you’ll find how often you should be reviewing things like your balance sheets, other financial statements, and Excel templates to help you build your own statements to use. It’s incredibly valuable — download it now!

Small Business KPI Reporting Tool

Photo credit: Death to Stock Photo, miguelb,

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