26 Mar Profit and Loss vs. Balance Sheet

Profit and Loss vs. Balance Sheet

Working with new and seasoned small business owners over the years, I have often heard the frustration when it comes to understanding their company’s Balance Sheet.  Profit and Loss, I have found makes “more sense” to the individual whose interests are not in accounting.  The Profit and Loss is a list of all the revenue a company received, less the expenses and hopefully, there is more revenue than there is expense, thus creating a profit.  Balance Sheets on the other hand, are not quite as clear.

Things that every small business owner should know about their balance sheet.

The Balance Sheet is a list of 3 things in your company:

 

1. 1. Assets: These are positive things in your business.  They include the balance of your bank and savings accounts.  They include Pre-paid expenses such as a security deposit on your rental space.  They include equipment that you own like computers, machine tools, as well as furniture and fixtures.  If you own property, this is an asset to your business.  If you have a mortgage on that property, the mortgage is a part of your Liabilities.  Assets include inventory too, if you are selling product and that product is sitting in your warehouse, this is an asset to your business as it has real value.  The last big thing that is an asset to your business is your Accounts Receivable.  This is the amount of money that is owed to you for the work your company has completed for others.

1. 1. Liabilities: Did you have to take out a loan from the bank or maybe from your Uncle Tom to get the business off the ground?  This is a liability to your business.  Also included in Liabilities would be any credit card balances that are unpaid and additionally, money that you may owe to your vendors, by way of Accounts Payable.  If you lease a car, you do not own this car, a car dealership or a financing company owns that car.  You have a Lease Liability to pay that company because you are set up for a fixed length of time to pay a certain amount per month for the use of that car.  Another common liability is Sales Tax Payable or Payroll Tax Liabilities.  When you sell a product for which Sales Tax is due, you are essentially collecting money on behalf of your State and holding that money until it is due.  This is a liability to your business, and by similar thoughts, the same is true for Payroll Taxes Due.  You have a tax obligation created by paying an employee and you are holding that money in your business until the government requires it.
   2. Equity has two major components: The Owner’s Draw/Partner Distributions/Shareholders Pay and the Retained Earnings.  The Owners Draw is the amount that the owner has tied up in the business.  This is where the money for Partner Distributions goes.  Many are confused by this.  If a business owner takes money out of the business outside of issuing themselves a paycheck that is subject to payroll taxes, they have taken a Draw.  No tax has been paid on this amount yet but it is no longer available in the business.  Because owners have been known to take out Draws on an as-needed basis to match their personal expenditures, this is a common reason why a very profitable

 

Retained Earnings is the other big thing on the Equity list.  Retained Earnings are the company’s net earnings not paid out as dividends but instead, retained by the company.  Retained Earnings tells the story of adding the net income of the business or subtracting the net losses of the business from the prior balance, while subtracting dividends paid to shareholders.

On a Balance Sheet, the equation is as follows:

ASSETS = LIABILITIES + EQUITY

A balance sheet speaks to the health of the business via the total of Assets and Liabilities and how the Equity is applied.  It will give potential investors an idea of how much cash is on hand, how much debt is owed to others, and how much the owners are taking out of the business.  If debt levels are high in comparison to assets, it might not speak well to the potential of gaining funding.  On the other hand, if Assets are high, a potential investor might be prompted to ask questions about the state of the current equipment on hand and where that equipment is in its life cycle.  The Balance Sheet tells a different story from the Profit and Loss Statement.  As a small business owner, understanding the story that your numbers tell will help you make optimal decisions for the health of your business, Balance Sheet included.