Small business accounting: balance sheet decoded

Balancing act

Small business accounting balance sheet

The balance sheet provides a snapshot of your company’s financial position on a given date. It lists the assets (what a company owns), the liabilities (what it owes) and the owners’ equity in the business.

The balance sheet is based on the basic accounting equation: Assets = Liabilities + Owners’ equity.

The left side (assets) is the value of everything the business owns.   The right side (liabilities + owners’ equity) represents how the business paid for the assets. A business can borrow money from outsiders, receive equity investments from the owners or reinvest profits.   Any changes made to a balance sheet can never violate the basic accounting equation. In order to maintain “balance” you must always make at least two changes:

  • Assets            =          Liabilities        +          Owners’ Equity
  • +100                =          +50                                      +50
  • +100                =          +100                                    no change
  • +100                =          no change                       +100
  • +100, -100   =          no change                       no change

When preparing a balance sheet several important account guidelines have to be followed.

These include:

  • Monetary Unit Assumption – All values must be recorded in U.S. dollars and the effects of inflation are ignored. You can’t mix currencies and you don’t go back and update numbers because of inflation.
  • Cost Principle – All values are recorded at their actual cash cost and stay that way. A building bought for $200,000 in 1986 that could be sold today for $3 million is still recorded at $200,000 on the balance sheet.
  • Conservatism – When in doubt always play itself. If there is more than one acceptable way to record a value, choose the way that minimizes the asset value or increases the liability value.

Maintaining an accurate balance sheet is very important for securing a loan.

Lenders will usually require regular copies of your balance sheet prepared by an accountant. In addition to agreeing to pay back the loan, they will also require that you agree to maintain certain minimum and maximum ratios based on balance sheet amounts. These requirements are called loan covenants.

Typical balance sheet loan covenants

Debt-to-Equity ratio: Liabilities divided by Owners’ equity. A ratio of 1.5:1 means that for every dollar in debt your business has a dollar in equity Working Capital ratio: Current (short-term) assets – Current (short-term) liabilities. A minimum working capital requirement ensures that your business has enough cash and other assets that can be converted to cash quickly to cover debts coming due within a year. Read more…

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