10 May Financial Statements: How to Prepare a Balance Sheet
A balance sheet serves as a health report for your business. This information allows the reader to analyze past operations, sources of cash, and how well it can handle a downturn.
A common mistake by many new entrepreneurs is their tunnel vision on the income statement, leading them to overlook other statements such as the balance sheet and statement of cash flows. While each statement has their importance, not one should be used alone to analyze your company’s performance.
What is a balance sheet?
A balance sheet is a snapshot of your company’s current health. It shows many important aspects such as liquidity, leverage, equity, total assets, total liabilities, etc., all important factors in decision making and analysis. Is your company highly leveraged? Might want to consider paying debt down before taking more on. Is your company’s liquidity subpar with excess cash flow at a minimum? Might want to look into selling fixed assets and increasing liquidity.
How to properly setup and prepare a balance sheet
The main equation to remember with a balance sheet is that Assets = Liabilities + Equity. While your journal entries should equate to this, it is a good checks and balance figure to know if a mistake has occurred or not. It is also important to remember that most accounts will be entered on a historical or cost basis. For example, if it costs your company $100,000 to purchase a building, then the gross building amount would be $100,000 the entire time it is on your balance sheet. It is important to remember that if improvements are made, the cost of these improvements will generally be lumped together in a “buildings and improvements” account. Depreciation will also take place, creating a net amount on the balance sheet. Many argue that the absence of fair market value on a balance sheet creates an understatement of actual asset amounts, especially long-term assets, resulting in off-balance sheet-equity.
On the left side of the equation is assets, and therefore they should be placed on the left side of the balance sheet (some balance sheets are vertical, having assets on top is fine too). Assets need to be placed in order of liquidity. This would mean tangible current assets first, then tangible long-term assets, and followed by intangible assets.
A current asset is an asset that will reasonably be converted to cash within the year. As mentioned above, this needs to be in the order of liquidity. A list of the most common current assets and their accompanying order is as follows:
1. Cash- no conversion needed, will always be the asset with most liquidity.
2. Marketable Securities– These are close to cash, but generally take a few days to convert.
3. Accounts Receivable– Depending on your clients and credit terms, this asset generally takes one to two months to convert. It is also important to remember an allowance for doubtful accounts if you anticipate any receivables not being paid. Without this contra account your overall liquidity and assets are overstated, a misrepresentation to the reader.
4. Inventory– This highly depends on inventory turnover times and how much inventory your company carries.
5. Prepaid Expenses– This consists of prepaid expenses that will be used within a year. Examples of this could include prepaid insurance, prepaid rent, etc. Time varies on the type of expense that is prepaid.
6. Notes Receivable (Current Portion)- A note receivable differs from accounts receivable. Accounts receivable is stated by an invoice while a note receivable is stated by a promissory note. This is common in lending institutions such as a bank, but can also be used if a supplier agrees to clean up past due A/R by extending it in the form of a note. The portion receivable within a year is included in current assets while the amounts in excess of a year will be in long-term assets. Remember this should only include the principal portion, as interest income will be accounted for on the income statement.
While this is not an exclusive list, they are the most common current assets that a company will have on their balance sheet. After all current assets are properly accounted for it is advised to create a Current Assets total. This will be used in further ratios and allows quicker access for the reader.
After this is complete, you are ready to insert your fixed or long-term assets. Fixed assets are assets that will not reasonably be converted to cash within the year. Separate titling is not needed, but for purposes of education long-term assets are divided into three categories:
Long-term investment assets
Investment assets are assets that are intended to provide future economic value, just not within the next 12 months. Assets included in this category would be:
7. Notes Receivable (long-term portion)- As mentioned in line 6, companies can also carry notes receivable. Many times this will extend past a year and needs to be accounted for properly. This account would contain the portion to be received after a year from statement date.
8. Stocks- Whether your company has invested in another company with the intentions of a long-term relationship or you simply plan on holding stocks for more than a year, this would be considered a long-term investment.
Property, Plant, and Equipment
Property, plant, and equipment (PPE) includes various types of physical assets. These assets are generally not held for sale, and will be held by the company for several years. Examples of items included in this:
9. Land- Although the purchase price of land and buildings are generally lumped into one price, they need to be separated on the balance sheet. This is due to two reasons. The first, they are two separate assets and need to be shown this way. Second, land needs to be accounted for separately from depreciable assets as land is not depreciable. Land can be impaired if a major event occurs (i.e earthquake), but is not subject to normal wear and tear like other assets.
10. Buildings- If your company owns a building, it will be placed here on the balance sheet. As mentioned above, the amount shown will only relate to the building. An account titled “Buildings and Improvements” can be created if improvements are made. Be sure to check depreciation methods as these separate improvements may be subject to different depreciation schedules.
11. Machinery and Equipment- Relates to any machinery or equipment you would use in a line of business. An erection company would likely have large equipment such as Cranes included in this account.
12. Vehicles- This would include all company owned vehicles used in business operations.
It is important to remember accounting for accumulated depreciation. If you are expensing depreciation but forget to include on the balance sheet, your books will not match. General practice is to show all of your depreciable assets as individual gross amounts, with one lump sum accumulated depreciation amount underneath them. This will create a Net PPE account, which will be the amount contributing to the total asset figure. The gross amounts listed are merely for the reader’s purpose and do not directly contribute to the total asset account.
Last but not least, the intangible assets. These assets are last as they will never be converted to cash, yet provide an economic value and remain on the asset list. Assets in this category lack physical substance and relate to “blue sky” items. Common intangible assets include:
13. Goodwill– This asset can only be created when you acquire a business. It is the above asset value a company brings. Examples would include brand recognition or customer loyalty. Not a physical asset, but an asset that provides value to your business. Goodwill is no longer amortized in financial accounting but is subject to impairment testing at a minimum of once a year.
14. Other intangible assets would include common items such as trademark, patent, non-competition agreements, etc. Anything that provides value to your company but is not a physical or tangible asset. This type of asset is amortized in accordance with its useful life.
As with depreciable assets, it is important to remember an accumulated amortization account for amortizable assets. These again would be shown by gross individual amounts and then one accumulated amortization account. This would create a Net Other Intangible Asset account, which would contribute to the total assets account.
After these assets are properly accounted for, you will want to create a Total Assets column. This provides the reader a total of all assets, while a separate column allows for quicker discovery.
While assets have guidance on how to order, liabilities are merely subject to current first and long-term after. This creates a varying order of accounts between companies.
A current liability is a liability that will be paid in less than one year. A list of the most common current liabilities is as follows:
1. Accounts Payable- This consists of accounts payable to vendors. Every vendor is subject to different terms while most won’t extend past 60 days.
2. Accrued Expenses- These are payables that generally don’t have an invoice attached to them, likely internal payables. Examples would be wages, tax, benefits, etc.
3. Short-Term Borrowings- Items such as credit card and lines of credit (if it matures in a year or less),
4. Current Portion of Long-Term Debt- This one is probably the most overlooked current liability on company financials. While your long-term debt (LTD) doesn’t mature for over a year, there is still a portion due within 12 months. This portion is known as the current portion of long-term debt (CPLTD) and needs to be separated from the portion payable past 12 months. It is also important to remember that this figure only consists of principal payments, as interest is an expense and accounted for on the income statement.
5. Unearned Revenue- This one is a confusing category to most as it’s hard to accept any revenue as a liability. While this logic is true, the reason it’s listed in the liability section is that you have received cash for a service not yet provided. Once the service is provided it will be transferred to revenue. Until then it needs to be listed as a liability, primarily due to the fact that the project risks not being completed.
6. Deposits- Same logic as Unearned Revenue, but a deposit is cash received for a service or reason that you are not yet entitled to. This account is common for landlords. Many will retain a deposit from renters and return at the end of a lease, assuming there isn’t damage to the home.
Again, this is not an all-inclusive list, but rather that of the most common accounts you will see. After all current liabilities are in place it is advised to create a Current Liabilities total. After this is complete, you will move on to long-term liabilities.
Long-term liabilities are liabilities that will not be paid in less than 12 months. Remember, if a portion of this will be paid in less than 12 months, it needs to be separated and included in current liabilities. This was explained in account 4, CPLTD. Below is a list of common long-term liability accounts:
7. Mortgage loans (Net of CPLTD)- If your company has purchased an office building, you will likely have a mortgage loan on your books. This account would show the principal amount remaining, in excess of payments to be made within 12 months.
8. All other long-term asset loans- This account consists of loans used to finance other fixed assets. Such assets would include Equipment, Machinery, Vehicles, etc. This would be the same as mortgage loans, showing the principal amount remaining in excess of payments to be made within 12 months.
9. Shareholder loans– This account can be tricky in classifying correctly, as many times a shareholder loan will not have set terms. Instead, it will be paid as the entity is able to do so. This makes it difficult in determining CPLTD vs LTD. Due to this, it is best to always have a defined repayment plan on these loans (if possible). The creditor is generally easy to work with if a payment can’t be paid one month.
10. Bond Instruments– This is an account you will seldom see if you’re running the books of a small business. Bonds are debt instruments used to raise capital, something not many small businesses will do.
After these liabilities are complete, you will want to create a Total Liabilities amount.
Last but certainly not least, the Equity section. Equity represents the owner’s value in a company’s assets. If the doors closed today and everything was sold, what is a reasonable amount of cash that the owner would net. It is important to remember that many times this equity amount isn’t the value of a business looking to sell, as ongoing operational income (EBITDA) is often looked at as a included multiplier. Equity section of the balance sheet depends on the structure of your business, but it’ll generally consist of three parts:
11. Initial contributions- This section is the portion of equity that was initially contributed by ownership.
12. Additional contributions- Most commonly known as additional paid-in capital, this is the portion that ownership has contributed after operations began. This can be due to operations not being as profitable as anticipated, or funding for growth.
13. Retained earnings- This account shows what profits the business has retained since operations began. This account is calculated as net profits from operations less distributions.
All three of these parts will contribute to the total equity figure. Once Owner’s Equity is complete, you are ready to finish the balance sheet and ensure everything balances properly.
Again, a standard format will be a split screen, with Assets on the left, Liabilities on the top right, and Equity under liabilities. This provides the easiest format, as the Total Assets and Total Liabilities plus Equity will be on the same row. This is easier for the reader and for those ensuring the balance sheet balances. Although a balanced balance sheet doesn’t ensure that everything is done correctly, it is a great tool that eliminates many errors. Equity is the amount of assets exceeding liabilities, which is the reason why it is very important to remember the balance sheet equation of Assets = Liabilities + Equity.
While this is the process for manually preparing a balance sheet, there are many software options available today that have simplified this process. Please contact us today to review your options.