by Zaf R.

Created on: April 20, 2008

To many business owners, the balance sheet might as well be written in a foreign language. However its place at the altar of the business world (next to the profit and loss statement of course) speaks volumes about its significance. Sure everything balances, but what do the figures mean, and what impact do they have on the business?

The balance sheet is a management tool, and as such it's used for decision making, long and short term. Using historic data, it presents a summary of performance, and on its own, can provide a real insight on what is currently happening. When placed side by side with previous balance sheets, it can reveal even more, and can even be used to make projections of future balance sheets during the budgeting process.

For one to fully understand and appreciate the balance sheet, the basics need to be understood, and I cannot explain it without at least illustrating with figures. Before you get scared, I assure you that I'll keep it simple, but I have to show you, for its like learning to swim. If I explain how to swim you still won't know unless I show you how in the water!

Now here's the simplest balance sheet using an illustration: I start a business by first opening a checking account and depositing $1,000. In accounting, the business is seen as a separate entity from its owner, so in fact the $1,000 does not really belong to the business, it belongs to me- so it's like I loaned the business this money to start. This makes it a "liability" from the business' point of view- it "owes" me this money. But it also has $1,000 to spend, which simultaneously makes it an "asset". So here's my balance sheet:

ASSETS
Bank $1000

LIABILITIES
Capital $1,000

Capital is the term used to identify the money used to start the business, also called "equity", and in accounting it usually keeps its identity. The balance sheet then, is really defined as ASSETS = CAPITAL + LIABILITIES. From here on end, nothing else changes except sub-classifications of this equation. For example, if I withdraw $600 in cash, and use $200 from it to buy goods to sell in my business, my balance sheet changes, on the asset side only, into $400 in the bank, $400 cash on hand, and $200 in inventory- still totaling to the same $1,000. Now it just shows more information. Over time though, the total dollar value overall will change as the business makes profits (or losses).

Believe it or not, that's all there is to it. If I borrow money, sell goods on credit, or buy machinery, buildings, vehicles,

• 1
• 2
• Next Page >>