What are Financial Statements and Why Do I Need Them? The Balance Sheet

Many business owners think the terms Income Statement and Financial Statement are interchangeable. The Income Statement is indeed one part of a Financial Statement package, but owners should know there are usually three other statements and why they are important.

There are four basic financial statements are:

  • Income Statement
  • Balance Sheet
  • Statement of Cash Flows
  • Statement of Changes in Equity

Let’s start with the Balance Sheet.

The balance sheet is made up of three sections: Assets, Liabilities, and Equity. The basic accounting equation is Assets = Liabilities + Equity. The balance sheet shows a company’s financial position on a specific date.

Assets

Assets are the resources of the company that have been acquired through past transactions and have future economic value. Examples of assets are:

  • Cash in Bank
  • Accounts Receivable (amounts due from customers)
  • Inventory (merchandise for re-sale or materials to be used in production)
  • Prepaid Expenses (items paid in advance like insurance and property taxes)
  • Land
  • Buildings
  • Machinery (used in manufacturing production)
  • Computer Equipment
  • Software
  • Trademarks, Patents, or Copyrights

Assets are classified into distinct groupings.

  • Current Assets are assets that will generally be used within an accounting cycle. They include cash, accounts receivable, inventory, and prepaid expenses.
  • Fixed Assets are items that provide long-term use for the company. Things like land, buildings, machinery, and computer equipment will benefit a company for longer than one accounting cycle.
  • Intangible Assets are those items that are not physical and will last longer than one account cycle, like computer software or trademarks.

Liabilities

Liabilities represent obligations for past transactions that must be paid by a company. Liabilities can be thought of as a source of the company’s assets and claims against those assets. They include:

  • Accounts Payable (amounts due to suppliers)
  • Short-Term Notes Payable (the portion of any loans due within one year)
  • Wages Payable (amounts due to employees but not paid as of the date of the statement)
  • Interest Payable
  • Customer Deposits (advance payments received for work or goods not yet provided)
  • Accrued Expenses (obligations that have been incurred but not yet recorded in Accts Payable)
  • Notes Payable

Liabilities are also classified into groupings:

  • Current Liabilities are obligations that are due within an accounting cycle. Accounts payable, wages payable, customer deposits, and accrued expenses are examples of Current Liabilities.
  • Long-Term Liabilities are obligations that are due over more than one accounting cycle. Notes payable (less the current portion shown in Current Liabilities) are listed here.

Equity

The items listed in the Equity section vary, depending on the legal form of the business. Owner’s Equity is used when a company is a Sole Proprietorship; Members’ Equity is used for a Limited Liability Company; Stockholders’ Equity is used for a corporation.

The Equity accounts for a Sole Proprietorship will include:

  • John Smith, Capital
  • John Smith, Draws
  • Net Income (cumulative for the current year)

Equity accounts for an LLC are:

  • Members’ Equity
  • Members’ Draws
  • Net Income

Equity accounts for a corporation include:

  • Common Stock (shows the original cost of the company shares sold to stockholders)
  • Preferred Stock (not every corporation has this)
  • Retained Earnings (the cumulation of net profits/losses from prior years)
  • Net Income

An accountant who understands how to properly classify items on the balance sheet is crucial to having useful financial statements. Staying on top of accounts receivable is essential for good cash flow; knowing how often inventory turns over can help you determine if you are carrying obsolete items; recognizing when an item should be recorded as a fixed asset and when it should be expensed will keep you out of trouble with the IRS.

 

Starting a New Business

Starting a business can be one of the most exciting things you do in your life. You have a great idea and you have figured out a way to make money with it. So let’s get things going!

Fire! Aim! Ready!

Slow down. Some careful thought, foresight, and planning will go a long way to increase your chances of success. A methodical plan of action will help you to fulfill your dream of being your own boss and running a successful business. The steps below are the start to a basic action plan for the beginning stages of your business.

  1. Prepare a Business Plan to clarify your marketing, management, and financial plans. While this task may seem unnecessary and even daunting, especially if you have never seen a Business Plan, this one thing alone will do more to help your business succeed than anything else you can do. A well-thought out Business Plan will help you to crystalize your motives for starting this business, who your competitors are and how you will compete with them, and how much money you will need until the business becomes profitable. (The elements of a solid Business Plan will be detailed in my next blog post.)
  2. Determine how much capital you need to take you through the first two years of business. Following the steps of a sold Business Plan will help you consider all the different factors in projecting cash needs. Identify your sources of capital, whether they include your own savings, partner investments, or loans.
  3. Select a business location. Some businesses can be run from your home or a small office, others might need industrial space, and still others will need a retail-type site. If your business is in the third category, selecting a location is the second most important thing you do. Your location will affect not only the quantity and quality of traffic that passes each day, but different cities have very different taxes, regulations and licensing requirements that should be considered.
  4. Select a business structure that best fits your needs by evaluating tax advantages, legal exposure, and ease of compliance. Whether you operate as a Sole Proprietor, a Limited Liability Company, or a Corporation is entirely your choice, but each structure has different filing and tax aspects that need to be considered. You can consult with a general business attorney, a CPA, or a seasoned accountant to help you with this decision.
  5. Register your business name or trade name. If you are going to operate as a Sole Proprietor, you should register a DBA (doing business as) with your state. If you plan to operate as an LLC or a corporation, you need to verify that your chosen name is not already taken and then it must be registered with the state. When choosing a name, think about whether you plan to have a website and check to see if the matching domain name is available. You might also need to consider trademark possibilities, in which case you need to check with the U.S. Patent and Trademark website.
  6. Register with the IRS to obtain an EIN (employer identification number).
  7. If you expect to collect sales tax from customers, you will need to apply for a sales tax permit from your state.
  8. If you will have employees, you need to register with your state for income tax withholding.
  9. Find out if the city or township in which your business resides requires any kind of business licensing.
  10. Open your business bank account. You will need your EIN and a copy of your Articles to do this. When selecting a bank, consider the convenience of branch locations as well as fees and charges assessed to your account.

These steps may seem daunting, but a seasoned business professional can help walk you through these tasks to make sure you start your business the right way.