The Balance sheet is one of the more widely recognized accounting tools, and is used extensively in the banking and financial world to determine a businesses overall health. What is the balance sheet, and why is it so important in determining the overall health of a business? Let’s answer this two part question, one piece at a time.
Balance Sheet Defined
The official definition of the balance sheet is a list of the assets, liabilities, and owner’s equity as of a specific point in time, or period of time. The balance sheet is most often generated at the end of the month, quarter, and year.
Now, why would we want to generate a balance sheet, and what can we learn about the health of our business from the balance sheet? The answer to these questions is going to surprise you. The balance sheet is like the composite of all your financial transaction for the entire time period covered on a specific balance sheet. All the debits, credits, cash flows, sales, expenses, and any other financial transaction that has occurred are summed up on this balance sheet.
Lending institutions look at your balance sheet, to determine the overall health of your business. Now, what exactly do we mean by overall health? Businesses don’t get colds, the flu or pneumonia, so what do we mean when we say health? The financial health of your business refers to a certain ratio of equity to debt, adequate cash flow, net gains and losses in equity and assets, and a quick list of your current assets versus your current liability. The balance sheet provides, to the trained eye, an opportunity to perform a quick, but fairly accurate assessment of the state of your business.
Another important piece of the balance sheet equation, are your accounts receivables and your accounts payables. These accounts generally require a less than 30 day turnaround on an invoice. If your accounts payables is much larger than your cash on hand and accounts receivables, your business may be on the brink of disaster. The small business owner, who suddenly decides it’s time to sell the family business, will quite often refuse to produce a balance sheet, or wait until the deal is sealed before producing a balance sheet. This is an attempt to shield the would-be buyer from the fact that maybe there is a looming problem in the business. Or, it could simply be from a lack of poor management.
One area of the balance sheet we’ve not discussed is known as the “property, plant and equipment” value, shown in the asset area. What does this label represent, and why is it included in the balance sheet, under a separate listing? The PP&E, or property, plant and equipment, listing is representative of the equipment and major property investment of the business. This is the bread and butter of the business operation. Without proper equipment, property size, and building size, a business will not be able to function properly, and create the necessary levels of output needed in order to sustain its growth. You can’t take a half an acre, and build 5000 airplanes. PP&E figures must be adequate in relation to the volume and output of the business.
Can you begin to see the importance of understanding many of the accounting tools, from a business owner, or even just an interested party’s standpoint? You may someday consider purchasing or starting your own business. A general knowledge of the function of the accounting process, the reports generated, and how to interpret the information contained therein, can mean the difference in the success of failure of a business.