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Understanding the Balance Sheet

The following guideline is general in nature and may not include all situations that a business will need to consider. It is strongly advised that business owners work with a qualified accountant in determining the structure of business financial statements and appropriate methods for accounting that meet the needs of the business and remain compliant with Canada Revenue Agency (CRA) requirements.

A Balance Sheet, also known as a statement of financial position, reveals a companys assets, liabilities and shareholders equity (net worth). A Balance Sheet reveals to a business owner, or a potential lender, the overall financial health of the business from an equity standpoint. General Definitions: 1. Assets are what a company owns and uses to operate its business. 2. Liabilities are what a company owes on purchase of assets or in financing its operations. 3. Shareholders' equity is the amount of money initially invested into the company plus any retained earnings (net income). The Balance Sheet is divided into two main sections (Assets and Liabilities) that, based on the following equation, must equal (or balance) each other. The main formula behind the Balance Sheet is: Assets = Liabilities + Shareholders Equity It is important to note that a Balance Sheet is a snapshot of the companys financial position at a single point in time. An example of a Balance Sheet is attached on Page 4. It may be useful to view this while reading. Details: 1. Assets Assets are what a company owns and uses to operate its business. There are two classes of assets, Current assets and Fixed or Capital assets, as defined below. a) Current Assets Current Assets are assets that a company has at its disposal (liquid) and that can be easily converted into cash within one operating cycle. An operating cycle is the time that it takes to sell a product or service and collect cash from the sale, i.e.: 30-60 days. Such assets classes are: i. Cash & Equivalents are monies in business accounts. This is usually cash however cash equivalents could also be stock investments, etc. Cash and equivalents are completely liquid assets. ii. Short-Term Investments normally come into play when a company has enough cash on hand that it can afford, and chooses, to invest this money in order to earn interest. Short term investments are those that come due, or can be converted to cash without penalty within one year. This investment cannot be immediately turned to cash without planning but it will earn a higher return than cash in a business bank account. iii. Accounts Receivable consists of the short-term obligations owed to the company by its clients. Companies may sell products or a service to clients on credit, which is tracked in this line until the client pays their invoice in full. iv. Inventories may represent raw materials in stock, work-in-progress goods and finished goods for resale. Not all companies have inventories, particularly if they are consulting or service based companies. v. Prepaid Expenses are expenditures that the company has already paid to its suppliers or service providers for future costs such as insurance, rent, etc. Although this is not liquid in the sense that, if cash was needed, a refund may not be possible, it is an asset in the sense that it preserves cash for future use.

Basin Business Advisors Program Business Guidelines: Understanding the Balance Sheet Page 1

b) Fixed or Capital Assets Fixed/Capital Assets are those that are not turned into cash or liquidated easily, expected to be turned to into cash within a year and/or have a life span of over a year. Examples would be: i. Tangible assets such as machinery, equipment, buildings and land. A business should seek the advice of an accountant to determine what assets should be assigned as Fixed/Capital assets if there is any doubt. ii. Intangible assets such as goodwill, patents and copyrights. Note: Depreciation or Amortization calculations will appear in this section of the Balance Sheet. Depreciation is calculated and deducted from tangible assets, while Amortization is the corresponding calculation for intangible assets. Both calculations represent the economic cost of fixed assets over their useful life. As an example, a company vehicle is considered an asset of the business. It is not expensed at the time of purchase but rather depreciated at an assigned percentage, until the asset is fully depreciated. The value of Depreciation/Amortization is booked in as an expense in the companies Income Statement. 2. Liabilities: Liabilities are what a company owes on purchase of assets or in financing its operations. There are two classes of liabilities: Current liabilities and Long Term liabilities as defined below. a) Current Liabilities Current liabilities are the financial obligations a company owes to outside parties that are due within one year or could be called in for repayment by the lender at any time and include: i. Short-term loans: Lines of Credit and Credit card balances ii. Deposits on unfulfilled contracts, relevant for building contractors. iii. Accounts Payable are financial obligations the company owes for services or goods purchased. iv. Accrued Liabilities: tax remittances (ie: GST) and payroll benefits, e.g. money owed to employees as salary, vacation pay and bonuses that the company currently owes. v. Current portion of long-term debt is the total amount of long-term debt that must be repaid within a year. b) Long Term Liabilities Long-term liabilities are debts, which are due after a period of at least one year from the date of the balance sheet. Long terms debts may include: i. Secured Bank loans with terms of repayment over one year ii. Mortgage financing iii. Shareholder loans, whether they have an active agreement for repayment or not. 3. Shareholders Equity Shareholders equity is the initial amount of money invested into a business plus any subsequent investments less cash withdrawn and plus or minus Net profit. When a company generates a profit, management will either pay shareholders a cash dividend, or retain the earnings to reinvest into the business. Corporations can manage their tax implications through payment of these dividends and retained losses. An accountant is required to guide the business in managing this aspect of the business effectively. When a sole proprietorship generates a positive Net profit this profit is reported as personal income in the year it is incurred. In order for the Balance Sheet to balance, Total assets must equal Total liabilities plus Shareholders equity.

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Below is an example of a Balance Sheet. Company Balance Sheet as at Dec. 31 Assets Current Assets Cash & Cash Equivalents Accounts Receivable Inventory Pre Paid Expenses Total Current Assets Fixed Assets Land Buildings and Improvements Fixtures & Equipment Vehicle - truck Less: Accumulated Depreciation Total Fixed Assets Total Assets Liabilities & Shareholders Equity Current Liabilities Accounts Payable Accrued Liabilities Current Portion of Long Term Debt Total Current Liabilities Long Term Liabilities Long term debt Shareholders Equity Shareholders Loan Less: Net drawings during the period Retained Earnings Total Shareholders Equity Total Liability & Shareholders Equity 200X

5,000 2,500 30,000 350 37,850 25,000 65,000 3,000 20,000 10,000 103,000 140,850

5,100 3,400 18,000 26,500 40,000 20,000 44,350 10,000 74,350 140,850

Note: The Equity portion of a balance sheet may appear differently on some financial statements. Owners Equity may appear rather than Shareholders Equity.

Conclusion The Balance Sheet, along with the Income and Cash flow statements, is an important tool for business owners to gain insight into their company and its operations. The Balance Sheet is a snapshot at a single point in time of the companys account balances and financial health. The Balance Sheet is useful in business analysis, in tracking financial performance trends and illustrating its ability to take on more credit or risk. It is important that all business owners know how to use, analyze and read their Balance sheet.

Basin Business Advisors Program Business Guidelines: Understanding the Balance Sheet Page 3