Three major financial statements are used by financial institutions to evaluate a company’s loan application, and also used by shareholders and prospective investors to evaluate the profitability of business enterprises: the Balance Sheet, the Income Statement, and the Cash Flow Statement.
Balance Sheet
The Balance Sheet shows the business assets, liabilities and shareholders / owner’s equity at a specific date, and as a result, gives a good picture of the company’s financial position.
Income Statement
The Income Statement shows the revenues and expenses over a set period of time. This statement is a good indicator of the profitability of a business during a particular period, as it shows the net result when the revenues of the business are put against its expenses.
Cash Flow Statement
The Cash Flow Statement shows the amount of cash generated and used by the company in a given period. It is calculated by adding noncash charges to net income after taxes.
Now, let us take a closer look at the Balance Sheet and what the numbers represent on this financial statement.
Assets
Assets are anything with commercial value that your business owns. They are divided into three categories: current assets, property, plant and equipment, and other assets.
- Current Assets are cash, accounts receivable, inventory, and other assets that will likely be turned into cash, bartered, exchanged, or converted into an expense within a year during the normal course of business. Included in this category are loans to shareholders, also known as due from shareholders.
Some business owners will not pay themselves a salary, preferring to take drawings, which they must deal with at year-end. In the current assets section, due from shareholders 1amounts may artificially inflate current assets if you plan to convert them to bonuses, dividends or management fees at year-end, at which time they become expenses of the business. - Property, Plant and Equipment have commercial value but are not expected to be consumed or converted into cash in the normal course of business. They are long-term, more permanent or “fixed” items, such as land, building, equipment, fixtures, furniture, and leasehold improvements.
Property, Plant and Equipment often decrease in value over time due to wear and tear from use or obsolesce. On your balance sheet, therefore, you will see the net book value of Property, Plant and Equipment which is their cost minus accumulated depreciation.
The federal government allows businesses to depreciate Property, Plant and Equipment items for tax purposes, and it has defined specific depreciation rates for different categories of these assets. In Canadian Income Tax Act, the term “Capital Cost Allowance” is used instead of “Depreciation”. - Other Assets are those items that do not fit into either of the above two categories, yet still belong to the balance sheet. They include assets like long term prepaid expenses, which have value but are not fixed, or necessarily to be expensed or converted into cash value during the next fiscal year.
Liabilities
Liabilities are company debts or obligations. Current liabilities are the portion of those obligations that are to be paid out during the next fiscal year, whereas, long-term liabilities are the portion of your company’s obligations that extend beyond that timeframe.
Current liabilities include amounts payable to suppliers of goods and services, accumulated taxes and payroll liabilities, and the current amount owing on business loans.
Long-term liabilities, meanwhile, include the balance of your loans, and other liabilities beyond the the next reporting period or fiscal year.
Intangible Assets
While Intangible Assets do not appear directly on your balance sheet, they can be a significant factor when one looks to buy or sell a business or part of the business.
Intangible assets include things like good will; intellectual property such as copyrights, trademarks, patents; leases; franchises; permits and so on.
While you do not list these assets on your balance sheet, they are reflected in the sense that they enable you to maintain profit margins and market share, so in turn they show up on the current assets section of your balance sheet through the revenue and profits they create.
Intangible assets are often seen on the balance sheet of a purchased company when the purchase price of the company is more than the fair market value of its tangible assets. The excess amount is then assigned to whatever intangible assets can be recognized for the company, like goodwill.
Equity
Something that is often difficult for new entrepreneurs to grasp is the way equity is calculated on the balance sheet, where the total assets always equal the total liabilities plus equity.
In other words, your company’s equity is equal to the value of its total assets minus its total liabilities. If the business assets are greater than the liabilities, which is hopefully the case, then the equity of the business is the positive difference between the two numbers.
Sample equity calculation:
On Company ABC’s Balance Sheet, the Total Assets are $100,000, while the Total Liabilities are $40,000. In this case, the shareholders / owner’s equity, which is the difference between the assets and liabilities, is $60,000.
If Company ABC had Total Liabilities of $50,000, with its Total Assets staying at $100,000, then the equity of Company at that time would be $50,000. The increase in total liabilities of the company in comparison to its total assets causes the shareholders / owner's equity to drop.
