42. How to Explain: The Balance Sheet

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Hey there, my name is Michael King. Welcome back to the Connected Accountant where I talk about starting, scaling and optimizing fractional CFO services. Have you ever had one of your CFO clients come to you and ask you questions about the balance sheet? Maybe they were trolling around QuickBooks and stumbled across the balance sheet and they started asking questions about liabilities or shareholders equity and you just weren't sure how to explain it to them in words that they could relate to. Today, I'm going to walk you through the exact process that I use to explain the balance sheet to our CFO clients. My hope is that you'll be able to take some ideas or inspiration from the way that I explained it so that you can break it down for your clients better next time they come to you. Let's take a look. Yeah, it's true. I'll admit it. The balance sheet tends to be the redheaded stepchild of the financial statements. And I'll also admit that the balance sheet lacks that fundamental swag that its older brother, the P and L, has. But the balance sheet is actually much more important than the P and L when it comes to understanding the financial health of your business. Today I'm going to break down the balance sheet into bite sized bits and I'm going to tell you exactly how to use the balance sheet to determine the financial health of your company. The balance sheet is actually one of three financial statements in your business. It goes along with the statement of cash flows and the profit and loss statement. So what even is a balance sheet? In simple terms, a balance sheet is just a report that shows you what your business owns and what your business owes on a given day. And these two numbers are always equal, which is why we call it a balance sheet. Today we're going to actually dive in and learn what each part of the balance sheet means. But before that we do that, let's look at a for real pretend balance sheet. This is a balance sheet straight out of QuickBooks Online for my dream company, Mike's Breathwork for Bosses. All balance sheets have three primary sections. Assets, liabilities and equity. We'll dive into each of these sections and what they're telling you in just a minute. But for now, I want you to notice one really important feature of the balance sheet. The assets portion of the balance sheet is always equal to the liabilities portion plus the equity portion. In fact, there's a thing in accounting called the accounting equation. And that equation is assets equals liabilities plus equity. The left side must always equal the right Side. This is actually why they call it a balance sheet. The two sides are always equal or balanced. You're probably thinking to yourself, mike, I've seen a balance sheet before. What I need help with is understanding what it actually means. So let's break the balance sheet down into its three individual components. First, we have assets. And assets are just things that your business owns. Within assets, there's two primary types. First, you have current assets, and that's just stuff like cash and accounts receivable. And you have non current assets. Think of non current assets as more expensive things your business owns, like bougie furniture, fancy computer equipment, maybe gold or Bitcoin. That's it. Next, we have liabilities. Liabilities is money that you owe other people. And just like with assets, liabilities can be broken into two primary groups, current liabilities and non current liabilities. Current liabilities are debts that you owe to other people that you plan to pay off within the next 12 months. Think about things like credit cards or accounts payable. Non current liabilities are, you guessed it, debts that you owe other people that you plan to pay off in greater than 12 months. For that, think about things like car loans or car leases, or maybe a big loan you took out to buy buy a building. Let's jam about equity. I am here for some equity. Earlier we talked about liabilities as being money that you owe other people. Equity is very similar to liabilities, but instead of it being money you owe other people, equity is actually money that you owe yourself as the owner of a business. Now, in the world of accounting, equity can start to get really complicated really fast. But as a business owner, I want you to understand that there are three primary components to equity. First, we have capital contributions. Capital contributions is again, just a fancy term from money that you've put into the business. As the business owner, you know how a lot of times you hear people humble brag about how they started their quadrillion dollar empire with just $1. That $1 that they use to start their business would be their capital contribution. The second term, accumulated profits, is just another way of saying all the net profits that your business has ever made. There's an important distinction to make here. On our last video, when I talked about the P and L, I told you that the P and L covers a fixed period of time. Accumulated profits takes into account all the net profits your business has ever made, all the way back to the OG days when you were first getting started. And finally, distributions is just another way of saying the money that you've paid to the owners of the company, AKA you. So how do these terms all relate to equity? To calculate equity, we simply take the capital contributions we put into the business, we add our accumulated profits, and then we subtract our distribution. But how should you be thinking about all of these terms and how they relate to the financial health of your business? When a business that's financially healthy runs its balance sheet, it'll see that both the assets and the liabilities and equity section are both positive numbers. And the bigger that number gets, typically it means the stronger your business's financial health is. On the other hand, when a business that's not as financially healthy runs its balance sheet, it'll see that those numbers start to go down or maybe turn negative. And once those numbers are negative, it means your business is upside down. Here's another way to think about it. Imagine for a moment that you buy a home and over time you invest money into that home to fix things up, like the master bathroom, the kitchen, and maybe you made a sweet man cave for your boo downstairs. When it comes time to sell the home, if the home is worth more than what you paid for it, plus all the money you put into it, you have positive equity in the home. That's a good thing. But if you overspent on all those upgrades and now you owe more than what the house is actually worth, you have negative equity in the home. It's kind of the same thing with your business's balance sheet. When you have a positive equity, that's a good thing. When equity is negative, it's normally a bad thing. And it can indicate that your business is in financial trouble. And this is why the balance sheet is such a better tool at understanding the financial health of your business. When you compare it to just using the profit and loss statement. And that's because the P and L just looks at the profitability of your business over a particular period of time. But the balance sheet is looking at the financial health of your business since it was born. It's looking at lifetime profitability. It's looking at everything your business owns, everything that your business owes, and it's also looking at the equity that the owners hold in the business. There you have it, the balance sheet. This is exactly how I explain it to our CFO clients. And I, once again, I do want to point out to you that it's so important to remember that this doesn't have to be an in depth, technical explanation of the balance sheet. We're not trying to prepare them to sit for the CPA exam. We just want to give them a little bit more education and insight into what the balance sheet is telling them about the health of their business. Now, specifically with the balance sheet, I find that it's so important to use examples or metaphors, like I did with the real estate example that I. I shared with you. It really does drive home some of those points for them. All right, my friends, that's it for this week's episode of the Connected Accountant. I can't wait to see you back right here next week. See you then.