How to Read a Balance Sheet
As a small business owner, it’s important to understand the health of your business. That’s why we believe in educating our clients in what we do. The better you understand the reports your bookkeeping prepares for you, the better decisions you can make. This post will be the first in a series of three where we will introduce basic accounting concepts and reporting. First up: the balance sheet.
What is a balance sheet?
A balance sheet is a statement of financial condition which shows what your business owns (assets), what you owe others (liabilities), and what’s left is owned by you, the owner (equity). The most important concept in accounting is what’s known as the accounting equation. At its most basic level, the equation is Assets = Liabilities + Equity. The total of assets will always equal the total of liabilities and equity. If you picture a scale with assets on the left and liabilities and equity on the right, the scale will always be in balance. Here is an example balance sheet that we will walk through for the rest of this post.
A sample balance sheet for a small construction contractor.
As you can see, the total assets balance and the total liabilities and equity balance are the same amount, so our balance sheet is in balance. This is an important check and should be the first thing to verify when your accountant or bookkeeper shows you a balance sheet. If it’s not in balance, something has gone wrong.
What are assets?
Assets are items that your business either owns, controls, or has rights to receive. Most of the time, these accounts are things that you can easily see like cash or fixed assets, and sometimes these accounts are things that will eventually become cash. Here’s a brief summary of the assets on our sample balance sheet:
Cash
Probably the most straightforward part of most balance sheets, this account shows the amount of cash you have in your bank account. This amount may not match the amount on your bank statement each month, and you or your bookkeeper should perform a bank reconciliation to identify the differences between the two.
Accounts receivable
After you’ve completed your job and issued your invoice to your customer, you will recognize revenue and increase your accounts receivable, known as A/R for short. Your A/R balances represent the value of the invoices you’ve issued to your customers that have not yet paid you. As you collect on those invoices, you will reduce the A/R balance and increase the cash balance.
Contract assets
Contract assets represent the value that you’ve created for your customers through executing your contracts, but you’ve not yet billed to the client. Most frequently, this balance will be a combination of your unbilled receivables and your retention balances. In most cases, you will recognize revenue as you perform on your contract, but the contract terms may state that you are only able to invoice upon reaching specified milestones. In addition, your contract may state that some portion of your invoices may be held back until the completion of the project. These balances that are earned but not yet collectible are recorded to contract assets.
Fixed assets
Fixed assets (also known as property, plant & equipment, or PP&E) represent the real and personal property that the business owns or controls. This may be your office building that you own, your construction equipment, your computers, or any other piece of equipment that you expect to benefit from over more than one year. Instead of recording costs to purchase these items to the income statement, it gets recorded to the balance sheet as a fixed asset and then depreciated over time as you benefit from its use.
What are liabilities?
Liabilities represent obligations to pay other parties, whether it’s vendors, subcontractors, lenders, employees, or even the government. Over time, these liabilities will be removed by the payment of cash. These are the liabilities we see on our balance sheet:
Accounts payable
The easiest way to think of accounts payable, or A/P, is that it’s the opposite of A/R we discussed earlier. Essentially, what is an accounts payable balance to you is likely an accounts receivable balance to your vendor. A/P represents the amounts that you have been billed for on account. When a vendor delivers a product or service to you and sends you a bill to pay after the fact, the balance of that bill before you’ve paid it is part of your A/P balance.
Contract liabilities
Similar to contract assets discussed above, this account represents timing differences between what work you’ve done on your contracts and the amounts that you’ve billed to your customers. Most frequently, this balance increases when you receive payments in advance of work being performed. Depending on the industry, this account is often called unearned revenue or billings in excess of costs.
Accrued compensation
Accrued compensation most often occurs when there is a lag between when your employees perform work and when they get paid. For example, if you pay your crews on a weekly basis every Wednesday for the previous work’s Monday to Friday pay period, accrued compensation represents the amount that will be paid out on that payday prior to it being paid out.
Line of credit
For many contractors, a line of credit (or LOC) is the lifeblood of financing your projects while you’re waiting to be paid. Rather than having to pay for the project up front out of your own hard-earned cash, a bank may be willing to extend a line of credit for you to draw upon as your project progresses, with the expectation that the LOC is repaid as you collect on your invoices. Think of an LOC as a short-term loan that can be drawn on and paid down repeatedly, like a credit card. Depending on the terms of your agreement with your lender, this account may be secured by assets such as cash, equipment, or receivables.
Long-term debt
Long-term debt represents borrowings that you’ve incurred that you’re obligated to pay back over an extended period of time. This may be a mortgage on your building, the note on your equipment, or even seller financing you’ve agreed to pay to a former owner if you’ve recently purchased a business.
What is equity?
At it’s most simple level, equity represents the value of your ownership after repaying all of your obligations (liabilities). If your home is worth $500,000 and you have a $400,000 mortgage against the home, you would say that you have $100,000 of equity in your home. In the same way, our sample balance sheet shows that the owner has $50,000 of equity in her business. Absent any changes in the value of assets and liabilities, the owner would end up with $50,000 in her bank account if she were to collect on all of her invoices, sell all of her fixed assets, and repay all of her liabilities. In practice however, many business owners want to grow their equity balances over time as it represents growth in their business. This account can grow in two simple ways: either contribute more cash into the business or make more money. By retaining your earnings and profits in the business rather than withdrawing the money each year, you allow your equity to grow and reinvest in the growth of your business.
Final thoughts
I hope this overview and example of some common balance sheet items in the contracting world is of use to you. It is important to understand how to read a balance sheet as a part of better decision making to improve your contracting business. If you’d like further assistance in preparing your financials, including a balance sheet and more, please contact us about our bookkeeping services specializing in serving construction contractors.
