Accounting 101 teaches students the very basics of keeping track of expenses and as technology has made it easier, the truth is still that the Balance Sheet has to balance. All too often we see owners struggle with their money rules and what needs to be where. There are 3 main components of the overall balance sheet so let’s take a closer look at those and gain a little more understanding of how they all interface.
First things first: Assets. These Are technically defined as “property owned by a person or company, regarded as having value and available to meet debts, commitments, or legacies.” The great thing about assets is that they can provide owners with capital – before, during, and after they are purchased. This lone fact can allow you as the owner to use these pieces to generate additional capital by physical production – in the case of a manufacturing asset, in terms of securing more capital through leveraging the asset as part of a loan, or by depreciation schedules and the subsequent tax benefits. In short, real assets offer many different values, all of which can work for the business.
Next is Liabilities. While nobody likes to hear something referred to as a liability, a fact of business is that they are always there. Strictly defined as “a thing for which someone is responsible, especially a debt or financial obligation,” the fact is that liabilities truly are more than just overhead, depending on what those liabilities actually are. Take the purchase of a real asset, the purchase of which necessitates a bank loan. While the loan is technically a liability, the fact that ownership of the asset is a subsequent result over the life of the loan actually helps -especially if, as a result, the asset being purchased is capable of producing income for the company. This becomes a critical piece to remember as we look into the third part of the balance sheet – Owner Equity.
We’ve been hinting around this concept with both of our other components, but the concept of owner equity is often misunderstood as what the business owns. In reality, it is defined as, “the owner’s investment in the business minus the owner’s draws or withdrawals from the business plus the net income (or minus the net loss) since the business began. Mathematically, the amount of owner’s equity is the amount of assets minus the amount of liabilities.”
Properly established and documented, owner’s equity can often be displayed as a much larger figure than an owner may believe – remember, some assets can create income long after they are paid for and depreciated while many liabilities eventually will go away (with certain exceptions, of course).
Why is this so important? Simple – while many owners fail to think of their exit strategy for selling the business after it is opened, understanding how assets, liabilities, and owner equity all factor together are critical for undertaking the valuation of a business. It would be hardly practical to assume that older equipment can work indefinitely without replacement, so striking the right balance of how these three components interplay is critical to being able to sell any business. These facts all live on the balance sheet and proper bookkeeping is the way that you, as an owner, can provide the transparency for a prospective buyer. At the same time, as a buyer, being able to understand how these all interact will be critical as a buyer, too.
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