It is widespread for compact small business owners to measure their financial health determined by their revenue statement or bank account balance and deem their small business “fit” when the bottom line appears very good. To reveal why this approach might be deceptive, let’s apply a dieting metaphor.
Only looking at the bottom line is the equivalent of “sucking it in” when you appear within the mirror. Confident, it looks like you have lost some weight, but what takes place after you exhale? You might appear skinny for a moment, but that version on the circumstance isn’t precise.
In terms of your business’ overall health, the balance sheet is definitely the “real” you. Believe in the earnings statement (also named the profit and loss statement) as your eating plan log. It tells you how properly you did within a specific time period—last week, last month, or last quarter. We all know that there are excellent weeks and bad weeks on a diet regime. If you only appear at one week or month, are you getting a true picture of your overall health? Of course not.
The balance sheet, on the other hand, is depending on everything you have ever done. In our diet program metaphor, it accounts for how much you’ve exercised and what you have eaten over your entire lifetime. The sum of all that information is what you see when you stop sucking it in.
To understand this metaphor, you need to understand what the balance sheet is and how it relates to the earnings statement. Your revenue statement contains information about what has occurred within the current period. Revenue, cost of goods sold and expenses are some on the account types found on the revenue statement.
To get an correct picture of what’s happening in your enterprise, you must adhere to the matching principle. That means you record expenses and cost of goods sold after you have earned the revenue that they are related to (if an expense is not related to revenue, you record it during the period it is used). The balance sheet accounts hold these revenue and expense items until the period in which they are earned or used. We use accounts such as prepaid insurance, customer deposits, and accrued payroll to classify these things on the balance sheet.
Income statement accounts only reflect transactions in the current accounting period. At the end on the period, the net profit or loss is moved to the equity section of the balance sheet (to retained earnings). This means that the balance sheet reflects all prior period revenue, cost of goods sold, and expenses inside the form of retained earnings. The equity section also shows how much you’ve invested in and drawn out of your business enterprise. The equity section, therefore, shows what the company is worth to you.
So, how do you know if your company is “over weight”? Take a look at your debt to equity ratio (total liabilities divided by total equity). Compare that to your industry average and you’ll have a pretty fantastic indicator of one’s business’ weight. Too much debt and not enough equity means your enterprise is, in fact, overweight—even if your current period income statement appears healthy and you have money in the bank. Because everything shows up on the balance sheet, you can rely on it to depict the financial health of your organization.