An important part of running your art business or any business for that matter is to be able to understand your financial statements and use this information to better manage your business. You may get these statements from your accounting system, your accountant, bookkeeper or even on your phone. In this article I am going to take a look at one of the most basic yet most useful reports – the Balance Sheet. The balance sheet is a financial report which you may have seen or even prepared if you have ever applied for a home or other type of loan.
Unlike the Income Statement which measures your financial activity over a period of time like a month or year, the balance sheet measures your financial condition at a point in time and not over a period of time like a year, quarter or month. This point in time is a date where a “snapshot” of your financial condition was taken. These points could be December 31, 2014 or any other date in the past of your choosing. One of the advantages of using an accounting system is that you can create a Balance Sheet by pressing a few buttons.
What’s a balance sheet all about?
Unlike the Income Statement which reports your financial activity over a period of time, the balance sheet describes your financial condition at a point in time. The balance sheet is a financial report that summarizes a company’s assets (the things it owns), liabilities (the amount it owes), and owners equity.
The balance sheet is based on a simple formula: Assets – Liabilities = Equity. For example, if your only business asset is the $100 Bill in your wallet and all of your business debts total to $25 then the equity in your company is $75. Similarly, if your only business asset is the $100 Bill in your wallet and all of your business debts total to $250 then the equity in your company is negative ($150) – not a good position to be in!
Creating a balance sheet involves adding up all of your assets and subtracting the amount that you owe and what remains is your equity. The balance sheet got its name because Assets always equal Liabilities plus Equity (Assets = Liabilities + Equity) and therefore “balances”! An easy way to remember how the balance sheet works is the mnemonic ALE: Assets – Liabilities = Equity.
Like the income statement, it is extremely important that you understand what the balance sheet means and how to interpret it for your art business. Use the balance sheet to take a look at your financial position, help manage your financial activity and if you need to borrow money the bank will certainly ask for one.
Key Parts of the Balance Sheet
Assets are both tangible and intangible things that belong to the business that can be converted into cash and thus have an economic value. Generally assets are classified as either short-term (Current) or long-term (Non Current).
Short Term (Current) Assets
Your assets which can be converted into cash (this includes cash itself), sold or consumed within a normal business cycle (generally a year) are considered short term or current. Here are a few examples:
- Cash – Well this is just what it says: cash, savings accounts, checking accounts, money market accounts. This cash can be a result of funds that you have put into the business or monies you have collected from your customers as a result of sales.
- Cash Equivalents such as stocks or bonds – If the business owns stocks or bonds that you can easily sell, then they belong in the Short Term Asset category. If you own stock in a company where it is very difficult to sell the shares then this asset doesn’t pass the test of a short term asset being liquid.
- Accounts Receivables – Account receivables are the monies owed to you by your customers. There is usually an allowance made for a portion of your accounts receivables that you may not be able to collect. Accounts receivable are close to cash but they are not cash – you need to collect them first! Many small businesses make the mistake of treating their receivables as cash only later to find out that they aren’t collectable. This should highlight the importance of keeping up with and monitoring the money that is owed to you by your customers.
- Inventory – There are three basic types of inventory: raw materials, work in process and finished goods.
- Raw Materials – These are the things that go into making your art or creative products. They include materials such as canvas or clay, etc. You should also include supplies like paints that may have a long shelf life and are not consumed within a year.
- Work in process – These are your works that are not yet finished. They contain what was once your raw materials, labor, supplies, and overhead that went into them.
- Finished Goods – As you take the raw materials of your work and turn them into finished pieces they are then placed in this category. You may also sell items that are finished such as the works of others that immediately become finished goods when you purchase them.
- Prepaid Expenses – These are expenses which you have paid for but not yet used. Let’s say you pay for your insurance policy for the whole year. On your balance sheet you would show the total expense paid when you bought the policy and in subsequent month you would reduce this category by 1/12 for each month. As the time period of your balance sheet moves forward the amount recorded would get reduced.
Long Term or Non-Current Assets
By definition these are assets which are not short term or current, they cannot be converted into cash easily within a normal business cycle (usually one year). These include property, plant and equipment as well as intangible assets such as patents, copyrights, trademarks and trade secrets. Most likely you will only have property (real estate) and equipment that you purchased for use in your business.
Liabilities are the financial obligations incurred by your business. Like your assets, liabilities are classified as either short-term (Current) or long-term (Non Current). Current liabilities are those that are due in a business cycle (typically one year) and long term or non-current are due in over one year
Short Term (Current) Liabilities
- Accounts Payable – These are typically the funds due to suppliers and employees that have not yet been paid. When you purchase supplies and materials on credit you are creating an account payable. Similarly, if you have employees who you will owe money to in the future you have created an account payable.
- Current Portion of Loans or Leases Payable – This would include the amount due in the next year for your long term mortgages or leases. Note that this is the current portion, the remainder of the long term loan or mortgage will be listed below in non-current liabilities in the balance sheet.
- Other Items – You may have over short term liabilities such as income taxes or deposits/retainers due to clients. Don’t forget any business related credit card debts!
Long Term (Non-Current) Liabilities
Typically this will include the long-term portion of any loans or leases for which your business has entered into.
Shareholders or Owners Equity
By definition, when you subtract your total liabilities (current liabilities + non-current liabilities) from your total assets (current assets + non-current assets) you are left with equity. If your business is well capitalized, you haven’t been spending more than your business can support or your business is producing a profit (or a combination of the above) you should have a company where your equity is positive.
Your equity is further divided into two groups: capital stock and retained earnings. Capital stock is the amount that you put into your business to capitalize it or get it going. If you put more money into your business your capital stock will increase to reflect this. Retained earnings are the amount of profits (or losses) which your business has generated since its inception.
The bottom line(s)…
Although the concept of the balance sheet is fairly easy to understand, creating it may be a bit difficult. There are a lot of assumptions that go into developing your balance sheet. Your accountant or bookkeeper should be able to help you sort it all out. If you are doing your own books I suggest that you also work with an accountant to make sure that your balance sheet is put together correctly and to help you interpret the results.
Put some time into learning how to interpret your balance sheet and use the information to manage and direct your art business. And when you go for a loan you will be prepared when your banker asks “What does your balance sheet look like?”
If you would like to learn more about fpreparing your own business plan, building your art business and selling more art I invite you to check out my book – The Artist’s Business and Marketing ToolBox. Good Luck!
Neil McKenzie is the author of The Artist’s Business and Marketing ToolBox – How to Start, Run and Market a Successful Arts or Creative Business available in softcover from Barnes & Noble and Amazon and as an eBook from iTunes, Amazon and Barnes & Noble. He has developed and teaches the course “Artrepreneurship” at the Center for Innovation at Metropolitan State University of Denver, and is also a visiting professor at University College at the University of Denver where he teaches “Marketing the Arts”.
Neil has over 30 years’ experience as a management consultant and marketing executive, working with some of the world’s top brands. Neil is a frequent lecturer to artists and arts organizations, a guest columnist for Colorado Biz Magazine, where he covers the creative sector of the economy, and the author of several articles for Americans for the Arts, a national arts organization. Follow Neil on Twitter: @neilmckenzphoto