If you are in business you need to understand three basic financial statements, the Income Statement, the Balance Sheet and the Cash Flow Projection – artists and other creative entrepreneurs are no exception. This article will discuss the Balance Sheet or sometimes called a Statement of Financial Condition/Position. You can find out more about the Income Statement here: Financial Statement Basics – Income Statement.
Balance Sheet Concepts
Unlike the Income Statement which covers your financial activity over a period of time, the Balance Sheet describes your financial condition at a point in time. Make sure you grasp this concept – “at a point in time”. The point in time could be the end of last year, the end of last month, or as of yesterday.
The Balance Sheet is made up of three main items: assets, liabilities and equity (sometimes called owners or shareholders equity). The math behind the Balance Sheet is simple – Assets less Liabilities equals Equity. When I was a student in business school taking my first accounting class I used to remember this by the mnemonic “ALE”: Assets – Liabilities = Equity.
As with the Income Statement it is extremely important that you understand what the Balance Sheet means and how to interpret it for your art business. You 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
These are 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 you own stocks are 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! I have seen many small businesses treating their receivables as cash only later to find out that they aren’t cash. This should highlight the importance of keeping up with and monitoring the money that is owed to you by your customers.
- There are three basic type 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. and I would 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 a 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. As with 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 dues to suppliers and employees that have not yet been paid. When you purchase supplies and materials on credit you are creating an accounts payable. Similarly, if you have employees who you will owe money to in the future you have created an accounts 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 only – 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.
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.
Shareholder’s or Owner’s 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 or 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 which your business has generated since its inception.
Although the concept of the balance sheet if fairly easy to understand, creating it may be a bit difficult. There are a lot of assumptions that go into developing your balance sheet. You accountant or bookkeeper will should be able to help you sort it all out. If you are doing your own books I suggest that you work with an accountant to make sure that your balance sheet is put together correctly.
When you have your balance sheet you can start to analyze it to determine your financial health. Do some research or ask your accountant about financial ratios. And when you go for a loan you will be prepared when your banker asks “Do you have a Balance Sheet?”