The rise of the Internet and the global economic crisis have together created a resurgence in small business. Freshly laid off and unable to find new jobs, many people decided to quit the job market all together, become their own boss, and open a small business — after all, why deal with the headache when you can be your own boss?
Besides the comparative freedom of life outside the cubicle also comes the added responsibility of being a business owner. Part and parcel of this is a responsibility to understand the numbers. To be sure, few business owners actively enjoy accounting, but all successful ones recognize its importance. Accounting is a key part of running a functioning business, and bookkeeping creates the records which make accounting possible.
Why is accounting so critical? In order to have a sustainable business, you must know where you stand in financial terms. You must be able to see if your apparent good fortune now is a mirage that will lead you to bankruptcy later unless you change your spending habits. You also want to know if a given decision might significantly increase your profits without much work. Both of these are functions of accounting, and excellent reasons to educate yourself on accounting methods and accounting language.
Accounting becomes even more important if you want to grow your business http://www.smallbusinesscan.com/setting-business-budding-entrepreneurs-consider/ and obtain outside financing. Here, it’s important to be able to substantiate your claims of business success and opportunity with hard numbers.
In all of these cases, the key facts boil down to three terms. Assets, liabilities, and equity are the categories which make up a balance sheet, and they represent the underlying framework of understanding your business. Let’s consider them in more detail.
What Is An Asset in the Balance Sheet?
Assets are everything the business owns or is owned. For example, the business may own a certain amount of inventory and be owed a certain amount of money by its customers (the latter is commonly known as “accounts receivable”).
On a balance sheet, assets are generally listed in order of liquidity. This means that the most liquid assets — cash, or assets which can be easily converted into cash — appear at the top.
Assets are also divided into two categories so it’s easier to understand the financial health of the business. The first category, short term assets or current assets, refers to things which are very liquid and can be converted to cash immediately. Short term assets are things like cash on hand, accounts receivable, and inventory which has been paid for.
Long term or fixed assets are items such as real estate, capital equipment, buildings, intangible assets (patents, copyrights, trademarks), and some kinds of investments.
By bringing all these different kinds of assets together into one place, the business owner can see “at a glance” what the business owns both now and in the future. It may well be that the business is cash-poor, but if the business has been closing deals that will pay off months or years in the future, the assets part of the balance sheet can help quantify this number.
What Is A Liability?
In the balance sheet, if an asset is everything the business owns or is owed, liabilities are everything the business owes. Liabilities include debts to suppliers for services provided (accounts payable), business and bank loans, mortgages, or any other contractual obligation.
Like assets, liabilities may also be grouped into short and long term categories. Short term liabilities are those which must be paid during the next year, such as operating expenses, income tax, payroll, and the current portion of long term debt. Accounts payable (what the business owes its suppliers) and accruals (generally taxes owed) are also current, or short-term, liabilities.
Longer term liabilities, or non-current liabilities, are items like longer-term loans, deferred tax payments, lease obligations, and certain kinds of issued securities.
What Is Equity in the Balance Sheet?
Technically, equity is a type of liability. In accounting, the assets of a business must always be equal to the liabilities. In other words, if the business buys a piece of equipment, the books must record both the purchase of that equipment (as an asset) and the source of the money used to buy it (a liability — a bank loan, or cash investment by the business owner which the business “owes” its owner).
When the business makes money, the same principle applies. The money must “go somewhere.” If the business has outstanding debt, the money may be used to pay down the debt, in which case it is used to reduce a liability. If the money is not used to reduce another liability, it may be used to reduce the debt the business owes to its owner.
For this and other reasons, the owner’s “liability” account, as well as the “liability” accounts of the other investors, are broken out into a separate category known as equity. Equity represents the ownership stake, in dollar terms, that the owner and any investors have in the company.
When the owner spends some of his or her own money to buy equipment for the company, this expenditure is recorded as equity. For every dollar the owner pays, the business owes its owner a dollar in equity.
Therefore, when the books are tallied up, the business’ assets must be equal to the sum of the business’ liabilities and equity.
It’s true, bookkeeping can be easily outsourced. Business owners must still be careful to understand the basics of bookkeeping and accounting if they are to get any value from the process. Accountancy is not simply a prelude to tax preparation at the end of the year — it’s the way business owners monitor their operations.