It’s common for small business owners to measure their financial health based on their income statement or bank account balance. They deem their business “fit” if the bottom line looks good. To reveal why this approach can be deceptive, let’s apply a dieting metaphor.
Only looking at the bottom line is the equivalent of “sucking it in” when you look in the mirror. Sure, it looks like you’ve lost some weight, but what happens when you exhale? Breathe in and you might appear skinny for a moment, but that version of the situation isn’t accurate.
In terms of your business health, the balance sheet is the “real” you. Think of the income statement (also called the profit and loss statement) as your diet log. It tells you how well you did in a specific time period—last week, last month, or last quarter. We all know there are good weeks and bad weeks on a diet. If you look at only 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 based on everything you’ve ever done. In our diet metaphor, it accounts for how much you’ve exercised and what you’ve eaten over your entire lifetime. The sum of all that information in the balance sheet 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 income statement. Your income statement contains information about what’s happened in the current period only. It includes these account types (as well as some others):
- Revenue (money coming in)
- Cost of goods sold (what it costs to make what you sell)
- Expenses (other business costs)
It’s all in the timing
To get an accurate picture of your business health, you must use the matching principle. In accountant-speak: The balance sheet accounts hold revenue and expense items until the period in which they are earned or used occurs. That is, related expenses and revenue have to be accounted for—matched up—in the same period.
That means you record expenses and cost of goods sold when you earn the revenue that they are related to. (If an expense isn’t related to revenue, you record it during the period it’s used.)
Let’s say your business makes Super Awesome Widgets. You buy widget parts one month. Those parts belong to cost of goods sold when you sell the Super Awesome Widgets. When you buy the parts, they’ll be “held” in inventory on the balance sheet. Six months later, you make and sell some Super Awesome Widgets. When they’re sold, you record the revenue and cost of goods sold on the income statement. (The balance sheet inventory account is reduced when cost of goods sold is increased.) The income statement (also known as the profit and loss statement) accounts for the money you made (revenue) and the parts you bought (COGS) during the period that you earned the revenue (when you sold ‘em). The balance sheet “held” the COGS until it could be matched with the revenue it was related to.
In contrast, income statement accounts reflect transactions in the current accounting period only. This is the equivalent of sucking in your gut. It looks good in the moment (or not!), but isn’t a true picture. With our widget example, your income statement accounts would look unnaturally awesome when you sold the Super Awesome Widgets if you didn’t record the cost of goods sold in the same month. Conversely, the income statement would look terrible in the month you bought the parts.
In addition, the net profit or loss moves to the equity section of your balance sheet (to retained earnings) at the end of the period. This means that the balance sheet reflects all prior period revenue, cost of goods sold, and expenses in the form of retained earnings. The equity section also shows how much you’ve invested in and drawn out of your business. The equity section, therefore, shows what the company is worth to you.
Do I look fat?
So, how do you know if your business is “overweight”? Take a look at your debt to equity ratio. (Divide your total liabilities by total equity.) Compare that to your industry average and you’ll have a pretty good indicator of your business weight. Too much debt and not enough equity means your business is, in fact, overweight—even if your current period income statement looks healthy and you have money in the bank. Because everything shows up on the balance sheet, you can rely on it to depict the true financial health of your business.