It’s common for small business owners to measure their financial health based on their income statement or bank account balance and 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? 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 that there are good weeks and bad weeks on a diet. If you only look 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 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 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 has occurred in the current period. Revenue, cost of goods sold and expenses are some of the account types found on the income statement.
To get an accurate picture of what’s happening in your business, you must adhere to the matching principle. That means you record expenses and cost of goods sold when 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 of the period, the net profit or loss is moved to the equity section of your balance sheet (to retained earnings). 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.
So, how do you know if your business 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 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 financial health of your business.