“Think of it as your business dashboard, providing a snapshot of the financial health of your company at a specific moment in time. The purpose is simple: balance sheets list assets, liabilities and owner equity, typically in order from shortest- to longest-term assets and liabilities divided on either side of the balance sheet.”

Financial Post

The Balance Sheet includes spending and income that isn’t in the Profit and Loss. For example, the money you spend to repay a loan or buy new assets doesn’t show up in the Profit and Loss. And the money you take in as a new loan or a new investment doesn’t show up in the Profit and Loss either. The money you are waiting to receive from customers’ outstanding invoices shows up in the Balance Sheet, not the Profit and Loss. The Balance Sheet shows many reasons why profits are not cash, and why cash flow isn’t intuitive. It’s all related to the essential principles of cash flow.

The Balance Sheet shows your financial picture – assets, liabilities, and capital – at some specific moment. It helps to understand that the Profit and Loss shows financial performance over a length of time, like a month, quarter, or year. The Balance, in contrast, is a moment. Usually it’s the end of the month, quarter, or year. Sometimes it’s the end of the business day.

Balancing is a common term associated with bookkeeping, accounting, and finance. We “balance the books.” It’s a lot like reconciling a checkbook: if it isn’t right down to the last penny, then it’s wrong. Assets have to equal liabilities plus capital. Always.

A traditional Balance Sheet statement shows assets on the left side and liabilities and capital on the right side or the bottom, as in this illustration:

The balance sheet involves the other three of the six key financial terms (the ones that aren’t on the Profit and Loss: Assets, Liabilities, and Capital).

• Assets. Cash, accounts receivable, inventory, land, buildings, vehicles, furniture, and other things the company owns. Assets can usually be sold to somebody else. One definition is “anything with monetary value that a business owns.”
• Liabilities. Debts, notes payable, accounts payable, amounts of money owed to be paid back.
• Capital (also called equity). Ownership, stock, investment, retained earnings. Actually there’s an iron-clad and never-broken rule of accounting: Assets = Liabilities + Capital. That means you can subtract liabilities from assets to calculate capital.

Although traditional printed balance sheet statements are usually arranged horizontally, as in the illustration above, balance sheets in financial projections are usually arranged vertically, showing the assets first, then the liabilities, and then the capital. Here, for example, is the balance sheet for the first few months of the bike store I mentioned earlier. It’s the balance sheet associated with the Profit and Loss for the same company, Garrett’s bicycle store:

This is planning, not accounting. It’s one of the primary principles of the lean business planning. To make a powerful and useful cash flow projection, you need to summarize and aggregate the rows of the balance sheet. Resist the temptation to break it down into detail the way you would with a tax report after the fact. This is a tool to help you forecast your cash.

The Link Between Balance and Profit

The balance sheet is so different from the Profit and Loss that there is only one direct link between the two, a vital one that connects them so that when the books are right, the balance balances: That is the direct line from profits (Net Profits) on the Profit and Loss to Earnings and Retained Earnings on the Balance Sheet. The illustration here shows the link with the bicycle store sample:

A projected Balance Sheet is a perfect example of the critical difference between planning and accounting. The Balance Sheet statement produced by accounting is full of important detail about each item, while the Balance Sheet projection in forecasting is necessarily summarized and aggregated.

This means that your balance sheet categories should be summary categories from your accounting. For example, assets categories are probably only Cash, Accounts Receivable, Inventory, Other Current (or Short-term) Assets, and Long-term Assets (or Plant and Equipment). Liabilities are probably only Accounts Payable, Current Notes (or Loans), Other Current Liabilities, and Long-term Liabilities. Capital is only Paid-in Capital, Retained Earnings, and Earnings.

There are two good reasons for this:

1. You can only produce properly linked and correct fully balanced projections of Profit and Loss, Balance Sheet, and Cash Flow if there are exact links between the items on the Projected Balance Sheet and those in the Projected Cash Flow. That’s a fact of math and financial principles.
2.  It’s useless to try to predict future assets and liabilities in detail; nobody can do it. So you might be able to estimate the total amounts of future purchases of assets, using some reasonable assumptions; but trying to estimate the month of purchase and value of each future asset is a waste of time.

In contrast to the Projected Balance Sheet, the Balance Sheet as a financial statement is a compiled report drawn from a database of details. Accounting knows each transaction: exactly when each asset was purchased, for how much, and its depreciation history and schedule. Accounting knows each loan (called notes) history. Every detail in the statement is based on actual transactions. It goes into tax reports and legal reporting. The projection, on the other hand, is a collection of educated guesses that help you plan your financial needs in advance.

Handling of depreciation is the best example. The accumulated depreciation in a Balance Sheet Statement is a summary of detailed depreciation for each asset the business owns. It comes from the depreciation in the Profit and Loss Statement, which is compiled from the detailed depreciation of each asset. Tax code defines allowable depreciation schedule for each asset according to type, so for example, buildings are normally depreciated over 30 years, while vehicles might be over three or five years. Depreciation in a Projected Profit and Loss, in contrast, is an estimated guess of an aggregated future amount. A good forecaster will look at depreciation over the recent past, plus projected purchases of new assets, to estimate future depreciation. That estimate ends up in the Balance Sheet as Accumulated Depreciation, which subtracts from the value of Long-term Assets.

To do your financial projections well, you need to start the balance sheet and then adjust it according to assumptions in the cash flow. How you start your balance sheet depends on what numbers you have.

For an Ongoing Company

If you’re an existing or ongoing company, your starting balances for next year’s plan are derived from this year’s plan. The following illustration shows what Garrett’s Projected Balance Sheet looks like at the beginning of next year’s plan. Let’s pretend Garrett’s bicycle shop is an ongoing business. Instead of estimating startup costs, he would start his annual plan for this coming year in October of last year. He would have started it with the last two columns of his planned balance sheet from the previous year’s plan, as shown:

For a Startup

However, Garrett’s bicycle store is a new startup business, so he plans for startup costs. He uses the startup worksheet in this illustration:

And his Projected Balance Sheet has a column for starting balances:

You might notice that the startup has a loss at the beginning. In this case it’s a loss of $3,150. Almost all startups begin with an initial tax loss equal to the startup expenses (don’t be disappointed; that’s the way almost all startups begin. That loss means you’re keeping track of expenses so you can deduct them from taxable income later, when you make a profit).