In an overview of a financial model, we talked about three important financial statements that should be included in every model. The balance sheet holds the topmost priority among them. So let’s delve deep into what an e-commerce balance sheet is made of, why you should prepare one, and how you can help your business grow by doing so.
What is a balance sheet?
A balance sheet can be described as a snapshot of a company’s financial position at a specific date. In other words, it is a statement that reflects all the assets held and liabilities owed by the business at any given point in time. This is unlike the income statement which showcases your business performance over a period of time.
Why do you need a balance sheet?
The balance sheet helps you evaluate your company’s financial health. It can be prepared at the end of every month, every quarter, and every year to give you a comprehensive analysis of your business.
Why should e-commerce vendors prepare monthly balance sheets?
Because it allows you to spot trends and quickly infer the financial position your online business is in. As far as cash accounts are concerned, the main goal is to increase cash flow and reduce debts. If this is reflected in your balance sheet, your business may very well be successful. The priority is to reduce the assets required to increase maximum revenue. The balance sheet helps you estimate how successful your business is at doing so.
How is a balance sheet presented?
A typical balance sheet is made up of assets, liabilities, and owner’s equity (net worth of your business) divided into two balanced sides. The figures should be accurate and represent the financial status of your business as of the day on which you’re preparing the statement.
In general practice, assets appear on the left side and liabilities along with equity on the right. However, some firms choose to present them horizontally with Assets on the top and liabilities right below.
Balance sheet of an ecommerce business
A major share of assets in an ecommerce business would include equipment such as work laptops, rented office space and storage premises etc.
It is unlikely that you’d be dealing in factory size machinery so a lot of the common usage doesn’t apply here.
In other words there can be slight variations in what is and isn’t generally included in the balance sheet of your online business, compared to corporate statements.
However, the principle remains the same.
Asset is a collective term that refers to anything of value controlled by your business. Note that this is regardless of who it belongs to. In other words, assets could be anything that’s possessed or controlled by the company, regardless of who owns it.
What comes under Assets?
They include the cash you have in hand and anything else that can be liquidized (converted into cash). Your inventory, the accounts you are yet to receive and prepaid expenses are all assets by definition and will be included in the balance sheet.
Fixed assets such as your desktops, furniture, office premises you own and other property are also included. In other words, any physical property owned and used by your business that you don’t intend to sell is a fixed asset.
Simply put: assets will mostly include cash, equipment, accounts receivable and inventory.
It is interesting to note that, say, a car you bought using borrowed money can still be considered an asset, whereas the money you owe will be under the liabilities side of the balance sheet.
Let’s stress this point because it can cause a bit of confusion later on: Asset is everything of value that your business controls or possesses, even if it isn’t necessarily owned by you.
So any possession of value owned or controlled by the business is invariably termed an asset. These are items that can be sold or used in production. They include tangibles such as physical property, premises, machinery, equipment as well as intangibles such as patents, goodwill, etc.
Normally, when you prepare a balance sheet, the assets that can be quickly converted to cash appear at the top and the least liquid assets appear last. Let’s do a quick breakdown of items that are generally included in the asset side of an ecommerce balance sheet:
Asset side of an ecommerce balance sheet
Cash in hand
Cash accounts are of topmost priority in the asset side of the balance sheet. These are readily available funds that the business possesses at the moment.
Generally, as far as ecommerce sellers are concerned, accounts receivable here would be the payment yet to be received for items sold by the business. In other words, debtor customers.
Inventory is a current asset that refers to the unsold items left in stock. If your business also handles production and manufacturing in addition to sales, then your inventory will comprise raw materials, unfinished goods and products ready for sale.
Eg: An online T-shirt business with its own production unit would include items such as the cloth material, shirts that are produced but haven’t been printed on and shirts in stock that are ready for sale at the time of preparing the balance sheet.
Prepaid expenses are also considered assets because they are products or services that have already been paid for in advance and will be received during the contracted time period.
Any money your business owes to someone else is a liability. They are of two types: short term and long term.
Current or short term liabilities are obligations that the business expects to pay off within a year. Taxes are a good example of a short term liability.
Liabilities that exceed a year are called long term liabilities These include any amount you owe in the long term such as financial loans or money borrowed from the shareholders.
A typical liability side includes loans, credit card balances,accounts payable and other debts you owe.
If you’re an ecommerce business owner, your equity would be the share of business that you clearly own, free of liabilities. Let’s say you converted all your assets into cash and cleared all your liabilities (paid off all your debts), then the remaining amount would be owner’s equity.
Owner’s equity will include the capital invested in the business as well as retained earnings (profit that is reinvested into the business). Retained earnings are also called owner’s contributions.
Separating liabilities and equity
The liabilities section is made up of debts that the business owes to others and equity. Equity and liabilities are generally separated in the balance sheet, even though they come under the same heading. This makes it easier to differentiate between what the business owes its creditors and what it owes the shareholders. Most small-businesses and ecommerce ventures are owned by a sole proprietor. So it would be simpler to say, equity is the value of assets your business owns.
What comes under the liability side of the balance sheet?
They normally include loans, rent, payments yet to be made to suppliers for products and raw materials, taxes etc.
The most common liability an ecommerce business will encounter is accounts payable. This is money owed to others in the course of business . They could include payment owed to vendors for the products and services rendered, that were purchased on credit. This is an example of a current/ short-term liability since the business expects to clear it within a year.
The guiding principle
The most important thing to note when you prepare a balance sheet is that: Both sides (Assets and Liabilities) must always tally up to the same amount. Hence the term “balance sheet.”
Here’s how it is represented in an equation:
Assets = Liabilities + Owner’s Equity.
The difference between Assets and Liability is the Owner’s Equity.
Let’s walk you through a few key things to note when you read an ecommerce balance sheet:
How to read assets for your ecommerce business?
Reading Accounts Receivable
An increase in accounts receivable can be a warning sign. It means many of your customers are defaulting. This could be challenging for your business. As you know already, you need to ensure there is enough cash flow coming in to sustain the business and grow.
Reading inventory turnover
Another important point to note from your balance sheet’s asset side is the inventory turnover rate. A healthy rate of conversion is neither excessive nor deficient but lies somewhere in the middle. If you possess a lot of goods in stock for a lengthy period of time, it means your sales aren’t doing well and also costs you more in storage and spoilage.
Let’s put it this way:
“A low inventory balance actually gives potential investors the idea that your business is running low on stock and won’t be able to meet growing production demands, which can deter them from investing in your business. On the other hand, if your inventory balance is too high it can seem as if you aren’t making enough sales. This is why it is important to strike a healthy balance between the two.”
By paying attention to the balance sheet you can know just the right amount or level of inventory you need to keep your business running at a profit without sabotaging its potential to grow.
The goal for any online business that holds inventory is to reduce inventory days – This is the period of time your goods are held by you before they’re sold. ) The longer time they spend on the shelf, the lesser your inventory turnover rate is going to be and the harder it is going to be to make returns.
The turnover rate of your inventory is a key pointer in your balance sheet. Leftover goods are simply cash that can’t be spent which is why it needs to be managed effectively. If your turnover rates are poor, you might need to implement systems to track your inventory from time to time.
Equity is yet another important pointer because it shows you the previous year’s performance in terms of retained earnings (which is the money to be reinvested in the business). Apart from owner contributions, equity also displays the net income for the year, taken from the income statement, which we will discuss at length in the next lesson. The more your equity grows, so does your business.
Cash and accrual accounting
The balance sheet helps you to also compare cash and accrual accounting records. As an ecommerce business owner, it is your go-to statement for deciding where your company stands.
Since it is quite common for ecommerce sellers to buy products on credit, it is important to keep track of such liabilities until they are paid. This is so that the balance sheet shows the true financial position of the business.
Most products also have a certain amount charged as sales tax. This is yet another accrued liability that the balance sheet needs to account for because it is money owed to the government. This way, you actually get a pretty accurate estimate of your real cash balance after you clear off liabilities. This is how accrual accounting records are kept. Your balance sheet should be a composite of both.
So far we’ve covered the major items included in any standard e-commerce balance sheet. We’ll be exploring the balance sheet in further detail in the coming lessons. For the next lesson, let’s take a quick look at the income statement and why it is so important to e-commerce businesses.