If you are trying to get a loan or raise equity finance, one of the first things you will be asked for is a Balance Sheet. However, 80% of people in business have no idea what a balance sheet is. Even Deborah Meaden got it wrong recently on Dragons’ Den when she started explaining how sales would appear in your balance sheet. They don’t!
If investors and lenders want to see the Balance Sheet, it makes sense that you at least have an idea of why they want to see it to increase your chances of successfully getting funding.
In just three steps I’m going to explain where the balance sheet fits in, what’s in it and what it reveals about your current financial buoyancy. Before we start, here’s a “health” warning – what we are about to cover in one article takes trainee accountants years to get to grips with. So my learning objective for you is just to get a warm feeling…
Step 1: Context
When you are running a business there are just three things you need to keep track of: income and expenses, cash flow, and what the business owns and owes.
Income and expenses are shown in the Profit and Loss report (known as the P&L) and this report shows the profitability and viability of the business i.e. is the business selling more than the costs.
The Cash Flow is in a report helpfully called the Cash Flow. This report typically has months along the top, and then sections for money in, money out and the expected balance at the bank. The Cash Flow shows if you are about to run out of cash! Hence it should go at least 9-12 months into the future to give you enough warning if you do need more funding. Bear in mind, money folk hate last minute requests for funding.
Finally, what the business owns and owes (the assets and liabilities) are shown in a report called the Balance Sheet. To understand why this report can help keep your business buoyant, lets look at how the balance sheet is laid out.
Step 2: Balance Sheet layout
The balance sheet would typically be laid out with the following sections:
• Fixed Assets – this is equipment that the business owns.
• Current Assets – items owned that are expected to turn into cash within the next 12 months e.g. Cash at bank, stocks of raw materials, work in progress and money owed by customers (aka debtors).
• Current Liabilities – items that are owed and need paying within the next 12 months e.g. Money owed to suppliers (Trade creditors) and money owed for VAT.
• Net Current Assets – this is a sub-total of current assets less current liabilities.
• Long term liabilities – items that are owed and which are not due to be repaid in the next 12 months e.g. loans or leasing arrangements.
• Shareholders Equity (or ownership) – money owed to the owners (Shareholders), being money that has been invested by them in the business for shares and any unpaid profit.
Step 3: What the Balance Sheet shows
The Balance Sheet shows three key things at a particular date i.e. the Balance Sheet date. These are:
• The Net Current Assets figure shows whether the business can meet its short term liabilities – has the business got enough “readies” aka liquidity to meet the short term bills.
• The Long Term Liabilities shows whether the business has over borrowed. Crudely, banks will look at this figure and compare it with what is owed to the owners to assess any increase. Investors will look here to see if the level of borrowing is reasonable. They wont invest if their cash is then used to service or repay borrowings.
• And then finally if you look in Current Assets and Current Liabilities you will see the key components of working capital – working capital is money owed by customers (debtors), plus money tied up in stock less what is owed to suppliers (creditors). You will not find these numbers in the Cash Flow or P&L.
In summary, the Balance Sheet shows the financial risks facing the business at a particular date – does it have enough liquidity to meet its short term bills (that was the Net Current Assets figure). Has it borrowed too much, and how much cash is tied up in working capital. In short hand you can think of the Balance Sheet showing how buoyant your business is – right now without any bull. So next time you get asked for a balance sheet you will know why.
With thanks to Ben Fernmoor who came up with the idea of business buoyancy at my recent British Library workshop. Inevitably, I have taken short cuts in this article – for more support on Balance Sheets, get a Numbers Coach training bundle.