Balance Sheet Tutorial - How to Use Your Balance Sheet to Make Important Business Decisions
By Evan Carmichael
Hi I'm Evan Carmichael and today I want to talk about a topic that a lot of entrepreneurs are scared about but shouldn’t be and that's your balance sheet.
Many entrepreneurs know a balance is something their accountant gives them at the end of the year but they don’t really know how to use it to make important business decisions. I want to quickly talk about what a balance sheet is, what the main elements are, and then give you some tips and strategies on how you can use the information in your balance sheet to run your business, potentially raise money for your business and also sell your business.
Here we go!
The Balance Sheet: Assets = Liabilities + Equity
To quickly explain what a balance sheet is, I've loaded Sage 50 Quantum Accounting. Just go to Reports, click on Financials, scroll over to Balance Sheet and this will help you prepare a balance sheet for the company.
The sample company is a construction business and here is their balance sheet. The balance sheet will basically tell you what your business owns, what is owes to other people and then what you as a business owner actually have in the company.
The Assets are what your company owns. The Liabilities are what you owe to other people and the Equity is what you as the entrepreneur will own in the actual business. The formula is always Assets equals Liabilities plus Equity or, if you think about it another way, the Assets (what your company owns) minus the Liabilities (what your company owes) is what you end up with as your Equity in the company... and hopefully that's a lot of money!
I want to quickly just touch based on what each category is so you have a overall understanding.
Assets - Current Assets
Under Assets, the first category is Total Current Assets. These are Assets that are either cash or can be converted into cash really quickly. Cash will be listed here and then usually the biggest item in the Current Assets is Accounts Receivable.
Accounts Receivable is money that is owed to you. You have invoiced your client and are waiting on payment. It could be 30 days or 60 days or 90 days, etc. before you get paid. Hopefully your receivables will be converted pretty quickly so you have money to spend in your business!
Inventory Assets is the second category and these are items that you have that hopefully can be converted quickly into cash if you need it. If you look at what we have here in our sample data, we've got drywall, hardware, lumber, and roofing. It's a construction company so these items would make sense.
If the company really needed to generate cash, they could probably sell these items and make some money from it.
Assets - Capital Assets
The next category is Capital Assets and these are items that you cannot covert into cash very easily but are still worth a lot of money.
On the balance sheet of our sample company they have a lot of Capital Assets. If you dig deeper you'll see items like furniture, equipment, vehicles, computers, building, and land - basically all things that have value but are hard to convert into money if the company really need to do it quickly.
Assets - Other Non Current Assets
The last category is Other Non Current Assets and these are items like goodwill or patents that are potentially worth a lot of money.
The flip side of Assets are Liabilities and Equity. Liabilities are what you owe as a company. They are divided into Current Liabilities and Long Term Liabilities.
Current Liabilities is money that you owe that has to be paid within the next year. It could be Accounts Payable (something that you have bought that you haven’t paid off yet), credit card debt, bank loans, bank advances, corporate taxes, etc. - basically items that you need to pay for within the next year.
Long-Term Liabilities is money that you owe to other people or other companies that isn't due until beyond a year.
These could be a bank loan, mortgage, or a loan from a shareholder - items that you have to pay off but you don’t have to pay within the next year.
Equity & Summary
So far we've covered off Assets and Liabilities. What's left over is going to be Equity which is basically how much you own as the entrepreneur in the business.
To help you remember, Assets are what your company owns, Liabilities are what your company owes to other people or companies and if you subtract those two you will end up with the Equity which is how much you actually have left in the business.
So that's what a balance sheet is. Let me now explain to you how you can use the information in your balance sheet to run your business, raise capital for your business, and then potentially sell your business as well.
Running Your Business #1 - Working Capital
Two important numbers that we can get from our balance sheet to help us run our businesses are working capital and turnover in Accounts Receivable.
I'll start with working capital. You may have heard of it before - it's basically your Current Asset minus your Current Liabilities.
If we look at the Current Assets of our sample company, it's almost $350,000. We can subtract the Current Liabilities of $220,000 and we have working capital of about $130,000.
What working capital basically tells you is if your company can survive in the short term. If creditors come and say that they need their money now or if there is an economic slump and sales dry up and the company needs to pay off its Liabilities, you have the money to do it.
If you owe a lot of money (have many Liabilities) and you don’t have money coming in, then if you're faced with a cash crunch and sales drop off it's going to be hard for you to raise the money to be able to pay everyone.
Also being able to pay things like salaries and day to day expenses are a lot easier if you have good working capital. So you want to make sure that your Current Assets are greater than your Current Liabilities which will help ensure that your company can survive in the short term.
Running Your Business #2 - Turnover in Accounts Receivable
The second key number to look at is your Accounts Receivable which is usually a big part of your Current Assets.
For our sample company, we have $346,000 in Current Assets. Accounts Receivable is a big chunk of that at $236,000. This could mean you're getting money right away or could mean that you're not getting money for a long time (if ever).
The next step is to look at how frequently that money comes in. Is it 30 days payable? 60 days payable? 90 days payable? It's important because if you have a lot of Liabilities and you owe people money that's coming up, you might be in trouble. The bank needs their money regardless of how you feel so you have to make sure that your Accounts Receivable money comes in on time to pay your bills.
The other thing you want to make sure of is that people actually pay your Accounts Receivable and that you're working with companies who won’t go bankrupt or refuse to pay you. You might be showing it as an Accounts Receivable but if they don’t actually end up paying you the money then it's going to be difficult for you to be able to run your business.
Running Your Business Summary
So those two key numbers are really important to look at for growing your business. Again you want to look at your working capital, your Current Assets minus your Current Liabilities, which will tell you if you're able to survive in the short term.
Then look at your Accounts Receivable and see when they are due, if the money is going to be coming in on time for you to pay off what you owe other companies and if it 's likely that that money will come in at all based on the types of clients that you're working with.
Raising Capital #1 - Capital Assets
Next up is raising capital. If you're trying to raise capital from bankers or from investors, they'll definitely want to take a look at your balance sheet. You can make it as strong as you can by first making sure that there are Assets to lend against.
They won’t care so much about your Current Assets but they will want to look at your Capital Assets to see if there's anything that they can lend against. Bankers especially want to see that you have a lot of Assets. If you have land, if you have a building, or if you have any furniture or equipment that has some significant value then the way they think is: if you don’t pay off this debt we can take away that building or we can take away that land and sell it and we can make my money back.
They want to have that security that you have an Asset there that they can take away from you if you don’t make your payments. They want to make sure that you have those Capital Assets available.
Raising Capital #2 - Debt Levels
The other thing that they are going to want to look at is how much debt you already have so they're going to look at your Liabilities, especially the Long Term Liabilities.
They want to see do you already have bank loans? Do you already have a mortgage? Do you have loans to shareholders? If you already have a lot of Liabilities and you're owing people a lot of money, it's going to be a lot harder for you to be able to raise capital because even though you have great Assets, you're already maxed out and you can't leverage those Assets any more.
Selling Your Business #1 - Accounts Receivable
If you're trying to sell your business, the potential buyers are definitely going to want to see your balance sheet so I want to mention a couple of things they're going to look at.
If we're on the Asset side of the equation, they're going to check out your Current Assets and look at your Accounts Receivables. They're going to want to see how big the value is and if your clients have a history of paying.
In our sample company we have $236,000 in Accounts Receivable but if you know that clients don’t often pay on time or don’t pay at all then you're going to get your valuation number knocked back significantly.
Selling Your Business #2 - Inventory Assets
Another important number is your Inventory Assets. If you carry a lot of inventory, buyers are going to want to see what is the likelihood that you're actually going to use all of these items in your business and if they have to sell it for cash, if something happens and you had to get rid of you know your hardware for example, could you actually sell it for $98,000? Is it worth that much or is it worth a lot less if you're going to sell the actual hardware itself?
A buyer is going to look at every single number on your balance sheet and start asking you questions to see if your company is actually worth the amount that you say it's worth.
Selling Your Business #3 - Other Non Current Assets
An additional factor to look at when selling your business is the Other Non Current Assets. This again could be things like patents and goodwill. It's also called Intangible Assets - they're called intangible because they are really hard to get a numerical value for. How do you value what a patent is worth? You might think it's worth a lot but buyers will often give you a zero dollar value. Be prepared for it.
Selling Your Business #4 - Track Record
A potential investor is also going to look at if you have a track record of success. You can create a balance sheet for every year that you've been in business and hopefully you've been around for a little while before you try to sell.
They're going to want to see that you've grown the business and that you've gained Assets and you've gained in your Equity. They want to see that you're acquiring more Assets. It could be land, buildings, more equipment, etc. to grow the business.
They also want to see that you're reducing your Liabilities or at least your Equity is growing faster than your Liabilities. If your Assets are going up then either your Liabilities or your Equity have to be going up so hopefully it's the Equity side instead of you financing the growth by taking on a lot of debt.
A new owner doesn’t want to come into a business and have to pay off huge amounts of debts. Typically they want to look at three years or five years of growth if you have it. If you don’t have that much available then provide as much as you can.
You should definitely be prepared with your balance sheets because it makes you look a lot more professional, makes you look like a serious business person, and it increases the chances that you'll be able to sell your business and hopefully get a good price for it!
I hope you enjoyed and this gave you some more information on what a balance sheet is and how you can use it to make important decisions for your business.
Evan Carmichael is the founder of http://www.evancarmichael.com, an online magazine for business owners that has helped over 14 million entrepreneurs to date by giving them the motivation and resources to be successful.