A Balance Sheet is a summary statement of the firm’s financial position at a given point in time.
During the initial steps of requesting either a business loan from a Lender, or equity investment from a Venture Capitalist the Client needs to provide a Current Balance Sheet. The balance sheet should represent the Client’s financial position from the most previous complete month. When a funding request is being made, it is imperative to provide the recent financial status of the firm.
It is truly amazing how many people submit a funding request with a bunch of sales hype, and little in the way of current financial information. If you have ever played sports you know that there are times that the coach gets the team back to doing the basics so they have a solid foundation to improve on. The reason the Business Funding Secrets is published is to provide tips and techniques concerning business funding. Sometimes it is necessary to publish some of the basic information.
Following is a simple explanation of what should be represented on the balance sheet and then why the information is important for a loan officer.
For a month end, or year end Balance Sheet Statement - the statement balances the firm’s assets (what it owns) against it’s financing, which can be either debt (what it owes), or equity (what was provided by the owners).
Current assets and current liabilities are short term assets and liabilities. This means that they are expected to be converted into cash or paid within one year, or less.
Fixed or long term assets and liabilities are expected to be on the firm’s books for more than one year.
Assets are usually listed in order of the most liquid assets down to the least liquid. Liabilities, like assets, are listed from short term to long term.
Current Assets (short term):
Cash - the amount of cash currently on hand.
Marketable Securities - are financial instruments such as T-bills that can be quickly turned into cash.
Accounts Receivables - credit sales that can be quickly turned into cash.
Inventories - includes raw materials, work-in-process (partially finished goods), and finished goods held by the firm.
Prepaid expenses - advanced payment of services such as insurance premiums.
Fixed Assets (long term):
Gross Assets (is the cost of the long term assets at their original cost) - land,
buildings, vehicles, equipment.
Accumulated Depreciation - is the recorded amount for the depreciation of the assets.
Total Assets - is the difference between the original cost minus the depreciation.
Current Liabilities (short term)
Accounts Payable - obligations owed for inventory or services.
Notes Payable - short term obligations to banks or creditors.
Accruals - Amounts owed, which may not be billed, such as taxes due, or wages payable.
Long Term Liabilities:
Mortgages - real estate.
Installment loans - equipment.
Stockholders Equity - represents the owner’s claims on the firm.
Preferred Stock - has a higher priority (senior status) relative to common stock.
Common Stock - stock issued to common stockholders.
Paid-in Capital - is the amount received in excess of the par value of the common stock.
Retained Earnings - is the cumulative total of all earnings retained, but reinvested in the firm to help finance the firm’s assets.
Total Assets should equal total liabilities and owner’s equity.
These are just the basic entries, which are common on a Balance Sheet Statement. The more complicated and diverse the business, of course the more complicated the balance sheet will be.
Balance Sheet Analysis
The balance sheet will reveal quick qualifying information that is very important for the Lender or Broker.
Cash and Cash Equivalents:
With information on the balance sheet that is no older than 30 days it is easy to see what cash position the firm is in. If there is very little cash, or cash equivalents, and the Client is looking to obtain funding - it isn’t going to happen because:
1. They aren’t showing they have the cash to service the debt.
2. Due Diligence needs to be completed. This can include property appraisals, business valuations, environmental studies, third-party analysis of technical aspects of the business, flights, hotels, accountants, attorneys, etc. The Client must prove their position to receive funding. It is their responsibility to pay for the due diligence. If they don’t have the necessary cash, the deal can’t move forward.
A quick qualifier calculated from information on a balance sheet is the debt ratio. Debt ratios are intended to measure the degree of the financial risk. The larger the debt position the client currently has, the higher the interest rates and the higher the term payments must be. Higher payments may make it more difficult for the firm to meet its other financial obligations.
Debt ratio = total debt divided by total assets.
This ratio provides a sense of how much of the firm’s assets have been financed, the degree of indebtedness, and the ability to service the debt. Different industries will have different industry standards as to what the maximum ratio should be. As a standard guideline some banks use a maximum ratio of 45%.
More on financial ratios in upcoming Business Funding Secrets newsletters.
Often business owners will want the capital they personally invested in the company to be recorded as a loan (debt) instead of stock (equity). They do this in preparation, as a personal safety strategy, in case something was to go wrong with the business and the firm had to be liquidated. With the liquidation, debts will be paid first before the stockholders (equity) are allowed to receive funds from the sale of the assets. This may be an adequate protective stance if the company is not going to being looking for capital. However, if they arrive at a time in the company’s life that they need a loan, or an investor, the debt vs. equity strategy won’t be acceptable because:
1. If a business owner is not willing to risk an equity position in his own
business then why should an outside investor?
2. If the business owner records his investment as debt, this will increase the
total liabilities, which could cause the debt ratio to fall outside acceptable levels for a loan.
3. The debt vs. equity strategy will often cause the balance sheet to show a negative equity position, which doesn’t motivate investors.
Many Clients attempting to obtain funding on sales hype alone will provide a
projected balance sheet based on the perfect picture after receiving funding. Projected statements come later in the funding process. With the initial contact and analysis the lender needs to know
the company’s current financial status.
Tip - if the Client won’t provide current details don’t expect the funding request to proceed to the next step.
When searching for capital, along with the current balance sheet, a Client should provide some basic company information. Basic company information can be submitted in a one page summary detailing facts, and not sales hype.