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Monday, November 9, 2015

What Do My Financial Statements Mean? - The Balance Sheet

Today's post is going to be the first in a series of posts that looks at those things you pay your accountant to prepare every year: your historical financial statements.

If you are like most small business owners, you probably feel that they tell you next to nothing about your business that you do not already know, and consequently, you have trouble seeing the value in having them prepared. But do they? Is it possible that they do contain valuable information that has simply never been explained to you in a manner that makes sense.

If you read this and my subsequent four posts, you will discover that your financial statements, while they do have their limitations, do indeed contain useful information that you as a business owner should understand and be aware of. The most compelling reason why you should understand them is that your banker and investors, if you have any use them to evaluate their investment in and loans to your business. So it only makes sense that you should at least understand what they are looking for when they look at your financial statements. Having a basic understanding of them will also help you work more effectively with your accountant at year end as well.

Today's post looks at the first financial statement that is usually prepared, called the balance sheet.

What is a balance sheet? 

A balance sheet is a statement that tells you what assets your business owns at a particular point in time, and how those assets have been funded. A typical balance sheet looks like this:

Image result for balance sheet images

Usually, the liabilities and owner's equity that is shown on the right is presented at the bottom of the balance sheet so that the entire statement is usually a three column statement, with the first column containing the description of all the line items and the second column containing the dollar amounts both at period or year end and at the same time in the prior year.

What Does a Balance Sheet Tell Me or Another Reader?

There are generally three major pieces of information that a balance sheet tells a reader:

1. How much liquidity your business has.
2. How much skin you have in the game, i.e what your equity to debt ratio is.
3. How capital intensive your business is.

What is Liquidity?

Liquidity is a measure of how quickly a business can generate cash to pay its immediate liabilities as they fall due. A business that is highly liquid will have a lot of assets that are either equivalent to cash or can be converted to cash relatively quickly like accounts receivable, or treasury bills for example. Its ratio of these liquid assets relative to it's current liabilities will be higher than 1:1 when a business is highly liquid.

On the other hand, a business that is illiquid will have a lot of assets that are not easily convertible to cash like equipment or inventory, or it will have current liabilities that vastly outstrip its liquid assets.

How Does the Balance Sheet Present Liquidity?

One of the ways that the balance sheet presents or highlights the liquidity position of the business is to clearly separate the current assets from the long-term assets, and the current liabilities from long-term liabilities. Current items are simply those that will be fully realized by the business within a year of the balance sheet date. Long terms items will remain outstanding for over 1 year.

Secondly the assets and liabilities are usually presented in order of their ease of conversion to cash in the case of assets, or how quickly they are expected to be paid in the case of liabilities.

What Does a Lender Look for When Assessing Liquidity?

Most conventional banks want to see a ratio of liquid assets to current liabilities of at least 2:1. In measuring this they will usually count inventory as a liquid asset, since very few businesses that sell inventory will have a ratio of 2:1. Thus you should monitor your ratio on a regular basis, especially if you have bank financing, since your bank will often attach a covenant condition to your bank loan which will allow them to call it for repayment if you are not in compliance. It is an easy calculation to do: simply divide your total current assets by total current liabilities.

Skin in the Game or Equity

Most lenders and investors want to minimize their risk in either investing in or lending to your business. One measure of risk is how much investment you have made yourself in your business relative to how much of the funding has come from other people. Another term for this is leverage. A leveraged business will have been funded by mostly debt and very little equity (investment by owners).

Equity, Shareholder's Equity, or Owner's Equity consists of four components:

1. Share Capital
2. Contributed surplus
3. Due to shareholder (s)
4. Retained Earnings

Share capital is the amount of money that was initially obtained by the business from investors when the business issued its shares to the shareholders. Contributed surplus is not seen that often on financial statements, but it represents monies that shareholders have contributed to the business that are intended to remain with the business as permanent investments. It cannot be repaid unless the shares held are redeemable for an amount greater than their face value.

Due to shareholder simply represents monies that you have lent the business. Every single time you pay a business expense using your own cash, a personal cheque, or your own credit card, you are creating of increasing the amount of money your business owes you. Every time you pay a personal expense with a company cheque or a company credit card, or otherwise withdraw cash you decrease this balance, thus it can be negative where you owe the company money.

Because the amount due to shareholder(s) is a loan, it follows that it can be repaid by the business with no tax consequences whatsoever to the shareholders who lent the money in the first place. However, the same does not hold true for negative loans. The reason is the Canada Revenue Agency wants to stop business owners from taking money from their businesses that would normally be taxable to them and avoiding tax by calling them loans from the business. Under current Canadian tax rules, you must either repay any loans taken by the next balance sheet date of the business, or you must include the amounts borrowed in income, either as a dividend or as a salary.

On the balance sheet, amounts due to shareholder are always presented as assets or liabilities, but lenders almost always include them in their calculation of equity.

Retained earnings represents the total after-tax profits earned by the business since inception, that have not been distributed out to shareholders as dividends. Because most of the retained earnings will have been re-invested in other business assets as the business grows, this amount does not generally represent amounts that are available to be distributed in cash, but rather it represents the maximum amount that could be distributed to shareholders if the business had the cash to do so.

These four items when added together give a measure of how much skin you have in the game to to speak. The more you have, the more comfortable a lender feels in either continuing to hold existing loans to the business or in making additional loans.

What Do Lenders Look For In Assessing Equity?

Most lenders want to see a debt to equity ratio of no more than 3:1 for a successful, established business and 2 or 2.5:1 for other businesses. The lower this ratio is the better will usually be your interest rate on borrowed funds.

Comparing the balances in equity from year to year will tell investors and lenders how much money you took out of the business during the year. This is important as many loan agreements will contain restrictions on how much money you can take out in a year. So you have to read your loan agreements carefully and if you are off-side in this regard, you should either make arrangements to replace the funds taken out or alert your bank before your financial statements are due. Often if you tell them beforehand and show them how you intend to restore compliance, many banks will waive the breach of this condition on their loans.

How Capital Intensive the Business Is

The balance sheet presents capital assets such as property, plant and equipment separately, which allows a reader to see how capital intensive the business is. This is important because capital intensity requires capital maintenance for the business to be sustainable. Equipment depreciates over time and must be repaired, maintained and replaced regularly. Thus a reader is alerted to additional considerations that they must take into account when evaluating a business. If a business is very capital intensive then a reader knows that they have to look at what the annual maintenance costs of those assets are, and whether the business has been maintaining its assets, as well as whether the equipment is in need of expensive overhauls or replacements.

That concludes my post about the balance sheet. On Wednesday, I will go over the second statement, that most of you will understand, called the Income Statement, or Statement of Profit or Loss.

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