| Business Basicsfor Engineers by Mike Volker |
The Balance Sheet
Contact: Mike Volker, Tel:(604)644-1926, Email: mike@volker.orgWhat is a Balance Sheet?
Recall that a balance sheet is a financial snapshot which showsthe current health of the business as measured in terms of its assets andliabilities. Assets include items such as cash, inventories and accountsreceivable (e.g. amounts owed to us by our customers). Liabilities includethings such as bank indebtedness and accounts payable (e.g. amounts owingto trade creditors). So, how can we determine what our inventory will be(in dollar terms) at the end of the first or second years? What about 5years forward? How much cash will our customers owe us?Why Bother?
Why do we care? The balance sheet is essential in forecasting our financialhealth so that we can make sure that the business remains healthy, i.e.that it is adequately funded. The balance sheet would be useful to a bankeror investor for assessing risk and collateral issues. For the CFO (Chief Financial Officer), balancesheet proformas (proforma means "in advance", i.e. occurring in the future) are very useful for managing assets, e.g. are inventorylevels too high?How To?
We've looked at how to prepare proforma profit and loss (income) statementsand how to generate cash flow forecasts fromthese. Once we have the cash flows, it is a quite straightforward processto come up with proforma balance sheets. All we have to do is to continueto add a few more lines to the cash flow rows on the spreadsheet. For example,note that the Cash Flow which we have prepared already tells us the monthlyvalues of one very important asset: Cash. Similarly, it is possibleto calculate balances for the other key assets and liabilities in the business.Here's how:To begin, let's take another look at our proforma Profit and Loss statementalong with the cash flow previously produced for one set of assumptions:
MONTH#1 MONTH#2 MONTH#3 ... MONTH#12 FYTOT:GROSS REVENUE($): 11200 27720 54886 ... 325903 2162713COST OF GOODS SOLD: 7680 19008 37636 ... 223476 1483003GROSS MARGIN: 3520 8712 17250 ... 102427 679710EXPENSES: Sales: 9060 8167 12222 ... 23573 199954 R&D: 1100 867 1022 ... 15373 92044 G&A: 1100 1267 1322 ... 15923 93944TOTAL EXPENSES: 11260 10300 14567 ... 54868 385942NET PROFIT (BT): -7740 -1588 2683 ... 47559 293768CASH FLOW #1($): Month#7: Month#12: Open Balance: 0 -7680 -26748 ... -102641 ... 20489 + Cash from Sales: 0 11200 27720 ... 186394 ... 278550 - Cash re Expenses: 0 -11260 -10300 ... -27450 ... -52830 - Cash for Prodn: -7680 -19008 -37636 ... -162688 ...-223476 = Closing Cash: -7680 -26748 -46964 ... -106384 ... 22733(The interested student may download the spreadsheetused in these example. Note that some calculations for month#12 may appearstrange. This is because you may need data for month#13 and beyond in orderto get valid numbers for month#12. For this exercise, to simplify matters,we are assuming that month#13 P&L data is identical to that of month#12.)
Now, let's add some additional rows to cover those other, non-cash,items. Let's begin with what is probably the second most important asset,Accounts Receivable ("A/R").
We start with a zero A/R balance (sorry! no sales yet!). To figure outour A/R increases and decreases during our first month of operations, wemust add the billings from sales for the month and subtract and cash receiptsfrom current or prior sales. The billings are $11,200 and there are nocash receipts (since this is our first month) and the assumption whichwe are working under is that all sales in a given month will be collectedin the following month. In the second month, we start with the A/R balancefrom month #1, we add the billings for month #2 and we subtract the cashreceived from sales made in month #1. This produces the following spreadsheetresults:
ACCOUNTS RECEIVABLE: MONTH#1 MONTH#2 MONTH#3 MONTH#4 ... MONTH#12 Open A/R Balance: 0 11200 27720 54886 ... 278550 + New Sales: 11200 27720 54886 97806 ... 325903 - Cash From Sales: 0 -11200 -27720 -54886 ...-278550 = Closing A/R Bal: 11200 27720 54886 97806 ... 325903As we can see, this is fairly straightforward. It can, however, becomequite complex as we modify our assumptions to more correctly reflect reality.For example, we probably sell some goods for cash (i.e. offer no termsto certain customers), say 15%. Realistically, we know that some customers,say 25%, will pay in the following month, probably 40% will pay in thesecond month following, and another 15-18% will be in third month. And,yes, some will never pay! (Let's make sure we have a tight credit policy!).In these cases, the A/R balances are not so obvious and the foregoing exercisebecomes more illuminating. But, in any event - the procedure is the same- only the spreadsheet formulas change!
Now, let's try the same thing for Accounts Payable, ("A/P").As before, we start with an opening balance. In this case, the openingbalance is not zero since we received, and were billed for, those goodswhich we ship in the first month, i.e. in the amount of $7,680. In thefirst month we receive those goods which we will ship in Month #2, so weadd these to the A/P Balance. We also become liable for the expenses itemsin the current month and most add that liability as well. Then, we mustsubtract any cash payments which we have made. In this case, we have assumedthat we are paying for the goods in the same month as shipped (since thesewere received in the prior month but we have 30-day payment terms on same).We must also subtract any cash paid out on the expenses which in Month#1 is zero. In Month #2, the process is repeated - in line with our assumptions.This produces the following numbers:
ACCOUNTS PAYABLE: MONTH#1 MONTH#2 MONTH#3 MONTH#4 ...MONTH#12 Open A/P Balance: 7680 30268 47936 81634 ... 276306 + Prod'n goods rec'd: 19008 37636 67067 97750 ... 223476 + Expense items: 11260 10300 14567 20867 ... 54868 - Goods shipped: -7680 -19008 -37636 -67067 ...-223476 - Expenses Paid: 0 -11260 -10300 -14567 ... -52830 = Closing A/P Bal: 30268 47936 81634 118617 ... 278344There is only one other important balance sheet item which we cannot ignore.That is another asset item, our Inventory. In this example, theinventory consists of those finished goods (remember our assumption thatwe are subcontracting production - therefore we are receiving finishedgoods as opposed to many little parts) which we are buying (or producing)and then selling. You can imagine that this become quite complex in a productionor assembly environment in which components and sub-systems have varyinglead times, order quantities, shelf-lives, etc. The spreadsheet can becomehumungous indeed. But, even in these cases, one may have to make some generalizationsand rough estimates. In our case, the Inventory row will look like:
INVENTORY: MONTH#1 MONTH#2 MONTH#3 MONTH#4 ... MONTH#12 Open Inventory: 7680 19008 37636 67067 ... 223476 + Prod'n goods rec'd: 19008 37636 67067 97750 ... 223476 - Goods shipped: -7680 -19008 -37636 -67067 ... -223476 = Closing Inventory: 19008 37636 67067 97750 ... 223476Make sure that you understand how the above inventory calculations weredone.
We have covered the most common and most important balance sheet items- Cash, Accounts Receivable and Inventory on the Assets side and AccountsPayable on the Liabilities Side. Does this make the Balance Sheet complete?No, there is more to come. One very important number is Retained Earnings.This is our accumulated earnings balance. In the above example, it is thenet profit for the year, i.e. $293,768. At the end of the second year,this would be the net profit for the second year added to the retainedearnings balance at the end of the first year. This number is already onour profit and loss spreadsheet and shows up as the "bottom line".
Other Important Balance Sheet Items
We have not yet discussed some other important balance sheet items suchas fixed assets (our furniture and equipment), bank loans, or shareholdersequity. These items can be added in next. Fixed assets may not be a significantaspect of our business. However, if we are in a manufacturing enterprisewhich requires machinery and equipment, an in-depth spreadsheet exercisemay be required. We won't delve into this here. Fixed assets are treatedin a special way - both on the income statement and on the balance sheet.Although an item, such as a $2,000 computer may be purchased and paid forin cash within one to two months, from an income statement point-of-view,only the depreciation (i.e. reduction in value) should be booked. The valueon the balance sheet will be the cost less the accumulated depreciation.Tax aspects must also be considered insofar as taxes are based on government-defineddepreciation schedules (known in Canada as capital cost allowances).For the time being, suffice it to say that these other balance sheetitems must also be taken into account and each item will entail its ownanalysis - often fairly easy to do - just by extending the spreadsheetsas we have done above.
Our balance sheet can now be filled in using the key data from the additionalrows to the original profit and loss projections. An initial start-up balancesheet as well as one for the end of the first few years of operation canbe prepared simply by looking at the ending balances at the end of the12th, 24th, etc months. The following balance sheets (combined on one page)have been prepared given the first set of assumptions. Other key balancesheet items such as fixed assets and share capital have been arbitrarilydetermined for the time being, taking care, of course to make sure thatthe balance sheet stays balanced (i.e. Assets = Liabilities + Equity).Note that for the first year ending, two columns are shown: a preliminarycolumn and a final column. The preliminary column includes only those itemswhich we have calculated from our spreadsheet and do not include the startupbalances or any of the fixed items. What is interesting is that the balancesheet balances - without any "fudging" just by adding these items alone(make sure you understand why!).
BALANCE SHEET as at:ASSETS 31Oct96 31Oct97 31Oct97 prelim* final Cash: 400000 22733 162733 (*taken from month#12 closing) Inventory: 223476 223476 (*taken from month#12 closing) Accounts Receivable: 325903 325903 (*taken from month#12 closing)TOTAL CURRENT ASSETS: 400000 572112 712112 Equipment: 50000 (from a separate schedule) Furnishings: 75000 Tooling, Molds: 60000 Intellectual Property: 25000TOTAL FIXED ASSETS: 210000TOTAL ASSETS: 400000 572112 922112LIABILITIES Bank Line: 50000 0 Accounts Payable: 278344 278344 (*taken from month#12 closing)Long Term Debts: 100000 100000TOTAL LIABILITIES: 150000 278344 378344SHAREHOLDERS' EQUITY: Share Capital: 250000 250000 Retained Earnings: 293768 293768 (taken from FY TOTAL)TOTAL EQUITY: 250000 293768 543768LIABILITIES + EQUITY: 400000 572112 922112To prepare the opening statement, i.e. for 31Oct96, we determined whatthe probable (or desirable) sources of capital would be that would providestart-up funding in the amount of $400,000 since that amount is somewherebetween the $100K and $700K as determined from the two sets of cash flowassumptions. Therefore, the $400K cash balance was obtained from a combinationof a $50K bank line, $100K from long term lenders (e.g. shareholder loans)and $250K in equity capital raised from outsiders by selling shares (i.e.equity) in the business.
After the preliminary column has been prepared, the final column canbe determined by "combining" the opening and preliminary columns. In thiscase, the share capital and long term debt amounts are unchanged (becauseof their very nature). However, because the company has been successful,we no longer need to borrow against the $50K bank line and have thereforereduced the borrowings to $0. As can be seen, some fixed assets have alsobeen arbitrarily added. Figuring out the final cash balance is the key to makingthe balance sheet balance. Initially, we leave this at the $22,733 preliminaryfigure. The total current assets of $572,112 must now be added to the otherassets, i.e. the fixed assets of $210K, to produce total assets of $782,112. Buttotal liabilities+equity add up to $922,112. The difference between thepreliminary figure for total assets and total liabilities+equity is $140K. Wemust now add that amount (the $140K) to our cash balance ($22,733) toproduce a final cash balance of $162,733, which makes sense, right? In otherwords, since the numbers taken from the cash flow spreadsheet (for month#12) arehard numbers, the only thing left to "play" with is the cash balanceline. Another way to look at it is that the initial $400K cash balance wenttowards reducing the $50K bank line and purchasing the $210K in fixed assetsleaving $140K in cash that gets added to the $22,733 balance at the end of thefirst year. The $22,733 is the net result of cash flow taking into account thecash effect of ALL inventory purchases and sales, our collections from sales(A/R) and our payments to creditors (A/P). AND, there you have it!
We can repeat the entire balance sheet exercise for various sets ofassumptions (i.e. a sensitivity analysis). For each scenario, we can easily see what out financial healthwill be and hence, how attractive we will be to investors and financialbackers. How far should we go with this? We should continue until we aresatisfied that we have adequately covered all the real possibilities!
A Note on Cost of Goods Sold
How does "Cost of Goods Sold (CoGS)" tie in to the balance sheet? Whatis "Cost of Goods Sold" and how is it reported? The answer to this lieswithin the concept of accrual accounting. When you buy goods - be it partsfor production or finished goods for resale, these goods go into inventory.On your balance sheet, you would decrease cash-on-hand and increase inventoryby the same amount (if you pay COD) or you could increase your accountspayable by the same amount by which you increase inventory. (This is reallywhat we were doing in the previous spreadsheet example - using the simpleassumption that all materials (goods) sold in a certain month were acquiredin a certain number of months beforehand.) However, in terms of profitand loss, no profit or loss actually occurs until goods are actuallysold or consumed in some manner. This happens when you ship (i.e. sell)something. For example, if you buy $10,000 in parts in October, these partsgo into inventory until they are sold. If, in November, you use up $3,000worth of these parts in order to sell goods for $8,000, then you wouldadd $3,000 to the cost of sales (along with any other direct costs, likelabor charges) for November and you would in this case report a gross profitmargin of $5,000 in November (assuming no other direct production costs).In our example for cash flow, we made some very simple assumptions thatall goods sold in a certain month need to be purchased and paid for withina certain period of time. In practice, you may be buying some componentsin bulk and inventorying these until needed. At the time, they are usedand sold, they are expensed as cost of sales - not before! As you can see,all business transactions affect the balance sheet, but not all transactionsaffect the income accounts (that is the Profit and Loss statements). Computer-basedaccounting systems track all business transactions and ensure that eachtransaction credits or debits a balance sheet account. The simplest wayto think about all transactions is in terms of changes to asset and liability"accounts". An account could be the cash account (or several cash accounts),an inventory account, payroll account, and so on. When you spend moneyon items which are expensed, like rent or salaries, where does this showin the balance sheet? Easy - this is a charge against profits, i.e. theretained earnings account.
Let's say that the payroll in November is $25,000. On the balance sheetthis would be reported as a decrease in cash of like amount and a correspondingdecrease in retained earnings. Remember - every entry in a balance sheet,must always be offset by a balancing entry elsewhere! Now, let's say youhave a really good month. Your sales are $100K, cost of sales is only $45K,and all expenses (salaries, rents) are only $25K. This equates to a profit(before tax - never forget taxes!) of $30K. On the balance sheet, you wouldreduce your inventory by $45K, increase your accounts receivable (and/orcash) by $100K, add $30K to retained earnings and decrease cash (or increaseaccounts payable) by $25K. Are we in balance? Check it out! After you workout a few examples, it should become clear to you what is happening.
Here's another way to look at a business: You are buying "things" -like parts, manpower (really, person-power) and brain power and by cleverlycombining these "things", you sell "something" for more than what you paidto produce it. The difference is your profit. This arises from the valuethat you have added to the "things" by operating your business effectively.Some businesses, especially technology enterprises have a relatively high"value-added" component and can therefore achieve relatively higher grossmargins. Other business, like distribution companies, add relatively littlevalue to the products they sell and therefore their margins are relativelylower (where they can make attractive net profits is through huge volumesof transactions).
For More Information....
Many, many books have been written on the subject. Some of the coursereferences (check on home page) will point you to some of these.
Copyright 1997-2007, Michael C. VolkerEmail:mike@volker.org -Comments and suggestions will be appreciated!
Updated: 071024Backto Main Page
