(Nicole Newman) Business Tax Tip: Understanding The Balance Sheet
by Nicole Newman | July 16, 2013
Since the Corbett administration has nicely dismantled the women and minority business enterprise program, my business has to find a third party agency to certify our disadvantaged status. We selected the Small Business Administration 8(a) program because it is one of only a few free certification programs left. We spent 8 hours getting our paperwork in order on the SAM and GLS databases when we hit a snag in the requirements. One of the requirements is to have the last 3 years' balance sheets. We had the Profit/Loss (Income Statement) and the Statement of Cash Flows but we didn't have a balance sheet.
Richard Pittelkow, a business advisor for the West Central Indiana Small Business Development Center says "A Balance Sheet summarizes a company's Assets, Liabilities and Owners' Equity (Net Worth) at a specific point in time, usually at the end of an accounting period. The purpose of a Balance Sheet is to give users an idea of the company's financial condition along with displaying what the company owns and owes. It helps business owners quickly get a handle on the financial strength and capabilities of their business. Balance Sheets, along with Income Statements, are also the most basic elements in providing financial reporting to potential lenders such as banks, investors, and vendors who are considering how much credit to grant to companies."
Norm Brodsky, a seasoned entrepreneur says "Think of a balance sheet as a thermometer that provides a reading on the health of a business at the moment you take its temperature. You can quickly determine a business's solvency, for example, by checking its ratio of current assets (those assets expected to be converted to cash within the next year) to current liabilities (those that must be paid within a year). If the ratio is less than 1 to 1, the business is technically bankrupt. Granted, there's some wiggle room. You can postpone paying some bills or speed up collection of receivables and thereby keep the business afloat. But if the ratio falls below, say, 0.8, watch out. You're well down the path to insolvency--even if your company is profitable. Cash and profits are not the same. If you run out of cash, you're out of business."
Luckily for me, Freshbooks upgraded the system October 2012 and added the balance sheet report. On the first of many tries, my balance sheet did not balance! The equity I had invested in the business did not translate to assets (as we had to take many losses with our first accountant!) Then I researched the intangible assets (like reputation, name recognition, and intellectual property such as knowledge and know how) and my balance sheet finally balanced. Business Dictionary says "Intangible assets are the long-term resources of an entity, but have no physical existence. They derive their value from intellectual or legal rights, and from the value they add to the other assets."
Step 1 is to make the balance sheet balance. That is just the step 1, now you have to know how to interpret the numbers to get the financial picture. Quickbooks says "On completion of an accurate balance sheet for your business, you will be able to determine:
A. The productivity and solvency of the business.
B. The amount of capital retained in the business.
C. How fast or slow assets can be converted to capital."
The productivity and solvency is calculated by the of days of Working Capital - [(Current Assets minus Current Liabilities) divided by (Total Annual Expenses divided by 365)]. Richard Pittelkow says "This calculates how easily the company can handle the normal ups and downs of revenues while still paying its bills. Eventually, every business will have a month, a quarter, or a year when cash-out exceeds cash-in and without a cushion, the company risks going out of business when this occurs even if vendors, creditors, and employees know the set back is only temporary. In addition, the lack of sufficient Working Capital can be evidence of mismanagement to lenders and investors. Companies should have at least 30 days of Working Capital, and financially strong companies will have 180 days or more."
In the start-up phase of most businesses, the owner is investing more than retaining capital. Every business owner should be looking to see when the amount invested in the business is being returned to the business.
The SBA 8(a) program is specifically looking for three years to conduct trend analysis. Richard Pittelkow points out these questions when looking at trends "Is the receivables cycle lengthening? Can receivables be collected more aggressively? Is some debt uncollectable? Has the business been slowing down payables to forestall an inevitable cash shortage? Are Net Profits being retained in the business for future growth or being withdrawn by the owners? Is exhausted equipment being regularly replaced? Are the debts of the company trending up or down?"
Norm Brodsky said "Numbers run companies. It's your responsibility as an owner to know and to understand not only the income statement but also the balance sheet of your business. You ignore them at your peril."
That's sound advice that we are ready to take!
About Nicole Newman
Nicole Newman ( http://www.nicole-newman.com ) is passionate about seeing businesses grow using technology tools that increase productivity. The digital divide is separating the United States into two communities technology - savvy and technology-illiterate. With a Temple University bachelor's degree in Management Information Systems, she is armed with solutions.
About Chia-Li Chien
Chia-Li Chien, CFP®, CRPC, PMP; Chia-Li “like JOLLY,” Succession Strategist of Value Growth Institute, dedicated to helping private business owners increase their company equity value. She is the award-winning author of the books Show Me The Money and Work toward Reward and a faculty of the American Management Association. Her blog and newsletter was named a Top Small Business Resource by the New York Times You’re the Boss blog. Contact her at firstname.lastname@example.org or (704) 268-9378 .