Based on a set of assumptions, a pro forma balance sheet shows all the things your company would own (its assets), all the things it would owe (its liabilities), and their difference (shareholders’ equity).
These are the four questions the balance sheet answers for you and your potential investors:
- Will you be able to pay your bills?
– A current ratio less than 1.0 is a fairly good indication that the company is going to have problems. As your company evolves, your current ratio should become (and remain) above 1.2.
– Net working capital defines the cash you have available for paying off debt and running your company on a day-to-day basis.
– A negative value means you have a shortfall, and unless something drastic is done (like securing short-term loans), you will not be able to continue as you are.
- Where are you getting capital from? The debt to equity ratio (D/E) tells you what proportion of your capital is coming from loans vs. investments.– A value of 1.0 means that you are getting half from loans and half from investors.
– A value greater than 1.0 means that more of your money is from loans and less is from investors. The disadvantages of this are that you must continually make payments on loans (this drains cash and decreases profits), and loans are extremely difficult for start-up businesses to secure without collateral. The advantage however is that you will likely be able to maintain more ownership.
– A value less than 1.0 means that more of your money is from investors and less is from loans. This is more typical for a start-up.
– There is no single right value for a D/E ratio for a start-up. The two primary drivers of what will be the right value for you are: (a) the standards for your industry, and (b) your comfort level with debt.
- How efficiently are you using investors’ money to produce profit? Return on equity (ROE) tells you the answer.
– Most start-ups will have a negative ROE for the first 1-2 years, and will eventually have a positive ROE.
– For publicly traded companies, a ROE of 15% to 20% is considered good, but this measure is not so important for a start-up. On one hand, most investors are more interested in the internal rate of return (IRR) on their investment upon an acquisition than the annual ROE. On the other hand, an acquirer is likely to pay a premium price for a company with a high ROE because it indicates a more solid company.
- How quickly are you moving your inventory?
– If higher than industry averages, you run the risk of running out of stock. If lower than industry, you run the risk of spoilage and/or obsolescence.
– If much higher or lower than the rest of your industry, have you explained what specific strategies you will be implementing to make that happen? One does not achieve such changes without specific actions.
Let’s take a look at a balance sheet to understand how these four questions get answered.
The figure below shows a balance sheet for the first five years of a company.
All balance sheets are organized into two basic parts – (1) Assets and (2) Liabilities & Shareholders’ Equity:
Assets are a list of all items that the company “owns.” Two kinds of assets exist: current and other. Current assets are those that can be easily converted into cash in a reasonably short period of time, specifically one year.
- Cash (or cash equivalents) – a statement of any assets that can be converted into cash almost instantly.
- Accounts receivable – amounts owed by your customers for products they have purchased. You have booked the revenue, but have not yet received their cash payments.They are considered current because it is assumed that customers will be paying you soon.
- Inventory – considered current because it is assumed that you can sell it to customers (or if you are a manufacturer, you can transform the raw materials or work in process into finished products, which you can then sell to customers) within a year.
- Total current assets – the sum of the previous three items.
- Fixed assets – the major purchases that you have made, less their depreciation. It is shown on a line labeled property, equipment, and improvements, net.
- Total assets – the sum of the fixed assets and current assets.
Liabilities and Shareholders’ Equity
This section contains current liabilities (i.e., money the company owes that is due within 12 months), other liabilities (i.e., money the company owes that is due later than 12 months) and shareholders’ equity:
- Accounts payable – items purchased from suppliers or vendors, booked as expenses, but not yet paid for. It is considered current because it is assumed that you will pay it soon.
- Accrued liabilities – expenses (such as salaries for your employees) that you incur on a regular basis but do not pay until the following period. Since most start-ups pay their employees monthly, accrued liabilities at the end of any month (and in fact at the end of any year) will equal one month’s payroll.
- Short-term debt – the balance of all your loans (both those that are due within 1 year and those payments that are due within a year for longer term loans).
- Total current liabilities – sums the previous three items.
- Long-term debt – the balances of all loans due after one year.
- Shareholders’ equity – composed of two parts: (a) paid-in capital, i.e., the actual amount that investors paid for their stock, and (b) retained earnings or accumulated deficit, whichever applies, copied directly from the cum net entry of the income statement.
If all calculations are done correctly, the sum of all assets should equal the sum of all liabilities plus shareholders’ equity.
Below the balance sheet, some companies report values of some standard financial ratios. These often include:
- Current ratio. Your current assets divided by your current liabilities; both of these values appear right here on the balance sheet.
- Net working capital. Your current assets minus your current liabilities (it’s not really a “ratio”!); both of these values appear right here on the balance sheet.
- Liabilities/equity (aka D/E aka debt-to-equity ratio). Your total liabilities divided by shareholders’ equity; both of these values appear right here on the balance sheet.
- Return on equity (ROE). Your net income after tax (from the income statement) divided by shareholders’ equity (from the balance sheet).
- Inventory turnover. Your cost of goods sold (from the annual income statement) divided by the average inventory (from the balance sheet). Average inventory is generally calculated as the average of inventories at the beginning and end of the fiscal year. Inventory turnover is a measure of the number of times during a year that the entire inventory is sold (or otherwise used). It is highly dependent on the industry. Thus, for example, a fresh seafood retail business would expect an inventory turnover of around 365, while an art dealer would expect an inventory turnover of around 2.
The balance sheet differs from the pro forma income statement and the pro forma cash flow statement. The pro forma income statement, which tells you if you will be making revenues and profit, and the cash flow statement, which tells you where your cash will be coming from and going to, are dynamic reports. They show you what will be happening over periods of time.
Unlike those reports, the balance sheet shows you the state of your company at a point in time. It shows you what your company would look like if the calendar and clock could be stopped for just one moment; it is like a snapshot, showing you everything the company owns and owes at that moment.
In the case of a person, the difference between what you own and owe is your net worth. In the case of a company, that difference is the shareholders’ equity.
Using your balance sheet is the best way to view everything the company owns and owes at that moment.
Other articles you may find helpful in the series:
- Why Does My Startup Need Pro Forma Financial Statements?
- Seven Things an Income Statement Tells You
- Four Things a Cash Flow Statement Tells You
Al Davis is a Serial Entrepreneur, Angel Investor and Author of six books. He is CEO of Offtoa, Inc., his fifth startup.
Photo courtesy of Simon Cunningham (Creative Commons).