How to read a balance sheet for a startup

How to read a balance sheet

When you plan a start-up company, you will need to create pro forma financial statements, including the income statement, cash flow statement and balance sheet. A pro forma balance sheet shows all things the company would own (i.e., its assets), all things it would owe (i.e., its liabilities), and their difference (i.e., shareholders’ equity), based on a set of assumptions. Unlike the income statement and cash flow statement, which report data over a period of time (like a month or year), the balance sheet reports data at a snapshot in time. The figure below shows a balance sheet for the first five years of a company. It is organized into two basic parts:

Assets

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.

  • Current assets always start with cash (or cash equivalents), namely a statement of any assets that can be converted into cash almost instantly.
  • If any customers have purchased products, or services and you have booked the reve­nue, but have not yet received their cash payments, the amounts they still owe you are called accounts receivable. The total value of all your ac­counts receivable is the next current asset to be reported. They are con­sidered current because it is assumed that customers will be paying you soon.
  • The next current asset listed is the total value of your inventory. It is considered current because it is assumed that you can sell it to customers (or else, 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.

The next line of the balance sheet shows the total current assets, i.e., it sums the above three items.

  • Finally, the only other assets we will be discussing are the residual value of fixed assets, i.e., those major purchases that you have made, less their depreciation. It is shown on a line labeled property, equipment, and improvements, net.

Following this is a line called total assets, which adds the fixed assets to the 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:

  • If you have purchased items from your suppliers or vendors, booked these as expenses, but not yet paid for them, the amounts you still owe are called accounts payable. The total value of all your accounts payable is reported as the first current liability line. They are considered current because it is assumed that you will pay them soon.
  • Accrued liabilities are expenses (such as salaries for your employ­ees) that you incur on a regular basis but do not pay until the following period. Accrued liabilities are reported on the next line of current liabilities. 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.
  • The last current liability listed is the current short-term 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).

The next line is a subtotal line called total current liabilities, which sums the above three items.

  • The next entry is long-term debt, i.e., the balances of all loans due after one year. The sum of this entry and the entry referred to in the previous bullet should equal the balance due on all outstanding loans.
  • The final entry in this section, called shareholders’ equity is composed of two parts: (a) paid-in capital, i.e., the actual amount that investors paid for their common and preferred stock (sometimes this appears as two entries, one for common and one for preferred), and (b) retained earnings or accumulated deficit, whichever applies, copied directly from the cum net entry of the income statement.

Summary

If all calculations are done correctly, the sum of all assets should equal the sum of all liabilities plus shareholders’ equity.

Financial Ratios

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. It gives a pretty good indication of whether your company will be in a condition to pay off debt when it becomes due. A value less than 1.0 is a fairly good indication that the company is going to have problems, although there are often short-term fixes for short-term problems. As your company evolves, your current ratio should become (and remain) above 1.2.
  • 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. It tells you what proportion of your capital you are getting 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 likely you will be able to maintain more ownership of the company for yourself.
    • 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.

  • Return on equity (ROE). Your EAT (from the income statement) divided by shareholders’ equity (from the balance sheet). It tells you how efficiently the company is using investors’ money to produce profit. Although the official definition of ROE excludes preferred shareholders’ equity from the calculation, I would include it for start-ups because so much of equity raised in a typical investor-backed start-up is in the form of preferred stock.

For the first few years, most start-ups are not profitable, so ROE will be negative, and that is okay. If the company has accepted investor money, and plans to share profits with those investors (as opposed to having an exit strategy such as an acquisition or IPO), then ROE will become important once the company becomes profitable. For publicly traded companies, an ROE of 15% to 20% is generally considered good.

  • 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. It 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.
  • 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.

Pro Forma Balance Sheet for NewCo, Inc.

End of Fiscal Year
1

End of Fiscal Year
2

End of Fiscal Year
3

End of Fiscal Year
4

End of Fiscal Year
5

Assets

   Current assets:

 

 

 

 

 

      Cash and cash equivalents

104,157

262,084

403,487

1,100,033

2,045,941

      Accounts receivable

833

56,875

141,875

222,824

322,108

      Inventory

26,577

38,257

69,777

138,338

371,875

   Total Current Assets

131,567

357,216

615,139

1,461,195

2,739,924

   Property, equip’t & improvements, net

41,672

33,344

50,012

123,342

88,338

   Total Assets

173,239

390,560

665,151

1,584,537

2,828,262

 

 

 

 

 

 

Liabilities and shareholders’ equity

 

 

 

 

   Current liabilities:

 

 

 

 

 

      Accounts payable

8,402

13,017

20,898

40,823

65,118

      Accrued liabilities

52,917

66,675

58,345

61,258

64,320

      Current short- & long-term debt

0

0

0

0

0

   Total Current Liabilities

61,319

79,692

79,243

102,081

129,438

   Other long-term debt

0

0

0

0

0

   Total Liabilities

61,319

79,692

79,243

102,081

129,438

   Shareholders’ equity:

 

 

 

 

      Common and preferred stock

830,000

1,295,000

1,295,000

1,295,000

1,295,000

      Retained earnings (accum deficit)

(718,080)

(984,132)

(709,092)

187,456

1,385,824

   Total Shareholders’ Equity

111,920

310,868

585,908

1,482,456

2,680,824

 

 

 

 

 

Total Liabilities and Shareholders’ Equity

$173,239

$390,560

$665,151

$1,584,537

$2,810,362

 

 

 

 

 

 

Ratios:

 

 

 

 

 

   Current ratio

2.15

4.48

7.76

14.31

21.26

   Liabilities/equity

0.55

0.26

0.14

0.07

0.05

   Return on equity

(6.42)

(0.86)

0.47

0.60

0.45

   Net working capital

$70,248

$277,524

$535,896

$1,359,114

$2,610.486

   Inventory turnover

0.06

1.04

2.18

3.31

3.29

The above is extracted from my latest book, Will Your New Start Up Make Money? Buy your copy in Kindle at http://www.amazon.com/Will-Your-Start-Make-Money-ebook/dp/B00JOOZQNE or paperback format http://www.amazon.com/Will-Your-Start-Make-Money/dp/0996028307