Basics  for  
Mike Volker

The Balance Sheet

Contact: Mike Volker, Tel:(604)644-1926, Email: mike@volker.org

What is a Balance Sheet?

Recall that a balance sheet is a financial snapshot which shows the current health of the business as measured in terms of its assets and liabilities. Assets include items such as cash, inventories and accounts receivable (e.g. amounts owed to us by our customers). Liabilities include things such as bank indebtedness and accounts payable (e.g. amounts owing to 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 5 years forward? How much cash will our customers owe us?

Why Bother?

Why do we care? The balance sheet is essential in forecasting our financial health 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 banker or investor for assessing risk and collateral issues. For the CFO (Chief Financial Officer), balance sheet proformas (proforma means "in advance", i.e. occurring in the future) are very useful for managing assets, e.g. are inventory levels too high?

How To?

We've looked at how to prepare proforma profit and loss (income) statements and how to generate cash flow forecasts from these. Once we have the cash flows, it is a quite straightforward process to come up with proforma balance sheets. All we have to do is to continue to 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 monthly values of one very important asset: Cash. Similarly, it is possible to 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 statement along 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    2162713

COST OF GOODS SOLD:    7680   19008   37636  ... 223476    1483003

GROSS MARGIN:          3520    8712   17250  ... 102427     679710

   Sales:              9060    8167   12222  ...  23573     199954
   R&D:                1100     867    1022  ...  15373      92044
   G&A:                1100    1267    1322  ...  15923      93944

TOTAL EXPENSES:       11260   10300   14567  ...  54868     385942

NET PROFIT (BT):      -7740   -1588    2683  ...  47559     293768

CASH 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 spreadsheet used in these example. Note that some calculations for month#12 may appear strange. This is because you may need data for month#13 and beyond in order to 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 out our A/R increases and decreases during our first month of operations, we must add the billings from sales for the month and subtract and cash receipts from current or prior sales. The billings are $11,200 and there are no cash receipts (since this is our first month) and the assumption which we are working under is that all sales in a given month will be collected in the following month. In the second month, we start with the A/R balance from month #1, we add the billings for month #2 and we subtract the cash received from sales made in month #1. This produces the following spreadsheet results:

   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  ... 325903
As we can see, this is fairly straightforward. It can, however, become quite complex as we modify our assumptions to more correctly reflect reality. For example, we probably sell some goods for cash (i.e. offer no terms to certain customers), say 15%. Realistically, we know that some customers, say 25%, will pay in the following month, probably 40% will pay in the second 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 exercise becomes 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 opening balance is not zero since we received, and were billed for, those goods which we ship in the first month, i.e. in the amount of $7,680. In the first month we receive those goods which we will ship in Month #2, so we add these to the A/P Balance. We also become liable for the expenses items in the current month and most add that liability as well. Then, we must subtract any cash payments which we have made. In this case, we have assumed that we are paying for the goods in the same month as shipped (since these were 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:

   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 ... 278344
There is only one other important balance sheet item which we cannot ignore. That is another asset item, our Inventory. In this example, the inventory consists of those finished goods (remember our assumption that we are subcontracting production - therefore we are receiving finished goods 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 production or assembly environment in which components and sub-systems have varying lead times, order quantities, shelf-lives, etc. The spreadsheet can become humungous indeed. But, even in these cases, one may have to make some generalizations and rough estimates. In our case, the Inventory row will look like:
   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 ...  223476
Make sure that you understand how the above inventory calculations were done.

We have covered the most common and most important balance sheet items - Cash, Accounts Receivable and Inventory on the Assets side and Accounts Payable 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 the net 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 retained earnings balance at the end of the first year. This number is already on our 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 such as fixed assets (our furniture and equipment), bank loans, or shareholders equity. These items can be added in next. Fixed assets may not be a significant aspect of our business. However, if we are in a manufacturing enterprise which requires machinery and equipment, an in-depth spreadsheet exercise may be required. We won't delve into this here. Fixed assets are treated in 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 for in 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 value on the balance sheet will be the cost less the accumulated depreciation. Tax aspects must also be considered insofar as taxes are based on government-defined depreciation schedules (known in Canada as capital cost allowances).

For the time being, suffice it to say that these other balance sheet items must also be taken into account and each item will entail its own analysis - often fairly easy to do - just by extending the spreadsheets as we have done above.

Our balance sheet can now be filled in using the key data from the additional rows to the original profit and loss projections. An initial start-up balance sheet as well as one for the end of the first few years of operation can be prepared simply by looking at the ending balances at the end of the 12th, 24th, etc months. The following balance sheets (combined on one page) have been prepared given the first set of assumptions. Other key balance sheet items such as fixed assets and share capital have been arbitrarily determined for the time being, taking care, of course to make sure that the balance sheet stays balanced (i.e. Assets = Liabilities + Equity). Note that for the first year ending, two columns are shown: a preliminary column and a final column. The preliminary column includes only those items which we have calculated from our spreadsheet and do not include the startup balances or any of the fixed items. What is interesting is that the balance sheet 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:                  25000

 TOTAL FIXED ASSETS:                      210000

TOTAL ASSETS:             400000  572112  922112


   Bank Line:              50000               0
   Accounts Payable:              278344  278344 (*taken from month#12 closing)

 Long Term Debts:         100000          100000

TOTAL LIABILITIES:        150000  278344  378344


   Share Capital:         250000          250000
   Retained Earnings:             293768  293768 (taken from FY TOTAL)

TOTAL EQUITY:             250000  293768  543768

LIABILITIES + EQUITY:     400000  572112  922112
To prepare the opening statement, i.e. for 31Oct96, we determined what the probable (or desirable) sources of capital would be that would provide start-up funding in the amount of $400,000 since that amount is somewhere between the $100K and $700K as determined from the two sets of cash flow assumptions. Therefore, the $400K cash balance was obtained from a combination of 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 can be determined by "combining" the opening and preliminary columns. In this case, the share capital and long term debt amounts are unchanged (because of their very nature). However, because the company has been successful, we no longer need to borrow against the $50K bank line and have therefore reduced the borrowings to $0. As can be seen, some fixed assets have also been arbitrarily added. Figuring out the final cash balance is the key to making the balance sheet balance. Initially, we leave this at the $22,733 preliminary figure. The total current assets of $572,112 must now be added to the other assets, i.e. the fixed assets of $210K, to produce total assets of $782,112. But total liabilities+equity add up to $922,112. The difference between the preliminary figure for total assets and total liabilities+equity is $140K. We must now add that amount (the $140K) to our cash balance ($22,733) to produce a final cash balance of $162,733, which makes sense, right? In other words, since the numbers taken from the cash flow spreadsheet (for month#12) are hard numbers, the only thing left to "play" with is the cash balance line. Another way to look at it is that the initial $400K cash balance went towards reducing the $50K bank line and purchasing the $210K in fixed assets leaving $140K in cash that gets added to the $22,733 balance at the end of the first year. The $22,733 is the net result of cash flow taking into account the cash 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 of assumptions (i.e. a sensitivity analysis). For each scenario, we can easily see what out financial health will be and hence, how attractive we will be to investors and financial backers. How far should we go with this? We should continue until we are satisfied 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? What is "Cost of Goods Sold" and how is it reported? The answer to this lies within the concept of accrual accounting. When you buy goods - be it parts for production or finished goods for resale, these goods go into inventory. On your balance sheet, you would decrease cash-on-hand and increase inventory by the same amount (if you pay COD) or you could increase your accounts payable by the same amount by which you increase inventory. (This is really what we were doing in the previous spreadsheet example - using the simple assumption that all materials (goods) sold in a certain month were acquired in a certain number of months beforehand.) However, in terms of profit and loss, no profit or loss actually occurs until goods are actually sold 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 parts go into inventory until they are sold. If, in November, you use up $3,000 worth of these parts in order to sell goods for $8,000, then you would add $3,000 to the cost of sales (along with any other direct costs, like labor charges) for November and you would in this case report a gross profit margin of $5,000 in November (assuming no other direct production costs).

In our example for cash flow, we made some very simple assumptions that all goods sold in a certain month need to be purchased and paid for within a certain period of time. In practice, you may be buying some components in bulk and inventorying these until needed. At the time, they are used and sold, they are expensed as cost of sales - not before! As you can see, all business transactions affect the balance sheet, but not all transactions affect the income accounts (that is the Profit and Loss statements). Computer-based accounting systems track all business transactions and ensure that each transaction credits or debits a balance sheet account. The simplest way to 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 money on items which are expensed, like rent or salaries, where does this show in the balance sheet? Easy - this is a charge against profits, i.e. the retained earnings account.

Let's say that the payroll in November is $25,000. On the balance sheet this would be reported as a decrease in cash of like amount and a corresponding decrease in retained earnings. Remember - every entry in a balance sheet, must always be offset by a balancing entry elsewhere! Now, let's say you have 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 would reduce your inventory by $45K, increase your accounts receivable (and/or cash) by $100K, add $30K to retained earnings and decrease cash (or increase accounts payable) by $25K. Are we in balance? Check it out! After you work out 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 cleverly combining these "things", you sell "something" for more than what you paid to produce it. The difference is your profit. This arises from the value that 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 gross margins. Other business, like distribution companies, add relatively little value to the products they sell and therefore their margins are relatively lower (where they can make attractive net profits is through huge volumes of transactions).

For More Information....

Many, many books have been written on the subject. Some of the course references (check on home page) will point you to some of these.

Copyright 1997-2007, Michael C. Volker
Email:mike@volker.org - Comments and suggestions will be appreciated!
Updated: 071024
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