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($): 11200 27720 54886 ... 325903 2162713 COST OF GOODS SOLD: 7680 19008 37636 ... 223476 1483003 GROSS MARGIN: 3520 8712 17250 ... 102427 679710 EXPENSES: Sales: 9060 8167 12222 ... 23573 199954 R&D: 1100 867 1022 ... 15373 92044 G&A: 1100 1267 1322 ... 15923 93944 TOTAL EXPENSES: 11260 10300 14567 ... 54868 385942 NET PROFIT (BT): -7740 -1588 2683 ... 47559 293768 CASH FLOW #1($): 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:
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, 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:
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, 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:
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 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".
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 LIABILITIES Bank Line: 50000 0 Accounts Payable: 278344 278344 (*taken from month#12 closing) Long Term Debts: 100000 100000 TOTAL LIABILITIES: 150000 278344 378344 SHAREHOLDERS' EQUITY: Share Capital: 250000 250000 Retained Earnings: 293768 293768 (taken from FY TOTAL) TOTAL EQUITY: 250000 293768 543768 LIABILITIES + EQUITY: 400000 572112 922112To 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!
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.