Startup Financials - How To Read Balance Sheet And Tighten Up Your Operations
We've previously covered how to read income statements, in this article let’s jump into the details of how to read a balance sheet. Income statements attract the most attention from investors, however a balance sheet is the real indicator of a company’s financial position. Here are the most important details you need to know about balance sheet:
What is a balance sheet?
A balance sheet provides insights on what your business owns (assets) and owes (liabilities and equities), at a specific point in time. It is a snapshot of your company’s financial condition. Compared to an income statement, the balance sheet shows your financial condition at one moment, where an income statement shows what happened over a period of time.
What are the components of a balance sheet?
Here is the foundation of the balance sheet: Assets = Liabilities + Shareholder’s Equity.
Keep this equation in mind, and it will come handy when you are going through your balance sheet and trying to figure out how all the numbers work. I want to point out that a balance sheet always balances, unless your accounting software has a problem. So don’t stop there if you see your total assets don’t equal your total liabilities and shareholder’s equity, try to fix it, call your accounting software department! We are skipping some details here, instead we will focus on how you can use a balance sheet to make the best business decisions for your startup.
What do you use a balance sheet for?
- Get investors
Balance sheet is one of the main financial statements that investors ask for when they are making investment decisions. A savvy investor can spot hidden clues about the startup from the numbers provided on the balance sheet. For example, they can tell if the company has the ability to pay current operating expenses, meet future debt obligations, and make distributions to shareholders; they can also tell if the founder is frugal (from how fast they spend and what they spend on), keen on excellence (the quality of the balance sheet), etc. Make sure your balance sheet truly represents all the assets you own, and take off the liabilities that you have already paid off.
- Spot potential cash problems
Cash is the king! You want to monitor your cash reserve and make sure there’s enough cash to cover costs while carrying out company initiatives. Not having enough cash will keep you from being able to implement new initiatives and could even result in bankruptcy, you won’t want that to happen! One of the easy ways to spot these potential problems is to closely monitor your cash reserve and make sure you have enough cash!
- Tighten up your operations
A balance sheet shows current and long-term assets and liabilities. You can use the information on each chart of accounts to discover operational issues. For example, if you have large accounts receivable (A/R), you will want to start collecting your outstanding invoices soon so that you have more cash on hand to use; if your inventory amount doesn’t match with your purchasing record, you will need to find where the problem comes from and then fix it. See more details on this in CFO tips below.
CFO tips on cleaning up a balance sheet:
1. Cash
Cash is listed on the top of your balance sheet, and therefore, is the first thing that people will notice on your balance sheet. First impressions matter, so you want to maintain a healthy amount of cash reserve to impress your potential investors and bank officers.
2. Accounts Receivable (A/R)
Manage your A/R often. A/R indicates how much money you can receive from your customers, but haven’t received yet! Make sure to review each unpaid invoice, send out reminder emails/phone calls weekly to make the effort to collect the payments. I would urge founders to do A/R collection sooner rather than later, before these long outstanding unpaid invoices become uncollectible and eventually bad debt!
3. Inventory
If you sell physical products, inventory might be one of the causes of your headaches! Remember, there are different ways to record your inventory value: FIFO, LIFO and Average. You also want to link inventory cost to Cost of Goods Sold (COGS) on your income statement for accurate inventory count. It is not an easy exercise, I strongly recommend you to consult with your CFO/CPA to get inventory right from the start.
4. Depreciation for fixed assets
Do you own fixed assets? Have you been recording the monthly depreciation expenses? Don’t forget to record monthly depreciation expenses and remove the assets that have been fully depreciated. Most assets depreciate on a straight line, some depreciate on an accelerated base, or units. GAAP has clear guidelines on the type of depreciation method to use, make sure to do your research and use the right depreciation method.
5. Investors’ equity
Investors’ equity represents how much money your company currently holds from investors. Be mindful not to make any mistakes on recording investors’ equity on your balance sheet against the cap table, your investors won’t be happy if there are errors.
6. Retained earnings
Retained earnings show how much money your company has made over time. If your startup is pre-revenue, this number might be negative. Your goal is to grow the retained earnings number overtime, from negative, to breakeven, to eventually positive. The sky is the limit!
Takeaway:
A balance sheet is a snapshot of the financial condition of your startup, it tells a story on what your startup owns and owes. A healthy balance sheet helps you attract investors and mitigates potential risks. So be sure to maintain it well and use it wisely!
In the next blog, I will walk you through one of the most time consuming yet important exercise - how to create a forecast and budget for your startup.
