When you apply for a loan of any type, whether it’s from a bank, third party lender, or supplier be prepared to present your balance sheet statement for review. It may not seem very interesting to you, but to them, it’s the most important statement. It gets put under a microscope for review. The balance sheet is nothing more than the net worth statement of your business.
As a private citizen, you have a net worth for your household. If what you own is worth more than what you owe you have a positive net worth. That’s what you want. (It’s amazing how many people have forgotten that). If what you own is worth less than what you owe, your net worth is negative. That’s not fatal providing the business is growing profitably.
Your balance sheet has three key areas and you need to know these cold: assets, liabilities and owner’s equity. The first section, on the left hand side, captures the value of what you own and have title to. Those are your assets. Assets are cash or anything convertible into cash. If the asset is easily converted to cash within one year, that’s a current asset. Accounts receivables and inventory are two very common current assets. If the asset typically takes longer to convert to cash, like property, plant and equipment, these are considered fixed assets. These too are captured on the left side of your balance sheet. Add up the value of all current and fixed assets and voila, that’s your total asset base.
Liabilities are very important to lenders and rest assured, yours will be scrutinized. The liabilities section of your balance sheet is found on the right hand side and like assets, come in two flavors too; current liabilities (payable within the year) and long term liabilities (payable beyond one year). They are obligations on the part of the owner or the business to repay a debt.
The third element is owner’s equity. That’s the difference between the value of what you own and what you owe. Total Assets – Total Liabilities = Owner’s Equity. Owner’s Equity is derived. There are other categories in Owner’s Equity. I go into these in some specifics in chapter eight of my award-winning book, Accounting for the Numberphobic: A Survival Guide for Small Business Owners, so you can read up in more detail. For now, just know if owner’s equity is positive, that will bode in your favor when applying for a loan, though it’s still no guarantee you’ll get the loan.
The lender wants a high level of confidence that your business is able to pay back a loan within the required timeframe with adequate liquidity to run the business. This is no easy task. Your asset base will fluctuate because asset values will fluctuate. Buildings can go up or down in value. Equipment gets depreciated each year. These changes get captured on your balance sheet.
Every time you sell an item with a nice fat gross margin, cash or accounts receivables goes up the value of the sale and inventory goes down the value of cost of goods. The difference between the value of the sale and the cost to make the goods equals the gross margin you made on the sale. This is a beautiful thing. Where things can break down is if you ship a client or do work for a client than doesn’t pay their bill. In most service businesses, the client is extended credit with the expectation that they will pay the bill within 30 or 60 days. It is very rare that every client pays every bill on time. While you may have accounts receivables (current asset) just know, it’s unlikely you’ll realize the total value of that particular asset.
In short, a business is an asset-building engine. Assets are what you own, liabilities are how you paid for them. In the next few articles, I’ll take you through how to know if your assets and liabilities are in the safe zone or not. When you hear the term “strong” or “weak” balance sheet, the loan officer is referring to how large your liabilities are relative to the asset base of the business. Every banker knows this. If you apply for a loan of any kind, you should, too!