Information: Balance sheet

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:

1. 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:

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.

2. 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 agiven 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:

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!

3. 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:
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:

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".

4. 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!).

o 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 cashbalance ($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!

5. 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).