A well-organised balance sheet is vital to help you understand the story behind the numbers. Comprehension of what the sheet says makes it easy for you to calculate tax dues and deductions, for instance. This skill also lets you recognise cash flow problems and if you need to take out a loan to correct that.
How you organise your balance sheet is also critical to your ability to get approved for a loan. The loan balance sheet demonstrates how profitable your business is. This is one indicator of its ability to settle its obligations. It also indicates your debt to equity ratio, another indicator of your likelihood of defaulting on a loan.
Look at your balance sheet before applying for a loan, and see if you can reorganise it further to your benefit. You have to ensure your documents are in order when you extend your loan application. In any case, here are three efficient and effective ways to organise your balance sheet to demonstrate that your business is financially healthy.
Find Ways to Increase the Working Capital
The working capital is what lenders look at to determine if your business will remain in good health in the next few months or a year. The working capital has two components, namely, the working capital ratio and the networking capital.
To understand the working capital ratio, you first need to know what current liabilities and current assets mean. Current liabilities are those obligations that your business expects to clear out within one business year, while current assets are receivables that you expect to collect within the year.
Now, the working capital ratio is the quotient between your current liabilities and your current assets. Simply divide your total current assets by your total current liabilities. Lenders will look for a ratio of between 1.2:1 and 2:1 when determining your eligibility for a loan. However, the Bank of America says the actual ratio that creditors consider healthy varies from one industry to another, says the Bank of America.
Eliminate as Many Debts as Possible
Your debt-to-equity ratio is another indicator that signals your ability to keep up with your loan obligations. The ratio is the quotient between the business’ long-term debts and the shareholder’s equity. It measures how you use debt or equity to acquire your assets and accurately signals how deep into debt the business is.
Long-term debts take more than one year to mature and are not listed as current liabilities. However, the part of the debt due within the year is not listed as long-term but added to current liabilities. For example, a $100,000 loan with $30,000 worth of amortizations due within the year is accounted as a long-term debt of $70,000. The $30,000 is listed as a current liability under a different account name.
On the other hand, equity is the sum of the investors’ capital contributions and retained earnings. For sole proprietorships, the shareholder equity adds how much you contributed to the capital and the earnings you’ve retained. The shareholder’s equity is also the difference between the business’s total assets and liabilities.
Lenders consider those companies whose debt-to-equity ratios exceed 1.0 as risks for lending. This could indicate that the company borrowed more than a dollar for every dollar into the capital. If you plan to take out a loan in the future, it’s a good idea to start improving your debt-to-equity ratio as early as now.
This step involves evaluating your asset performance management. Asset performance tells you if your operational resources are harnessed fully to generate much-needed revenues for your performance. This is an opportunity to identify fixed assets and similar resources that are under-utilized or totally useless.
Grow Your Equity Even More
After eliminating your debts, you can use your remaining cash to invest more into your business. This will grow your equity and further lower your debt to equity ratio. This will increase your chances of being approved for a loan because of various reasons.
For instance, the lender will see you reinfuse capital as a vote of confidence in the profitability of your business. You see future growth in your enterprise and want to contribute to it by adding to its capital. Combined with a low debt-to-equity ratio, you become less of a risk for the lender if your balance sheets show that you’ve recirculated your dividends as capital.
There are many ways to reinvest in the company. You can start by keeping part or all of your dividends after a profit within the company. Any dividends that you choose to retain are considered retained earnings and form part of your owner’s equity. You could also convert any personal assets into cash if there are any that you’re willing to let go of.
In addition, you could also seek out sources of equity financing that could have factoring contracts and do not involve debts. Angel investors and venture capitalists are excellent sources of additional equity. Both operate similarly, but there are key differences between them.
Angel investors are individuals that are willing to invest cash into businesses that are showing promise. They commonly take on mentorship roles in the company or as board members in exchange for their investment. They usually base their decision on their personal appraisal of a potential investment. When dealing with angel investors, keep your business plan and financial statements handy.
On the other hand, venture capitalists are firms that pool together other people’s resources and invest them into startups. They have a significant interest in the progress of your business because of their clients. Venture capitalists will involve themselves in your business’ top management. Your personal stake and share equity get reduced, but they significantly boost your business’ overall equity.
One form of capital financing that has grown in popularity through the Internet is crowdfunding. Investors and entrepreneurs use this term exclusively for capital-related transactions that take place only on the Internet. Crowdfunding seeks cash for capital from individual investors through an intermediary or a third-party website that facilitates the transactions.
Crowdfunding is an alternate source of financing that grants companies access to funding. This avenue is also very convenient for both issuers and investors. The third-party platform provides the infrastructure for the two parties to conduct transactions in a very transparent manner.
Crowdfunding became so popular that the U.S. Securities and Exchange Commission amended the Securities Act of 1933 in 2015 to introduce exemptions for crowdfunding transactions. The amendments became law as part of the Jumpstart Our Business Startup Act starting in May 2016.
Last but not least, you should also see if your business has any unsettled shareholder loans. These are loans that certain entities extend to the business in exchange for shares of stock. These are still accounted for as debts. It would be a good idea to settle these loans and convert them to equity and working capital as soon as you can.
The Bottom Line
Reading a balance sheet is a skill that you should invest in as an entrepreneur. Understanding each account in this sheet helps you understand the financial health of your business and its ability to secure financing. You can, for example, look at your business from the perspective of the lender. This gives you the advantage of making accurate guesses of your eligibility for financing.
Intimate knowledge of the elements of a balance sheet can also help you reorganise it further to more accurately portray your business’ strength. You can correct any entries or accounts that could lower your odds of getting approved for a loan. This ensures that you can get access to financing when the need arises.
It is also your responsibility as an entrepreneur to stay on top of your business’ finances. Learning how to understand and organise your balance sheet is a good start. Knowing how to read your balance sheet helps you avoid nasty shocks by spotting potential problems early on.