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With Daim Ashraf

Understanding your balance sheet

Your balance sheet is a snapshot of the overall financial health of your business at a particular point in time, highlighting what you own, what you owe and are owed, and how much is invested in your company. Analyzing your balance sheet on its own or in conjunction with your P&L will give you invaluable insights into how resilient your business is, and how much runway you have left.

Daim Ashraf is an Accounting Manager at Enduring Planet. We sat down with her to learn what a balance sheet covers, the formulas behind it, and key ratios to track.

This is the third piece in a short series we’re publishing over the next few months, covering core financial concepts for climate entrepreneurs.

What’s on a balance sheet? 

1. Assets
Assets are divided into either short-term (also known as current assets) or long-term assets (also known as fixed assets). Current assets are those you expect to convert into cash or use up within the next twelve months, such as cash, accounts receivable, inventory, and short-term investments. In contrast, long-term assets  such as equipment and intellectual property, will stay on your balance sheet for longer than a year, and are generally a mechanism by which you generate revenue.

Depreciation is an attempt to capture how much of an asset you’ve already used up or how much its value has declined over time, and with different methods for measuring this loss in value available to you, consistency is key. One is the Diminishing balance method (also known as Reducing balance method), which is typically applied when an asset is used more in the early years of its life compared to the later years when the maintenance is high. 

A good example to consider are things like computers, printers, and other office technologies, which don’t age in a linear fashion. In this method, you determine a depreciation rate based on the usage of the asset and then you multiply that by the net book value, or the asset cost minus accumulated depreciation for the period. So $50,000 of technology assets depreciated at 40% per year for the first two years, would be as follows:

  • 1st year depreciation = $50,000 x 40% = $20,000 
  • Net book value at the end of first year = $50,000 - $20,000 = $30,000
  • 2nd year depreciation = $30,000 x 40% = $12,000
  • Net book value at the end of second year = $50,000 - ($20,000+$12,000) = $18,000

There’s also the Straight-line method, which is typically applied when an asset is used consistently throughout its useful life, such as, furniture, fixtures, equipment and machinery. In this method, you simply divide the total cost over the asset’s lifetime - so a $50,000 piece of equipment you intend to use for 5 years will depreciate by $10,000 a year. 

Tip: When you’re determining the cost of an asset, don’t just look at the retail price - include everything you’ve paid to get it into a usable condition, like import duties, moving fees, or maintenance fees. 

2. Liabilities
Your liabilities are divided into the same two categories as your assets - current and long term. Current liabilities encompass everything you have to pay within the next 12 months, like rent, payroll, taxes, and credit card bills, while long-term liabilities aren’t due for another year, and could include longer-term debts like bank loans or convertible notes.

3. Equity
This part of the balance sheet includes anything and everything that’s been invested into your business, both your own capital and funding from investors. It also includes a value that comes from your P&L - your cumulative net income minus any dividends paid in the form of retained earnings. This shows your total profit and loss on an accrual basis, and could be negative if you’ve been making a loss since starting your business. 

Balancing your books

The balance sheet takes its name from the fact that one side - covering the assets you own - is balanced out by the money you owe, and money you’ve taken from investors, on the other side. So, the basic formula when it comes to balancing your books is: assets = liabilities + equity. 

This means that if your liabilities increase dramatically, but your assets don’t, your equity value will decrease, since the equation always balances itself out eventually. A balance sheet that doesn’t add up is a sure sign your accounting is off, which is why it’s among the first things auditors and investors will check to see if your financials are accurate and well-maintained. 

Another point to note is that because everything in your financials is linked, every transaction will have two effects on two separate accounts. Let’s say you made $100k of sales in cash. Your cash will increase by $100k, as will your revenue. Eventually, the $100,000 in revenue will become part of your net income and show up in the equity section of your balance sheet under retained earnings. So on one side, your current assets (cash) increases and on the other side of the equation, your equity increases. 

Common ratios and methods of analysis

1. Horizontal and vertical analysis
There are two kinds of analysis you should be doing regularly to effectively understand your Balance Sheet (and the financial health of your business). Vertical analysis takes every line item and evaluates it as a percentage of your total assets or liabilities, to understand the relationship between lines.. This can help you understand how different investments are driving key commercial outcomes in any given time period. Horizontal analysis involves taking a wider perspective to review your statements on a week to week, month to month, or yearly basis in order to spot trends.

2. Current ratio
One of the most common liquidity ratios is your current ratio which tells you whether you can pay your current debts and obligations from the current assets that you own. To calculate a current ratio, you can simply divide your current assets by your current liabilities. A figure higher than one means that you have sufficient current assets to cover all your debt obligations in the next year.

3. Quick ratio
This works similarly to the current ratio, but subtracts inventory from your current assets, as it can take a long time to sell and so is considered your least liquid asset. It is a more conservative form of current ratio as it only considers assets which can be turned into cash quickly to cover short-term debt and obligations. A ratio of higher the one shows that the company will be able to pay off its current liabilities in the next 12 months, even without selling their inventory or obtaining additional funding.

4. Leverage ratio - Long-term liabilities to assets 
This ratio helps to measure how leveraged your company is by calculating how much of your assets are funded by your long-term liabilities. It should be less than 100%, and ideally less than 50% - the lower the better. 

While long-term liabilities (like a term loan) can help you expand your business, and you might be tempted by the low interest rates in comparison to equity, be careful. Leverage ratios should be closely monitored. When utilized effectively, funds raised should yield sufficient returns in the form of increased revenues, enabling timely repayment of long-term liabilities. Since investors prioritize your company's leverage, a heightened ratio can evoke concerns regarding loan repayment.

5. Runway
Looking at the interplay between your P&L and your balance sheet tells you how much cash you have available, and how long your business can stay afloat without taking in more revenue.  

One way to calculate your runway is to divide your bank balance by your net burn rate - your average revenue minus average expenses in the last 12 months. It’s good to be conservative, so don’t overstate your revenues or understate your expenses. If you want to get more precise, you might include some projected figures - for example, if you’re sure that you’ll receive payment from a customer in the next 12 months, then go ahead and include it on the revenue side of the equation. Likewise, if you’re on track to hire people in the next few months, you can incorporate those values in your future expenses. The key is to think about cash flow on a monthly basis, and plan ahead about how to combat any shortfalls in funding.

Tracking your ratios over time

It’s important to keep a close eye on your balance sheet in order to spot trends - and while improvements are good, what you really want to watch out for is whether any of your ratios start to slip. Find out what a healthy range is for businesses in your industry, and focus on staying inside it. 

Continuous tracking allows businesses to stay updated on their financial performance, identify trends, and address potential challenges proactively. By regularly reviewing key financial metrics and ratios, companies can assess their liquidity, leverage, and overall financial stability. Additionally, ongoing analysis enables businesses to adjust strategies, allocate resources efficiently, and mitigate risks effectively. 

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