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One easy way to understand your balance sheet (and how investors view your business financials)

People don’t understand balance sheets and, as a consequence, they don’t look after them.

by Sam Wood

I’ve been trying to write an article about why the balance sheet is important for a couple of weeks now but I’ve found it very hard. I know what I want to say but sometimes it’s harder than it seems it should be to get it onto paper.

I’ve ran through a couple of different formats, one of which had graphs, charts and even some hand drawn diagrams but none of them were saying what I really wanted to say. So here it is as simply as I could manage:

“People don’t understand balance sheets and, as a consequence, they don’t look after them. While most people can innately understand a Profit and Loss account (does what it says on the tin after all…) not many SME owners/founders truly know what their balance sheet is telling them, much less, how important it can be to the perception of their business. If you’re a founder looking for investment, a poor balance sheet can have a serious impact on fundraising efforts.”

So, here’s how I describe the balance sheet to my clients because I think that if you can picture your business as a car, anyone can easily crack it.

    You can understand your balance sheet if you think of your business as a car…

Your car has a past performance (you can see how many miles its done and how old it is), it has assets (a big engine, tyres full of air etc.), liabilities (a slow puncture, a broken exhaust etc.) and it runs on a liquid asset, Petrol/Diesel (apologies to any electric drivers out there). Cars also have drivers (apologies to Telsa owners again), some of which are better than others!

Assets, liabilities, liquid assets, past performance…sound familiar? Much of the same can be said of your business!

To understand my analogy, allow me to describe a race.

    I’m feeling lucky!

A gambler decides to place a series of bets on a race from Newcastle to London. The race is between 4 cars of varying make, age and specification and is a time trail (the winner will be the car which arrives in London first).

Throughout the race, observations can only be made of each car (and its progress towards London) when it passes checkpoints located in 3 cities: Leeds, Peterborough and London.

The gambler decides that they will risk £900 split three ways into bets at Newcastle, Leeds and Peterborough.

The question is: with the information available, who should they gamble on?

    And we’re off…Newcastle:

Time to place the first bet but at this early stage there is no substantial information about the competitors. The gambler decides to stick with lucky numbers and backs car 3 with £250.

However, they also play it safe with £25 on Cars 1 and 2. Number 4 hasn’t ever been lucky for the gambler and is ignored.

The race is on!

    Leeds:

We reach the first checkpoint and the results are in!

Car 2 has destroyed the field for pace, arriving first into the Yorkshire pit stop but there isn’t much between the others. The cars all seem in decent health but the rate of Car 2’s fuel consumption means it has 1/3 less petrol than Cars 3 and 4, while Car 1 is somewhere between.

Car 1 has two new tyres fitted at the pit stop, replacing two deflated rear tyres it had driven from Newcastle on.

At this first checkpoint, Car 4 also drops off two passengers (which the gambler didn’t know it was carrying) and off they go.

As an observer of the race, what can you infer from this info?

Maybe that the car that made it to Leeds first is clearly the pace setter and will blast to London in no time? Or perhaps that the car with the least fuel may not make it to London and is a risky bet despite its last performance.

The gambler focusses on performance and sticks £300 on Car 2, the pace setter!

    Peterborough:

The gambler is provided with the latest snap shot and to his surprise, we’ve lost a contender.

The early pace setter has burnt through all its fuel and exited the race. Bye-bye Car 2. That’s 1/3 of the gamblers cash lost on what had seemed such a promising contender. Must invest the rest more wisely!

Car 4 arrives into the station first but the lead has narrowed and the race is now neck and neck.

Car 3 has run out of fuel but tops up using cash from three hitchhikers that pay for a lift for Peterborough, adding lots of unexpected weight!

Car 1 has budgeted fuel well and the new tyres fitted at Leeds seems to be making a difference. It roars off confidently.

The gambler makes his final wager and places the last of his cash on Car 1.

    London:

The results are in and we only have two finishers!

The extra passengers have caused major fuel burn and Car 3 is a goner!

Those new tyres did a great job of pulling Car 1 into second place.

The winner is Car 4!

    Okay, I get the analogy, so why’s the balance sheet so important?

So, what has this shown? (other than that, my gambler isn’t very adept at his trade or that I know very little about cars and geography…)

Judging the likelihood of success of a car race on past performance alone is not enough. To make an educated assumption about future performance, it’s often the current position of the car that is more important. This is the same situation investors face when appraising a business/deciding whether to invest.

Your investors have imperfect information and are dependent on financial statements to enable them to better understand the “gamble” they made when investing in you. If you have a weak balance sheet it may be difficult to entice new investment because you are displaying a weak position.

Like the information on the cars at each stage, when a business publishes its financial statements it presents information on the past period’s performance. For a business, this is in the Profit and Loss account. This information spans a period (typically the last financial year) and is a record of the business PERFORMANCE over that period.

Note that there is no information on cash spent, received, or currently held to be found in the Profit and Loss account! Therefore, as with Car 2 (the early pace setter) a business can have amazing performance (it was winning the race!) but without the assets to maintain performance it can quickly find itself out of luck.

This demonstrates the need for extra information. The record of performance (the profit and loss account) is not an indicator of future performance in isolation. Enter the balance sheet….

Your balance sheet is so important because it shows the business’s POSITION without taking into consideration past performance. It’s this POSITION which is critical when seeking investment as it is A STRONG INDICATOR OF FUTURE PERFORMANCE and much more powerful than simply looking at historic trends. Though historic trends undoubtedly help to form well rounded decisions, far too often decisions made simply on historic data miss the detail of business position staring them straight in the face.

Far too often I see business owners focussing on past performance as an indicator for the future and, like I mentioned at the start, they very often can’t see the value in the balance sheet. However, if you’ve been paying attention you’ll have realised the following and hopefully you’ll begin to see why your balance sheet it crucial…

1. Your business is the car. It has assets, liabilities and a past performance.
2. Your Profit and Loss account shows its performance over the last period, in this case the last leg of the race.
3. Your balance sheet is everything else, the account of the ‘state of the car’ and includes assets and liabilities at a point in time (the end of the performance period.)
4. … and to extend further, your cashflow statement is an account of your cash use, or in this case, fuel usage.
5. You (the founder/ SME owner) are the driver.
6. Your investors are the gamblers.

    Love thy balance sheet!

Had the gambler understood the car’s ‘Balance sheet’ he would have noted the change in POSITION of the cars at each checkpoint. It is probable that the gambler would have noted the huge change in liabilities of the car when extra passengers entered or the low levels of fuel of the Leeds pace setter i.e. the significant liabilities. And, if he had done so, it’s very likely he would have changed his actions and gambled (invested) elsewhere.

This shows that your business/start-up may have performed fantastically thus far without necessarily being a sensible option for investment in its current position…or it may have not performed at all and still be ripe for investment! Look at Instagram, bought for $1 Billion USD before it had a sing dollar of revenue i.e. no performance at all on which to base the decision but what was (rightly) assessed by Facebook (the purchaser) to be an incredibly strong POSITION.

“It’s true that your balance sheet may not be the first thing on every investors priorities list. In fact, it may not be at the top of ANY investors list. However, it may be the stumbling block that kills an investment deal. A weak balance sheet lurks in the background waiting to raise its ugly head when a founder is least suspecting it.

So be careful when fundraising because despite headline grabbling MRR, user growth, glowing industry reviews and a stellar team, there’s a real possibility that an awful balance sheet could come back and bite you in the bum very quickly!”

Summary:

There’s a reason financial statements contain more than just a Profit and Loss account and if you’re looking for external investment you really need a nice clean balance sheet. It’s to inform you of both PERFORMANCE and POSITION. Much like the gambler, an investor will look at both but a wise investor will always place significant weight in the latter.

Don’t be blinded by sales, profit, or the lack thereof. On the scale-up journey, it’s almost a given that outside financial support will be needed to maintain growth at some stage. The amount and value of the support you are offered will based on the investor’s perception of your position and the associated risk. The stronger your position (balance sheet), the better the odds are stacked in your favour.

At Blu Sky Chartered Accountants, we use real time cloud accounting to give you the full view of your business you’ve always needed. Utilising best in class Xero software, we review your balance sheet thoroughly monthly to ensure you are aware of exactly what it’s showing and advise strategies to make it as strong as possible. We’ve helped hundreds of UK start-ups through investment rounds and helped them grow to Series A/B/C and beyond.
So, keep you balance sheet strong and if you don’t know how… please just ask!
Contact us now for a free balance sheet review or cloud consultation.
@Samwood41 @bluskytax info@blusky.co.uk 0191 258 7676

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