Why Does a Balance Sheet Matter to Contractors?
A balance sheet tends to be the most elusive accounting statement for most people. It is most often wrong or incomplete due to people not understanding what they are for or the makeup. This led us to start a new series to help you understand just that, so join us as we dive into the makeup of a balance sheet and what it tells us!
A balance sheet is vital to any company at any given time as most companies, those who do more than $250,000 in sales per year, must file one with their income taxes. However, this is just one portion of why we need a balance sheet. Balance sheets are generally vital for any significant investment or unsecured loan. Loans for a warehouse or new building are secured by the building. They may not need this, same for vehicle or equipment loans. Still, suppose you go out to get a line of credit or a loan for expansion. In that case, they are going to want to generally see your full financials, including a balance sheet, to be able to tell the financial health of a company.
So, if a lender wants to see a balance sheet so much, what does it tell them? Well, let’s start with what a balance sheet consists of:
Ultimately what this creates is an equation: Assets = Liabilities + Equity. Your total assets in the company, from bank accounts, equipment, vehicles, inventory, etc., must equal what you owe people plus the equity that a company has in it. Lenders like to see this because if you have negative equity, that means you owe more money than the company could pay. In contrast, positive equity means that there is an ability to either pay back or sell assets to cover the loan if necessary. This ultimately helps to secure the loan and make it less of a liability, increasing your chance of getting a loan but also helping to lower the interest rate which you will be charged, saving you money in the long run.
Therefore, having negative equity is not always a bad thing as it can point to a bad year. Most businesses just starting out will go through a few years with losses resulting in negative equity for a period until the business becomes profitable enough to reverse those losses. Some companies will even invest in expanding the business and may see a period of negative equity. Still, long-run negative equity is not something a business wants to see. It shows that the business does not have value to it as it stands and is more than likely suffering or going under in some way, thus making it a risky investment for a lender or investor.
A Balance Sheet Helps Define Long-Term Business Goals.
While not at the top of everyone’s mind, the long-term goal of any business, even if it is not your goal, is to create an asset or investment that you can cash in or sell at some point. Your balance sheet has a huge factor in the value of your company and is another reason why the balance sheet is so vital to any business. Every business has some type of value, whether it be from your customer list, your name recognition, your staff, or your recurring service plans for customers that you have returning year after year. Still, piecemealing a company and selling it off that way is not the most valuable way to sell your business. Most people prefer a turnkey business, but a turnkey business tends to come to any debt that the company has. Your value in a turnkey business primarily comes from your revenue and what you make at the end of each year, but turnkey means that you are selling assets (tools, vehicles, equipment, inventory, and more). If those assets aren’t paid in full or have a loan on them, it devalues them and devalues your company. Any business broker will want to see an accurate and up-to-date balance sheet that includes all assets and liabilities. With this, it is generally good to keep a count and understanding of any tools, vehicles, and equipment to assess their value or if you still have them yearly, hence why most accountants will keep a depreciation schedule for you.
Finally, keeping an accurate balance sheet and keeping it up to date is just as important as any other business task, along with understanding what it tells you. Click here to learn more about that. It should be just like your profit and loss or income statement in the importance of reading and understanding what is going on there at any given time. It should honestly be reviewed monthly, just like your Profit and Loss. The number of companies that I see come to me missing assets, especially large assets, or missing loans is the most prominent issue that exists. 95% of businesses that we work with require an update or cleanup to their balance sheet.