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Balance Sheet Projections and You

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Categories: Accounting, Business Strategy, Management

“Why does my P&L statement say we are making money, but I can’t pay my bills?”

“Why won’t the bank give me a loan after I gave them my Balance Sheet and Financial Statements?“

“What do you mean, we are running out of money?”

Welcome to the mysteries of fiscal management of a company.  Few business owners understand the difference between a balance sheet and a profit & loss statement, let alone the complexities involved in reconciling what you might have to do to create a better taxable situation against rewarding an owner or employees.  Good individuals in accountancy DO understand the differences, and it is why the single most frequent request received by ProfitSee is “can you do balance sheet forecasting?”

So, exactly what is balance sheet forecasting?  Why is it so important?  What are the challenges in building it into a software tool?  Most critically, why should it be important to you?

Let’s break it down into simple parts.

  1. Having enough actual cash to pay all the bills is necessary for a company’s survival.
  2. The Profit/Loss statement does not accurately show the real “cash position” of a company.  Things as simple as accrual verses cash reporting complicate the picture even further.
  3. Generally accepted accounting practices involving the Balance Sheet inadvertently “hide” the ability to know real cash flow.
  4. The business checkbook also does not tell the “real” story…

We can all understand the first statement; obviously, we need to be able to pay all the bills.  The challenges come in understanding where the money really is, and having a clear statement of the company’s cash position against its obligations and responsibilities.  If we can understand what is missing with the standard reports and fill in the gaps, we solve the problem.

What’s Missing From The Profit & Loss Statement?

The first challenge is “cash” verses “accrual”.

Cash P&L Statements  reflect what actual money has been collected, and what actual money has been spent.  This report seems to reflect a monthly and year-to-date cash position, but it tells us very little about the financial health of the company.

  • What does the Cash P&L not include?
  • Aging receivables: How much is owed to us, but has not been paid?
  • Aging payables:  Which bills haven’t we paid, for how long, and how much?
  • Those business loans: The interest portion of the monthly payment shows up on the P&L, but the principle portion, the part actually paying down loan does not.
  • The owner would rather not pay the government payroll taxes on themselves each pay period.  The tax calculation is complicated, and they never really know how much is really owed until the end of the fiscal year.  Because of this, the owners pay themselves by “borrowing” money from the company and “reconciling it” on the final financial statement of the fiscal year.  That means this payment does not appear in the P&L statement.
  • How much cash was on hand at the beginning of the fiscal year after all was said and done?  This never appears on a P&L statement.

What about an Accrual based P&L Statement?

Accrual based accounting records (posts) all activities that belong on the P&L Statement as if they have occurred, whether they have or not.  If you send out an invoice, Accrual posts it as a sale.  If you receive a bill and post it on the accounting software, it treats it as if it was paid.  Accrual P&L Reports may give a “high view” of the performance of a company, but it has even less of a relationship to reality than Cash based P&L Reports.  What is missing from an Accrual P&L Report?

  • Receivables are reported as cash having been deposited in the bank, whether they have or not.
  • Payables are reported as cash having been paid out from the bank, whether they have or not.
  • Business loans only show the interest portion of the payment, not the principle.
  • Owner’s compensation is not shown in the report if it is a “loan” to the owner.
  • Cash on hand at the beginning of the fiscal year does not appear on the P&L Report.

What is the Balance Sheet Hiding?

Balance Sheets are mysteries to most business owners.

“Why would a services business need a balance sheet?”

“I don’t have any real estate; isn’t that what the balance sheet is about?  Aren’t they assets that you can’t explain how they generate revenue, but are still owned by, and add value to the company?”

It is very easy to assume that what is simple to understand to yourself is simple to understand to your clients.  This could not be further from the truth.  Balance sheets speak volumes about a company, but only someone has a clear picture of what they are trying to say.

Your clients need a KISS (Keep It Simple St*pid).  Perhaps when you are spending time explaining all the implications of the elegant work you have done in preparation of their tax returns you can dive into the nuances of the Balance Sheet, but for right now, let’s focus on what they need to understand: it’s all about the cash!

What Is Hidden In The Balance Sheet?

The Balance Sheet contains a lot of information that is very important, but not easy to identify.  How do we get a simple look at the company’s true cash position and financial health that are not so easy to see?

Accounts Receivable: The money that is owed to the company, but not yet been paid appear in one of the “Asset” designations in the Balance Sheet.

Accounts Payable: This is money the company owes to others but has not yet been paid.  These appear in one of the “Liability” designations in the Balance Sheet.

The Principle paid on a loan.  This is a “sneaky” posting.  The Loan Principle does not appear as a posting in the Balance Sheet, but rather as a REDUCTION in one of the Liability designations in the Balance Sheet.  After all, we have a lesser obligation from the company to the lending institution.

Owner’s Compensation: Although “Owner’s Compensation” may appear as a label on a Company Asset, what the accounting software is technically saying is that the business owner borrowed the money from the company, and the balance sheet says that the owner owes it back to the company…

Cash On Hand: This is not hidden in a Balance Sheet.  It just tends to be ignored in business owner’s confusion over what a Balance Sheet is supposed to do.  Most business owners expect to see it in a P&L Report.

Based on the particulars of any given company and how the Chart of Accounts is set up, there may be other “hidden” elements in a Balance Sheet, but these are the most common.

“Real” Cash Flow:

This brings us to being able to understand “Real” Cash Flow.  If I can combine the Monthly Profit/Loss from a Cash P&L Report with the current Cash On Hand, and subtract both the Principle portion of any loan payments as well as subtracting the owner’s compensation I understand the actual Cash Position of the company on a Year To Date basis.

Real Cash Flow = Profit/Loss + Cash on Hand – Principle Loan Payment – Owner Comp

If you create a report that tracks Real Cash Flow historically on a monthly basis, you can see a trend for Cash in the company.  Unfortunately, this does not account the impact of Aging Receivables or Payables on the health of the company.  This brings us to Balance Sheet Forecasting.

Balance Sheet Forecasting:

Balance Sheet Forecasting starts with taking Real Cash Flow, combine it with the impact of Aging Receivables and Payables, Loan Payments, Owner’s Compensation, and any expected changes in the company’s business strategies and performance and putting them into a report.  The next step involves projecting the performance of the company on all of these elements (typically over a 12 month period) to determine the health and viability of business.

Most banks and other lending institutions use this as a method of determining a company’s viability for loans and other financial instruments.

This gets very complicated.  Think of the elements that have to be “forecast”:

  • Accrual Based P&L Projections (as it is nearly impossible to forecast Cash Projections)
  • Trends in Aging Receivables and Aging Payables
  • Owner’s Compensation
  • Taxes
  • Loan Payments
  • The consequences of business decisions in Receivables, Payables, Loans, and other business strategies.

It is no wonder Balance Sheet Forecasting is the #1 request ProfitSee gets as a new feature addition to our software!  Most CPAs and those in accountancy and advisory efforts wind up having to do this on a spreadsheet!

Through a variety of features in ProfitSee software as well as the robust granular data provided by Xero Accounting Software, we are set to release this new feature soon!

ProfitSee’s Balance Sheet Forecasting does more than just provide the forecast.  It allows you to:

  • Seamlessly create and distribute reports
  • Allows you to compare the baseline forecast against “what if” decision that impact True Cash Flow and business decisions
  • Provides the information banks and other financial institutions are looking for so efficiently that the monthly licensing cost of ProfitSee software (along with all its other features) is a fraction of the administrative costs to create a single Balance Sheet Projection
  • Allows you to include the impact of future loans and other business strategies to help keep your clients business healthy, profitable, and growing in value.

I hope you will join our many other clients in using Balance Sheet Forecasting to help your business clients!

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