There are three major financial statements – the profit & loss, the balance sheet, and the statement of cash flow. The balance sheet is what drives the cash flow of the business.
The balance sheet is an important financial-analysis and reporting tool that outlines the assets, liabilities and equity of the company at the end of the accounting period. If the balance sheet is not correct, then the cash flow forecast is most likely inaccurate and worthless.
Unfortunately the balance sheet is what is usually the most neglected and least understood.
In an effort to help get the balance sheet forecasting correct, here are some common mistakes that entrepreneurs, CEOs, business owners, and even business financial consultants regularly make:
The most common mistake made is not having a balance sheet. The balance sheet represents the most complex transactions of the company and may be left out because the company lacks the expertise of a CFO (Chief Financial Officer) or a firm with CFO services to assemble this critical part of the three major financial statements needed.
The major operating assets include accounts receivable, inventory, pre-paid items, and much more. The major operating liabilities include accounts payable, taxes payable, and other accrued expenses. When sales go up, accounts receivables go up, and cash goes down. However, does your information show that? If sales go up, can we expect our inventory level to stay the same? Most likely it will need to increase. The increments of these changes are dependent upon the relationship between the days sales outstanding and your inventory turnover.
As sales increase, your accounts payable usually increase as well. The timing of your payments against your accounts payable is a major outflow in the cash flow puzzle that is called working capital. We need to define the relationship that payables have with your operating activities and implement this relationship in your balance sheet.
There are several other operating assets and liabilities that dramatically influence cash flow. I’ll avoid all of the details of each, but it is fair to say that without properly forecasting them, your cash flow forecast will never be accurate.
Are we bringing in any more equity investments during the period? What is your dividend policy for shareholders? Is some or all of the active shareholders compensation coming through equity? All of these items can have a significant impact on cash flow, although none of them show up on the P&L.
In addition to equity transactions, the structure of all of the company’s debts and obligations need to be correctly reflected. This is done on the balance sheet. An interest only line of credit will keep the same balance until more is withdrawn or some is paid back based on the cash flow of your business. Term loans need to show the correct amount of principal being reduced every month.
Obviously these items can seriously change your cash flow, and they need to be included in the financial model so you can correctly forecast your cash flow.
Above are a few common mistakes, certainly not all-inclusive (you’ll notice I did not address capital expenditures at all), but should help create a positive foundation to build the balance sheet.
L & R Tax Preparation offers CFO services. We have helped our clients get a handle on their companies, make the best strategic decisions possible, raise necessary capital, and perhaps most importantly, track their progress so they can correct problem areas and make more valid assumptions in the future.
© 2010, Bruce Mc. All rights reserved.
