Financial statements—and your balance sheet in particular—are one of the key elements investors use to determine if your business is worthy of the risk they are considering taking. Your product and passion matter too, but demonstrating that your business is rock solid and ready for growth requires that your balance sheet items showcase your company in its best possible light.
Expansion and growth opportunities can come suddenly, so it is important to take action now so the scales will tip in your favor when an influx of cash matters most. Which accounting framework you use, your financial investments and your understanding of the numbers will each contribute toward successfully securing an investor.
How investors view your balance sheet items
Investors look at three major components in their balance sheet analysis: assets, liabilities and equity. They want to know what your company owns (e.g., cash, accounts receivable, inventory, land, intellectual property), what it owes (e.g., accounts payable, short and long-term debt, wages, leases) and the remaining value to the owner or shareholders once all liabilities have been subtracted from total assets.
Investors use the balance sheet to gauge historical and future performance of a company and to compare investment opportunities across different companies. How can you boost your balance sheet to appeal to these investors?
Switch to accrual accounting
If you haven’t already done so, changing your accounting framework from a cash basis to an accrual basis is preferred and often necessary to beef up your balance sheet. Accrual accounting adds a few steps to your bookkeeping process by matching your business activity to the periods when its revenues and expenses are earned or incurred.
Switching to accrual accounting is required by regulated and publicly traded companies, but it’s also essential for those seeking funding from investors. This GAAP (generally accepted accounting principle) requirement promotes transparency and more accurately presents your company’s financial position than books maintained on a cash basis. The matching principle requires revenues and their corresponding expenses to be recorded in the same period, and it involves adopting and recording prepaid expenses and depreciation.
Document assets with a prepaid expense account
In accrual accounting, when you pay for items that will provide you a benefit in the future, you create an asset account called “prepaid expense.” Adding this asset to your balance sheet increases your company’s value by appropriately documenting services owed to you in the future.
The mechanics of the process are fairly simple. As invoices are paid, such as an insurance policy or a building lease, you classify the invoice in your books as a prepaid expense and add it to a schedule that sums to the total in your prepaid expense account.
At the end of the month, you create and post adjusting entries that allocate the portion of each expense used during the period to its appropriate category. The value of your prepaid expense asset account will fluctuate monthly as you record expenses consumed and add additional prepayments.
Capitalized assets and depreciation
Physical items that are purchased for your business often provide you with future benefits. In accrual accounting, larger items—typically those costing more than $1,000—can be recorded as fixed assets (or capital) and depreciated over their useful life rather than being directly expensed when they are purchased. These transactions also increase your company’s balance sheet value, enhancing its appeal to investors.
Assets that are capitalized typically include cars, computers, office equipment and software. Your invoices will be recorded entirely to the appropriate fixed asset account. The monthly adjusting entries are slightly different from how you record prepaid entries.
With depreciation, a contra-asset account—i.e., accumulated depreciation—is used instead of directly reducing the balance sheet value of the asset. Your financial depreciation entry is not intended to adjust or reflect the market value of the assets, so it is captured in a separate account. There are different depreciation methods and time spans used depending on the classification of the asset. They may align with or differ from how you record depreciation on the company’s tax returns.
Showcase your personal investment
Other balance sheet items—liabilities and owner’s equity—are also important indicators for investors. Naturally, they want to see what the business owes to others, but in particular, they will look for your name. Investors want to see what the owners have contributed to the business. Financial investments, in addition to sweat equity, show you have “skin in the game” and demonstrate your commitment to the company.
Run balance sheet ratios
Outside investors adopt an analytical approach to assess your business, particularly when evaluating it against another opportunity. After an initial balance sheet analysis, they are apt to calculate various ratios to better understand your operations and financial management. Two ratios that are certain to be evaluated are the current ratio, which looks at liquidity, and the debt ratio, which demonstrates your ability to meet your obligations.
Liquidity and the current ratio
For businesses that require a heavy cash flow to support their operations, knowing your current ratio is essential. There are variations to it, but the current ratio gives a snapshot of how your current assets compare with your current liabilities.
Current ratio = current assets/current liability
The higher the current ratio, the higher the degree of liquidity. It can show that you have enough funds to meet your obligations or that you may be overextended and in need of a cash influx to meet payroll and other incurred expenses.
Assess risk with the debt ratio
Not all debt is bad, but it is always helpful to know exactly where you stand. The debt ratio compares your total liabilities to your total assets. Investors have parameters that they use to evaluate your debt ratio compared with industry standards and their own risk tolerance.
Debt ratio = total liabilities/total assets
Higher debt ratios indicate that there are already significant obligations to others. Investors will use that to judge whether they believe they can recoup their investment after other obligations are satisfied.
Know your numbers
Growing your business takes hard work, and to grow it exponentially, you’ll need more funds than your business currently generates. When that time comes, business owners need to get their balance sheet and other financial statements ready for scrutiny.
If your company is ready to position itself with potential investors, let Paro match you with highly vetted financial experts who understand what it takes to set your business apart. With strategic, actionable guidance and process implementation, you can focus on your pitch deck with increased confidence in discussing your financial position.