Growing Through Your Balance Sheet

When I was younger, I wanted to grow up and become a magician. I even remember getting a magic kit for my 7th birthday. My favorite type of magic was up-close, sleight of hand magic. It required mastery of mis-direction as you thought one thing was important, only to find out that it is completely irrelevant, and the thing that you ignored was CRITICAL.

I have grown out of my magic phase, but I work with entrepreneurs every day that are still fall for close up mis-direction. I am talking about the mistake that entrepreneurs make when they set their growth plans based solely on their profit and loss statement and not their balance sheet.

I completely understand why this is the case.

1. The Profit and loss statement is much easier to read than a balance sheet.
2.  It is easier to correlate your daily activities (and what is needed to grow) with your income statement than your balance sheet. Put another way – it is easier to think of growth in terms of selling more stuff (income) and spending more cash (expenses) than it is in terms of assets and liabilities.

It is true that you have to have profit in order to grow (that is unless you are funded by outside investors like Uber) but you should base your rate and size of growth on your balance sheet instead of your profit and loss statement.

When I said the above statement to a friend of mine (who, by the way is an amazing entrepreneur who has grown and sold multiple businesses) he said that he had no idea what that means. So, let’s dive into some specific things that entrepreneurs can look at on their balance sheet to help them with their growth plans:

1. Cash. Just about everyone has heard the phrase “Cash is KING” and it is pretty obvious why. With cash you can do the operations of your business, you can expand, you can reward the shareholders for the risk that they are taking. The amount of cash that a business has is found on the balance sheet, not the profit and loss. Some specific questions to ask about growth when it comes to cash:

• How much days of operations do you have on hand? To find this out, simply look at the total cost of running your business last year (don’t forget to include any loan or lease payments that you have) and divide that number by 365. Having 30 days of operations on hand is the baseline for your operating cycle, most business need to have 90 to 180 days of cash on hand in order to be properly capitalized.
• Many times, expansion leads to a decrease in profitability. This can be due to leadership being distracted with the growth operations instead of focused only on current operations, or maybe there is a lag time with bring sales in at the new location (or with the new product/ service you are offering). Do you have enough cash on hand to fill in the gap?

2. Inventory. Some companies are service companies and have relatively little inventory. Others have some type of manufacturing component and require a significant amount of inventory. As you look at your current inventory levels through the paradigm of expansion, here are a few questions to ask:

• Will your current supplier be able to meet the needs of your expansion?
• Are you too concentrated in your suppliers? What happens if one of them goes bankrupt or has an issue with delivering your inventory?
• How will you store additional inventory? If it is at a separate location, what is your inventory security and control plans to safeguard against theft and waste?

3. Accounts Receivable. Most companies do not operate in the “cash on delivery” world. Most are forced to give some type of terms to their clients. As you look at expansion, here are few questions that you need to answer:With your current receivables mix, is there a concentration (i.e. a client that has more than 20% of your receivables)? If so, what happens if this client is unable or unwilling to pay you?

• Will the expansion or growth increase or decrease this risk?
• With the current receivables mix, is there any client that is more than 30 days beyond what they agreed to pay you? For example, if someone agreed to pay you 60 days after you delivered the product, and it is 45 days beyond that – that can be a problem.
• Will the expansion or growth increase or decrease this risk?

4. Accounts Payable. While it is normal for entrepreneurs to have to extend terms to customers, thankfully the same can be said for their suppliers. Most suppliers provide terms to entrepreneurs. We already discussed the impact of the expansion on your ability to get new/ additional inventory, but:

• Will the expansion allow you to increase your volume with your current suppliers?
• If so, will this lead to more favorable terms from them? For example, will they except payment in 60 days from deliver instead of 30?

5. Working Capital Cycle. This is a fancy business (bank nerd) term for how long it actually takes to convert cash to inventory to finished goods to accounts payable to cash to inventory…… It also shows how cash flows in and out of the business.

• With the expansion, how will your working capital cycle be stressed, expanded, or lengthened?
• How will you fill the need for more cash as your working capital cycle expands? 

6. Types and amounts of liabilities. Most business have a few different types of liabilities. Short term liabilities (have to be paid within a year), long term liabilities (have to be repaid in longer than a year), and shareholder/ related entity liabilities (technically these can be both short- and long-term liabilities).

• How will your expansion plans impact your current level of liabilities? For example, if you have to take out a loan that will require a payback over 4 years, your long-term liabilities increase.
• If the expansion requires a new line of credit, you just increased your short-term liabilities.
• What are the terms of the shareholder/ related entity liabilities? In a perfect world, these would be repaid timely as the company produces enough cash profits to not only sustain itself, but to repay the owners / related party for their investment. The reality is that many times there is no formal repayment structure for these liabilities. This is completely normal and at the judgement of the owners, after all this improves the financial flexibly of the company. However, if there is a formal repayment plan, how will the expansion impact this in both the short and the long-term?

7. Leverage. In addition to CASH, this is the most critical thing to look at on your balance sheet as you are planning future growth (or even current operations). Leverage is a comparison of the assets you have to either the liabilities or the net worth (or equity) of the company. If a company has $1,000,000 in assets and $999,999 in liabilities then it is highly leveraged and has no financial flexibility (because it has to use the assets perfectly in order to pay back what is owed). Another way to think of equity is the value that has been retained in the company. Imagine you had a service company (doctor’s office). The major assets are cash and equipment. If the equipment is financed and you take 100% of the cash profits out of the business (a common practice for doctor offices) then you have left nothing in the business. The business has very limited equity. This makes it impossible to grow unless 1) some cash profit (equity) is left in the business and that is used to fuel growth or 2) cash is injected (either by the owners or through a loan) to fuel the growth.

Not enough entrepreneurs understand, value and protect the concept of leverage, which is a major indicator of your financial flexibility. The matter is much more in-depth than I can describe here, so please contact me if you want to nerd out on this more.

Growing a business shouldn’t be done with sleight of hand; and entrepreneurs should take in all the facts in order to maximize the success. How have you planned your growth? Have you ever considered the impact of your balance sheet or have you just looked at the profit and said – let’s do more of that?

Being an entrepreneur is one of the most difficult and demanding things you can do. The good news is that entrepreneurship today is a team sport. Hit the connect button on LinkedIn or Facebook NOW and together we will work towards hitting your 10-year target. Along the way we will increase your profit, strengthen your leadership skills and define your strategic vision.

Greg Martin is an entrepreneur’s insider to the banking industry and passionately believes that every person was uniquely designed for a higher purpose and calling. Greg guides entrepreneurs in defining and achieving their purpose and calling. His deepest passion is living life with his wife and their wonderful son.