Saturday, November 5, 2011

8 Red Flags You Don't Want on Your Balance Sheet

Business owners have (mostly) a working knowledge of their income statements. For most, the balance sheet is something they don't understand and pay little attention to. I've seen several balance sheets recently that would best be described as train wrecks. Curious, since it's the balance sheet that several people look at first. Those would include:
  • Bankers -- The balance sheet is the cross between the altimeter and the fuel gauge (the income statement is the airspeed indicator) for your business. The balance sheet shows the "vital signs" of the business. Bankers reject loan applications out of hand if they can't make sense of the balance sheet.  Their logic?  Why ask questions of you about the anomalies?  If you understood your balance sheet it wouldn't have been in that condition. 
  • Buyers -- If you're remotely interested in the long-term value of your business, a credible, buttoned-down balance sheet is essential. If you present a balance sheet riddled with questionable items to a potential buyer, they automatically assume the rest of the financials are suspect, as well. The result is a reduced multiple for their valuation and far more rigorous due diligence, since you've damaged your own credibility right at the gate.  If it somehow gets to an offer, you can be sure there will be multiple painful contingencies in the buyer's favor. 
  • Plaintiff's Attorneys -- I heard this from a sharp young lawyer this week. Things like loans into and out of the company, to and from shareholders, make it appear the business is being used as a personal "piggy bank". Running personal expenses through the business (usually over the company credit card) gives a similar appearance. Besides giving the impression of a lack of financial discipline, these actions can, in fact, provide evidence that the business entity (LLC, S-Corp or C-Corp) is really just a fake -- that the business is actually commingled with personal funds on a day-to-day basis. In the case of a judgment against the company, from which your corporate veil is intended to protect your personal assets, you give a plaintiff's attorney plenty of ammunition to prove that there's no veil at all -- the business and personal assets are commingled and therefore not protected. This is known as "piercing the corporate veil", and could easily allow a financial mishap in the company to take you down personally, as well.
I've recently worked through forensic accounting projects with several small businesses to clean up "red flags" on their balance sheets. Have a look at yours, and see if you find some of these red flags:
  1. Loans to Shareholder -- These are usually distributions in drag, sometimes made because posting the cash you took out of the business as a distribution would strip all the equity out of the company. Good example of commingling funds. If you need cash to buy groceries, borrow it as a personal loan or a home equity loan. You went into business to make money, not to loan yourself money.
  2. Loans from Shareholder -- These are usually equity investments in drag. You put money into the company. Why was that? Company not financially healthy enough to support itself? If the business needs to borrow money, borrow it from a "real" lender, like a bank or an individual. Can't get a loan from someone else? I don't want to loan you money, either.  In the case of any shareholder loans, a sharp/aggressive IRS agent may try to use these accounts to retroactively terminate an “S” election if the company has more than 1 unrelated shareholder --  major tax consequences.
  3. Missing Fixed Assets -- Where are the vehicles? Where's the furniture? Where's the office equipment (computers, servers, etc.)? The purchase cost, as well as the accumulated depreciation should be easy to find. There's a difference between fully depreciated assets and MIA assets.  Accumulated depreciation greater than cost of assets (see #4 below) means the owner does not look at the balance sheet and his/her accountant does not look at it either.
  4. Negative Assets -- Negative assets are usually liabilities in drag. Some can be legitimate in limited cases. Most aren't -- they're usually posting mistakes, sometimes years old. Clean 'em up.
  5. Negative Liabilities -- Why would you owe someone negative money? Generally a posting error.
  6. Negative Equity -- How did you take more money out of the business than you've made? Using the business as a front for your personal cash flow problems?
  7. Other "chaff" -- Odd "remainder" amounts in dormant accounts. If an item on the Balance Sheet hasn't changed in 2-3 years, it deserves a look. Is it real? Is it relevant? Can you explain what it is and why it's there?
  8. Inexplicable "clearing" accounts -- QuickBooks Payroll is famous for creating these. They're a red flag that payroll doesn't balance, and sometimes accumulate to big numbers over time, meaning that expenses are being either overstated or understated, depending on the reason for the payroll imbalance problems.
If you routinely give your Accountant a messed up balance sheet – he will clean it up (or should) and send you a large bill to do it.

Take a hard look at your Balance Sheet, just as a buyer, banker, plaintiff's attorney or IRS agent would. Does it pass muster? Can you explain every line item? If not, get a good financial advisor to help you sort through where the bodies are buried, get them cleaned up, and get your balance sheet presentable as evidence that your company is operating in control and you're running a business, not a personal piggy bank.

For most small businesses, making sure your cash, accounts receivable, inventory and accounts payable accounts are clearly reconciled to the supporting schedules, lists, bank statements, etc. is all the owner needs to do every month to feel good about the balance sheet.  By the way, you'll be surprised at how much you learn about your business during the exercise. 

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Terry Weaver

Chief Executive Boards International

Chief Executive Boards International: Freedom for business owners & CEOs -- Less Work, More Money, More Freedom to enjoy it 

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