Balance Sheet Analysis

How to Analyze a Pro Forma Balance Sheet:

Some investor pitches include a subset of a pro forma balance sheet for investors to review. Any investor interested in performing due diligence will ask for a pro forma balance sheet. Offtoa performs an analysis of the balance sheet looking for the same properties that many investors look for; these are properties that often foretell a poor financial outcome for the company. The primary reason for surfacing these issues is to find solutions early and to prevent problems. The primary reason for using a tool like Offtoa to find these issues is so you can either:

• fix these problems rather than suffer the embarrassment of potential investors finding them, or
• understand why the problem is not a problem, so you are better prepared to defend yourself if a potential investor raises the issue. After all, you may not consider every problem that Offtoa raises to be a problem.

Here is a partial list of the kinds of problems that Offtoa looks for

• Current Ratio in Some Years Is Negative
• Current Ratio in Some Years Is Less than 1.0
• Current Ratio in Some Years Is Less than 1.2
• Net Working Capital in Some Years Is Negative
• Net Working Capital Below 10% of Annual Revenues
• Net Working Capital Over 25% of Annual Revenues
• Debt-to-Equity Ratio Much Greater than Industry
• Debt-to-Equity Ratio Much Less than Industry
• Inventory Turnover Too High for Industry
• Inventory Turnover Too Low for Industry
• Return on Equity (ROE) Too Low
• Accounts Receivable Too High for Industry
• Accounts Receivable Too Low for Industry
• Accounts Payable Too Low for Industry
• Accounts Payable Too High for Industry

Whenever Offtoa finds a potential problem, it highlights the symptom for you on the balance sheet, and offers a list of suggested solutions, each of which describes exactly which assumptions you need to change to fix the problem. However, don't just “fix” the problem by blindly selecting one of the suggestions. That will result in you having a set of financial statements that look good but have no basis in reality. Instead, make changes to assumptions that you believe are feasible and then change your business strategy to reflect the new plan. If none of the suggestions are feasible in your mind, then perhaps you don't have a viable company :).

Questions:

What does pro forma mean?

When financial statements are being used to document your prediction of what the company will do, they are called pro forma. In this context, pro forma means “projected future status” based on all your business assumptions, as opposed to your company's real financial statements. It is Latin for “as a matter of form.”

Why doesn't the Accounts Receivable on my balance sheet equal Accounts Receivable on my cash flow statement?

The A/R line on the balance sheet shows the actual amount of money that customers owe you; it is your outstanding accounts receivable. Meanwhile, the A/R line on your cash flow statement reports changes in your accounts receivable since the last period.

What is a good value for the current ratio?

A value less than 1.0 is a fairly good indication that the company is going to have problems, although there are often short-term fixes for short-term problems. As your company evolves, your current ratio should become (and remain) above 1.2.

What is a good value for debt to equity?

There is no single “right” value for a D/E ratio for a start-up. The two primary drivers of what will be the right value for you are: (a) the standards for your industry, and (b) your comfort level with debt.

• A value of 1.0 means that you are getting half from loans and half from investors.
• A value greater than 1.0 means that more of your money is from loans and less is from investors. The disadvantages of this are that you must continually make payments on loans (this drains cash and decreases profits), and loans are extremely difficult for start-up businesses to secure without collateral. The advantage however is that likely you will be able to maintain more ownership of the company for yourself.
• A value less than 1.0 means that more of your money is from investors and less is from loans. This is more typical for a start-up.

What is a good value for return on equity?

For the first few years, most start-ups are not profitable, so ROE will be negative, and that is okay. If the company has accepted investor money, and plans to share profits with those investors (as opposed to having an exit strategy such as an acquisition or IPO), then ROE will become important once the company becomes profitable. For publicly traded companies, an ROE of 15% to 20% is generally considered good.

What is a good value for net working capital?

A negative value means you will have a shortfall of cash, and unless something drastic is done (like securing short-term loans), you will not be able to continue as you are.

What is a good value for inventory turnover?

It is highly dependent on the industry. Thus, for example, a fresh seafood retail business would expect an inventory turnover of around 365, while an art dealer would expect an inventory turnover of around 2.

So what of my accounts receivable is different than the rest of the industry?

This is not so terrible as long as you understand exactly why it is so. Your A/R will not differ from your peer companies just because you think it will be. You must take specific strategic steps to make it so. Are you accepting only cash while your competitors are accepting only credit? Do you convert checks into ACH while competitors do not? Do you demand payment upon ordering while competitors demand payment upon product delivery?

So what of my accounts payable is different than the rest of the industry?

This is not so terrible as long as you understand exactly why it is so. Your A/P will not differ from your peer companies just because you think it will be. You must take specific strategic steps to make it so. Have you already negotiated payment terms with your vendors and suppliers? If not, you'd better stick with industry averages.

So what of my inventory turnover is different than the rest of the industry?

This is not so terrible as long as you understand exactly why it is so. Your turnover will not differ from your peer companies just because you think it will be. You must take specific strategic steps to make it so. Meanwhile, if you maintain less inventory than competition, you may run out of stock. If you maintain more inventory than competition, you risk spoilage or obsolescence. Be careful.