Looking through Auditor and Lender’s glasses

THE STORY A BALANCE SHEET TELLS:LOOKING THROUGH AUDITOR AND LENDER’S GLASSESbalancesheet

Lenders and Auditors pay attention to the Business Balance Sheet. The Balance Sheet tells the story of your business from the beginning to the current day. The Profit & Loss statement is where your tax liabilities calculation is based, but it’s the Balance Sheet that Lenders and Auditors refer to for an accurate full view of how your money transactions are executed. Businesses most frequently audited are the ones that elect to skip the submission of a Balance Sheet with their tax return.

Balance Sheet

The balance sheet is the best measure of the financial health of an organization as it is the accumulation of all its fiscal activity. The balance sheet is a snapshot that shows both what you own (assets) and what you owe (liabilities) at a point in time. In your finances, the difference between what you own and what you owe is your net worth. Your net worth increases or decreases each year by the amount of your net income. Examples of what you own are your cash in the bank, your equipment, vehicles, office furniture, and (perhaps) your office building. Examples of what you owe include your credit card balances, accounts payable, and any loans. The balance sheet is so named because total assets always equal total liabilities plus net assets; the two sections of the balance sheet always balance each other. There are three sections: your assets, what you own; your liabilities, what you owe; and your net assets/equity, the difference between what you owe and what you own.

Audits

When conducting balance sheet audits, the reviewers look into the status of credit extended by the firm to its suppliers and customers. They can gauge whether the probability of payment for debts is high, doubtful, or somewhere in between. The reviewer can also check if the provisions set aside by the company for bad debts are sufficient. Auditors also determine if the company’s provisions for depreciation and other anticipated losses are at reasonable levels.

Auditors examine whether the figures assigned to the various headings under the balance sheet are accurate. They compare the information in the financial statement with third-party documentation. For example, auditors will determine if the assets and liabilities found in the balance sheet exist. They confirm that the assets legally belong to the company and the liabilities properly attach to the firm. They also check restrictions on the use of the assets, and whether those restrictions must be disclosed.

Liquidity and Solvency

When looking at a balance sheet, two of the most important things you want to pay attention to are a company’s liquidity and solvency. Liquidity is a company’s ability to meet its short-term obligations, such as its working capital needs and its debt obligations. Solvency is a measure of the company’s ability to sustain its activities over a longer period of time.

A company’s liquidity can be assessed by looking at a company’s current assets in relation to its current liabilities.. Current assets include cash, cash equivalents, securities, accounts receivable, inventory, and any other assets that can be converted into cash and used up within the current period. Current liabilities are what a company needs to pay off over the coming year. In general, a bank would like to see a current ratio of 2 to 1 for a small business, although this will vary from industry to industry. The company should have twice as many current assets as liabilities. The strength of the ratio as a measure of liquidity will also vary greatly by industry; a craftsman’s inventory will be a lot less liquid than that of a retail store.

Because inventory can be a lot more difficult to turn into cash, analysts use another ratio, known as the quick ratio, to measure liquidity. Typically the quick ratio excludes inventory from the numerator, leaving just cash, marketable securities, and receivables to be divided by current liabilities. These are considered the assets most easily turned into cash. However, it should be noted that some companies, those in retail for example, can probably convert their inventory into cash more quickly than others can collect their receivables.

A reviewer wants to look at the level of total debt relative to the equity used to capitalize a business by its owners to determine solvency. It will vary from industry to industry, but ideally the numbers should balance. For example, banks do much of their financing with debt, whereas a service company is likely financed mostly with equity.

Keep it Current

Most companies should update their balance sheet once per quarter, or whenever lenders ask for an updated balance sheet. Business owners will want to make adjustments by taking inventory, reviewing receivables, writing off bad receivables, plus verifying equipment is correctly allocated as equipment and not listed as supplies. Today’s accounting software programs will create your balance sheet for you, but it’s up to you to enter accurate information into the program to generate useful data to work from. This is also important for tax calculations. When a company shows less profit, it pays less tax.

 

BE CAREFUL – Lowering the net profit by lowering income or increasing expenses shows up and accumulates on the Balance Sheet. Over time, it becomes very apparent to the reviewer that the company was “manipulating” the numbers. A Lender will hesitate to sign a loan with a company that has a questionable Balance Sheet. An Auditor will inquire for more details generally leading to more tax liability from past years.

 

The balance sheet can be an extremely useful financial tool for businesses that understand how to use it properly. If you’re not as familiar with your balance sheet as you’d like to be, now might be a good time to learn more about the workings of your balance sheet and how it can help improve financial management.

Steven Z. Freeman, CPA provides trustworthy and professional Business Accounting and Tax Planning and can assist you with these services. If you have any questions on this matter, or to schedule an initial consultation, Please call us at (805) 495-4211.

 

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