The purpose of a balance sheet is to describe the resources that a business has and how those resources were acquired. This purpose is seen as an end result of financial planning but this purpose can be seen as a starting point of financial planning. As a starting point of financial planning people should think about how to accumulate wealth from the resources they want to have and how those resources are to be acquired.
Assets = Liabilities + Stockholders’ Equity
- Assets are resources used to create benefits in the form of higher revenues, lower expenses, or both.
- Liabilities are obligations that are settled by paying debts, delivering products, or providing services.
- Stockholders’ Equity is ownership through the contribution of capital and retention of earnings.
A balance sheet organizes the thinking of how to accumulate wealth from resources through classification. A balance sheet classifies assets into two primary categories: current and long-term. Current assets are resources that are converted into cash within one year while long-term assets are resources that generate cash flows over a period of time greater than one year.
Examples of current assets are
- Accounts Receivable
When thinking about how to accumulate wealth from current assets the priority is time. Time is the priority because businesses need to receive cash in a manner that allows them to honor commitments with creditors. How can businesses prioritize time? Businesses can prioritize time by their value propositions; value propositions are the characteristics that make businesses stand out from their competitors. Let’s look at how businesses can establish relationships between their value propositions and current assets through their accounts receivable and inventories.
Accounts Receivable represent the extension of credit to customers for what they purchase. The extension of credit is stated through payment terms. The most common payment term is net 30 which means a customer has 30 days to pay what it owes. Businesses also can offer payment terms that incorporate a discount to customers who can reduce the amount they owe by paying faster; for example, a payment term of 2/10, net 30 means a customer can take a 2% discount on what it owes by making a payment within 10 days. What should businesses think about when converting accounts receivable to cash?
What businesses should think about when converting accounts receivable to cash is quality.
One example of quality is the content of invoices that support accounts receivable. Content should include the products or services sold, the quantity of product or services sold, the price of products or services sold, addresses that reflect where products or services sold as well as who pays for products or services sold, and purchase order numbers that initiate the request of customers for products or services. Inadequate content can delay the receipt of payment for products or services and this delay can result in the delay of businesses honoring their commitments with creditors.
Another example of quality is the satisfaction that customers receive from what they purchase. Satisfaction is tied to importance, i.e. how important is what customers receive affect their ability to improve their well-being. If customers realize what they receive is important, they will make every effort to maintain this importance. How customers will maintain this importance is to prevent the delay in receiving products or services in the future. Preventing this delay is very simple, pay what is owed in a timely manner. Businesses, therefore, can convert accounts receivable to cash in a timely manner through the quality of its invoices as well as its products or services. Financial planning for accounts receivable therefore must incorporate a process of thinking about how businesses communicate its importance to the well-being of their customers.
Examples of long-term assets are
- Intellectual Property
The examples of long-term assets vary in form. Investments can be in bonds, stocks, or land. Land, buildings, and equipment have physical substance while intellectual property – e.g. patents, copyrights, trademarks – lack physical substance. Due to the variation in form thinking about how to accumulate wealth from long-term assets is necessary.
An example of thinking about how to accumulate wealth from long-term assets is what led Mark Hellendrung, the President of Narragansett Brewing Company, to do with monies received from investors. Mark had two choices: put the monies into a brewery or a brand. Mark decided to put the monies into a brand. Mark determined that the beer could be brewed by someone else so building a brewery was less important than building a brand.
Another element of Mark’s thought process may be his background; prior to becoming President of Narragansett Brewing he was President of Nantucket Nectars where he established a reputation for building a brand. This example is something for people to consider when thinking about how to accumulate wealth from long-term assets. For Mark a brand, intellectual property, was most important in building a company that can stand out from its competitors so people should think about which long-term asset or assets will help their businesses stand out from their competitors.
Businesses acquire assets from other entities. What must be part of the thinking process is how entities will provide assets. That answer is determined by whether assets should be acquired from creditors or stockholders.
Businesses acquire assets from creditors in the form of liabilities. A balance sheet organizes liabilities, like assets, by time: current and long-term. Current liabilities are obligations that will be settled within one year while long-term liabilities are obligations that will be settled in a time period greater than one year.
Examples of current liabilities are
- Accounts Payable
- Accrued Expenses
- Salaries and Wages Payable
The thinking process of how to accumulate wealth from current liabilities is similar to thinking about how to accumulate wealth from current assets in that time is the priority. Creditors will not wait forever for their obligations to be settled. As a result, businesses must think about how fast they can settle their current liabilities.
One of my favorite stories is the story of W.T. Grant. The management of W.T. Grant developed a growth strategy that included the creation of accounts receivable by relaxing credit standards. The relaxing of credit standards increased accounts receivable however the increase created a cash flow problem. The cash flow problem was addressed by delaying payments to suppliers. Suppliers responded by stopping shipments of merchandise. This stoppage caused a chain reaction which led to the company’s bankruptcy in 1976 which at that time was the largest corporate bankruptcy in United States history. So when people think about how to accumulate wealth from current liabilities they must think about how to settle these obligations as fast as possible from the quality of assets, i.e. the ability of assets to generate cash inflows as fast as possible.
The most common examples of long-term liabilities are bonds payable and notes payable.
When thinking about how to accumulate wealth from long-term liabilities the process must incorporate flexibility. Businesses must be flexible in their delivery of products, provision of services, and types of assets acquired. Being flexible with these elements creates the ability to exist for an extended period of time. One way to enhance flexibility is to have goals that err in being too broad instead of being too narrow. Goals that err in being too broad provide an opportunity for experimentation that may lead to failures but may lead to successes.
A balance sheet organizes stockholders’ equity into two components: contributed capital and retained earnings. Contributed capital represents what businesses receives from stockholders while retained represents what stockholders receive from businesses. How businesses should enhance their thinking processes on how to accumulate wealth from stockholders’ equity is a rule I learned from an angel investor:
“I don’t care what your idea is, I want to know how I’m going to make money.”
A balance sheet is used to assess the liquidity and solvency of businesses. These assessments are critical for businesses to inspire confidence from their stakeholders. In order to inspire confidence people inside businesses must think about how elements in a balance can accumulate wealth.