With year-end fast approaching, now is good time to take a critical look at your balance sheet. Sometimes balance sheet items that make perfect sense to a company’s owners and management trigger large concerns with bankers and suppliers. Does your balance sheet contain red flags? If so, get rid of them now, before December 31.
Common Red Flags
Negative Cash or Overdrafts – This is the very worst item to have on your balance sheet. Almost every creditor will look first at a company’s cash when they pick up a balance sheet. Very few understand the realities of using float for cash flow that cause paper overdrafts. To keep creditors happy, always have a fat cash balance at year-end.
Stockholder Transactions – Balance sheets that show numerous receivables, payables and loans to owners strike fear and create questions with creditors. At a minimum, these transactions trigger a request for personal financial statements and a personal guarantee.
If it is not feasible to eliminate stockholder transactions entirely, try to minimize them and keep them simple. For instance, can receivables and payables be offset and only the net amount show on the balance sheet? Can loans be consolidated into only one transaction?
If you must keep a stockholder transaction on the balance sheet, be sure it is footnoted in your CPA statement to the point where any reasonable reader of the statement could understand why the transaction was necessary.
Uncollectible Notes Receivable – If you spun off a bad account receivable into a note receivable and you are still not getting paid, write it off. Your creditors are smart enough to see that it’s not being paid down if it appears at the same amount statement after statement.
Conversely, if you have a good note with special interest-only terms, be sure to specify the terms in the footnote so creditors will not think the note is uncollectible.
Excessive Intangible Assets – Some business owners get very creative with what they consider an asset. Typical abuses include dealer contracts and other blue sky or goodwill type accounts. Most smart creditors will discount your intangible assets when analyzing your net worth. Nebulous assets may not be worth the bother of putting them on the balance sheet.
No Allowance Account in Accounts Receivable Coupled with Substantial Bad Debt History – To a creditor, there is serious question as to whether accounts receivable are “good” accounts and can be counted on to turn to cash. Almost every family business with receivables should have an allowance account unless you’ve had less than $5,000 bad debt per year in the last three years.
Inflated Fixed Asset Values – Fixed assets should always appear at book value on the balance sheet. If your assets are worth far more than book value, show the market value in the footnotes. Also, software, equipment repairs and assets purchased from affiliated companies at inflated values that get included in fixed assets are all viewed disapprovingly by creditors.
Unexplained Changes in Net Worth – Last year’s retained earnings plus this year’s profits (minus any dividends) should equal this year’s retained earnings. Any significant differences (particularly negative amounts where it looks like cash is disappearing) need to be explained in your footnotes.
Inaccurate Debt Presentations – Bankers in particular will pay close attention to all debts. The current portion of debt (which is the amount of principal to be paid in the next 12 months) should be listed in the current section of liabilities. If instead, the entire debt is listed as long term debt, it appears a deliberate and dishonest way to inflate the current ratio.
Lines of credit for working capital and equipment purchases with maturity dates less than 12 months in the future should also be listed in short-term debt.
Inaccurate Lease Presentations – The only lease that should show on your balance sheet as an asset is a capital lease where you will own the asset at the end of the term. As with a loan, the current portion of the lease (amounts due during the next 12 months) should be shown separately in current liabilities with the remainder in long-term liabilities.
Large Miscellaneous Accrued Expenses- Although maximizing accruals is an excellent temporary way to increase cash flow, particularly large unitemized amounts may be suspect. The solution to a large amount of accrued expenses is to break them out by the type of expense. For instance, segregate interest accrued from wages accrued from rents accrued, etc.
Excessively Large Prepaid Expenses – Prepaid expenses have a double negative impact. First, it appears that management is uneducated about good cash flow management (prepaying expenses keeps you from earning interest income on that cash). Second, the reader of your balance sheet may decide the reason your company needs to prepay is because creditors think the company a poor credit risk and are requiring advance payment. Neither assumption bodes very well in your favor.
If you have an unusual situation that has forced you to make prepayments, you may want to itemize the larger amounts separately. For instance, 75% of your prepaid expenses may be income taxes. If so, list “Prepaid Income Tax Expense” and then “Other Prepaid Expenses.”
To summarize, spending a few minutes “cleaning up” your company’s balance sheet before month-end could pay large dividends in the coming year – dividends such as larger lines of credit and lower interest rates!
