Balance Sheets
Now that we’ve talked a bit about break even, I’d like to talk about cash flow, especially your first cash flow model, which will tell you how much money you need to start your venture. But to do that, we need to discuss your balance sheet and have an understanding about assets, liabilities, and equity. Some of these are easy, and some are less clear, and even within their general groups, some sub-categories can be swapped back and forth.
For assets, generally think of these as good things. This is cash in your bank account. But it is also your merchandise on hand. It can be tools of your trade that you can sell. If you own your own building, that, too, is an asset. Does someone owe you money? That is an account receivable and is an asset. All pretty straightforward, right?
Now let’s get a little more interesting. How about a delivery truck? Asset? Sure, it’s a tangible asset that the business owns. But a delivery truck will also wear out, so someday you’re going to have to replace it, so it is a depreciating asset, meaning it is worth less each year.
What if you see a good deal on web hosting, a deal where you buy several years of service all at once? The years or time in the future that you are not using, those prepaid services are also an asset. These are called prepaid assets.
In fact, things like brands and patents can also be assets. If I have a patent that makes my widget special, something no one can copy because I have a patent on it, then if I needed to, I could sell or license that patent to others. A brand is similar though very much more an estimate. If people are willing to pay more for a product because it is part of your brand, that can be counted as an asset. This one gets really gray real fast so I won’t harbor on it now, but I wanted to highlight some things that people don’t usually think about when listing assets.
What about liabilities? Well, everything that is opposite of the above items. Cash is an asset, loans you owe are liabilities. People owing you money is an asset, but you owing other people is a liability. If you don’t own your property and have a lease, that lease is a liability. Leasing a truck instead of buying one, again, you guessed it, a liability.
If you sum up all of your assets, you have the total assets of the company. Sum up all the liabilities, and you have total liabilities. Equity is the difference between these numbers. For a successful business, you want the total assets to be larger than the total liabilities. If you have assets of $10,000 and liabilities of $9000, you have an equity of $1000. The idea is, if you could instantly liquidate all of your assets, then pay all your bills, you should end up with $1000 in your pocket.
In some industries, some of these may be counterintuitive. Think, for instance, a bank. People deposit their money in the bank, that’s great right, that money is an asset, we all know cash is a liability, right? Not so fast. Every penny deposited is owned by someone, and they can ask for it back, so every penny they have in-house from a deposit has an offsetting liability. So if all a bank did were take in deposits, their equity would always be zero. They’d have cash in a vault, but they owe the depositors the exact same amount. We can delve deeper into how banks actually make money later if there is interest.
But let’s get back to assets. Not all assets are the same. Some are long-term, and some are short-term. When thinking about if an asset is long or short-term, we are thinking about how long we’ll use that asset. So a building should be around for years, whereas cash we need to run our day-to-day needs. The rule of thumb is about a year. So anything you plan to use to take care of things within this coming year is a short-term asset. Did you prepay for a year of web hosting? Then you have 12 months of web hosting on your books as an asset. The aforementioned truck we plan to use over the next five years is a long-term asset.
The other idea we need to understand about assets is how long it takes to divest. Remember when we thought about liquidating all of our assets to pay all of our bills in the equity conversation? It’s often not that easy though. It takes a lot longer to sell a building than it takes to withdraw cash. So being too heavy in either category can be an issue in most industries.
To make things even less straightforward, some can fall into both categories. If you have given loans or leased space to someone over multiple years, the part that is due this year is a short-term asset, and the latter part can be viewed as a long-term asset.
Liabilities are the same idea. Long-term liabilities are things like leases that last multiple years. Short-term liabilities include an invoice that is due in 30 days.
The difference between short and long-term assets will be helpful to understand as we get to cash flow. If you have a lot of accounts payable, but they are not due for several years, your balance sheet may look great, because your assets are a lot larger than your liabilities.But if you have liabilities that come in before your long-term accounts payables are paid back, you need to make sure you have the cash on hand to pay those while you wait for your accounts payables to pay you back.
To finish this cycle, let’s say you don’t have the cash to pay the short-term liabilities while waiting for the long-term assets to return, then you take on a loan. It’s a multi-year loan, so now you have taken on a long-term liability to pay off a short-term liability, while you wait for a long-term asset. Fun, right? But that is what cash flow is all about. Do you have enough short term assets (simplified as cash because short-term asset flow doesn’t roll off the tongue) to continue to pay your liabilities while you build additional assets, usually in the form of sales?
So next week will be math-heavy. Sorry to all of you trying to avoid math, but we can’t teach how to build a cash flow without math. But I’ll use Excel and screenshots to try and make it as easy as possible for you. And as an entrepreneur, you need to learn to get comfortable being uncomfortable, and if you don’t like math, it’s better to learn this by reading my blog than when you’ve actually opened your business.
Speaking of cash flow and assets, let’s discuss tools. I love tools. For me, the math equation for the number of tools to own is X+1 = the number of tools to own where X is the current number of tools I own. But that simply doesn’t always make sense. If you are starting your own business, you may not want to spend the cash to buy a tool. Or if you are like me and love tools, even I can’t justify spending too much on a tool I may only use once or twice.
So then what are the options? Well, there are several. Let’s start with borrowing tools. Do you have friends that might have the needed tool? Try and borrow things first. It’s free or at least cheap if you take a thank you gift when you bring it back. No friends with the right tool? Try supply places. For instance, I work on cars. Most auto parts stores will let you borrow tools you might need to accomplish that.
I started my car hobby by buying most of my parts from an O’Reilly’s Auto Parts store, and they have a great “rental” policy (oreillyauto.com/store-services/rental-tools). I put the rental in quotes because you can “rent” any tool by leaving a deposit and then returning it to get your deposit back. The deposit is the price of the tool. So basically it works that you buy the tool, use it, then return it for a full refund. Thus it didn’t cost you anything, so it is more of a borrow.
If we want to relate this to the above lesson, you use a short-term asset (cash) to exchange for a long-term asset (a tool that you could theoretically use for years) and then swap them back. Your balance sheet total wouldn’t change, but your ratio of short to long-term assets would change.
And even if you aren’t working on a car, a lot of car tools can be used in other places around the house and on other things besides cars, so don’t limit yourself to just your suppliers. See who else is out there.
Next, let’s look at rentals. Many DIY shops rent tools because they want you to do the work yourself because while you’re in their store renting the tool, you’ll buy your supplies from them. So if you need things from hand tools to trench diggers, look around at local DIY places, and you’ll be amazed at what they will rent. Additionally, look at local rental places. Many of them rent to local construction companies already, so they have a lot of construction tools and will rent them to civilians as well. You might want to know how to use the equipment, as my local rental company will rent you a 1-ton roller (https://tools.cvrrental.com/equipment.asp?action=category&category=23&key=018%2D0030), but they have tons of tools and many of them as the types that you’ll use once and not need again for years, if ever. Might as well spend a little short-term assets (cash) renting it than a lot of short-term assets to own a tool that will sit around.
Finally, rent a specialist. By this, I mean hire a local tradesman to do a portion of the work. When I built my first 24 Hours of Lemons car (24hoursoflemons.com), we could have hired a car prep company to convert our 1984 Acura Integra into a Lemons legal car, but we wanted to learn; plus it would have been really expensive. That being said, Lemons cars need very specific cages. We found a place called Roll Cage Components (rollcagecomponents.com) that made the pieces for a cage and we bought the kit. But we didn’t have welding skills and Lemons is a stickler for a good cage; as well as it is obviously important for safety, so we didn’t think two guys who didn’t know what they were doing should do the welding. So we hired a local welder to weld the cage in place. The kit and the hired welder were a fraction of having a traditional cage builder build our cage from scratch.
There isn’t always one answer, find the one that works best for you and your situation.