222 CHAPTER 10 FUNDING THE BUSINESS
Balance sheets and cash flow mechanics
Creating balance sheets and cash flow is very simple. In practice, you will probably work
methodically through the figures that you have produced so far – sales, capital spend-
ing, profit and loss – and create the cash flow and balance sheet from them as you go. An
alternative is to work in the other direction. To aid your understanding, we will do both.
First, consider how you create balance sheet and cash flow projections from the capi-
tal outlays and current expenditure forecasts already in your possession. There is a short
cut, but for the moment, imagine that you are going to work through your expenditure
forecast line by line. It is useful to see how the balance sheet and cash flow forecasts
shape up when you follow this long route.
You will note that spending is always financed in one of three ways.
1 You pay cash – the way that you handle this is illustrated opposite.
2 You accrue the expenditure (or take credit on an account payable) and pay it later
– see page 224.
3 You prepay the expenditure and expense it (charge it to expenses) later – see
page 225.
The fast track to funding
1 As an aid to your understanding, start by looking at the long way of creating
a balance sheet and cash flow projection from your capital and profit and
loss accounts. Please do not skip this groundwork unless you are already
familiar with the techniques.
2 Now to work. Copy spending on fixed assets and depreciation into the
balance sheet and cash flow projections.
3 Work through the profit and loss account, matching any non-cash entries
(prepayments, accruals, receivables and payables) into the balance sheet and
cash flow projections.
4 Enter a cash surplus as cash at bank, or a deficit as bank borrowing or capital.
5 Value the business on the basis of the future stream of income that you have
forecast.
6 Decide how to fund and cash deficit.
7 Decide if the figures are acceptable – otherwise return to revise your strategy
and operating plan.
BALANCE SHEETS AND CASH FLOW MECHANICS 223
You can allocate all your current spending to the balance sheet and cash flow state-
ments using the three techniques illustrated on pages 223–227. When you buy inventory
on credit, the entries work in the same way as an accrual, showing on the liabilities side
of the balance sheet in accounts payable instead of accruals. Accounts receivable – money
owed to you by customers – work in reverse on the asset side of the balance sheet.
Accounting for capital outlays is similar and is described on page 226. In the same way
that your balance sheet shows the total of fixed assets at a given date, so it shows the
end-period total for inventory lifted straight from your sales spreadsheet (Chapter 8).
Make sure that you understand the logic of the following procedures. But before you
rush off and use them to produce balance sheet and cash flow projections, check out the
short cuts discussed on page 227.
‘Business is many things, the least of which is the balance sheet.’
HAROLD GENEEN
Balance sheet and cash flow (1) – from cash outlays
Suppose that you projected the following spending on salaries:
Expenditure account, whole month Jun Jul Aug Sep
Salaries 12,000 12,000 12,000 12,000
Salaries are normally paid in cash. Assume that this is the case here. There is a
direct cash flow implication, but (for our current discussion) no balance sheet
effect – see footnote. The matching entry created to balance the expense account
charge is as follows:
Jun Jul Aug Sep
Balance sheet, end month
No corresponding entries yet ... ... ...
Expenditure account, whole month
Salaries 12,000 12,000 12,000 12,000
Cash flow, whole month
Salaries –12,000 –12,000 –12,000 –12,000
Note: Experienced bean counters will have spotted that the cash flow is actually
also the balance sheet effect. In other words, the total cash flow will later be
reflected in the balance sheet as borrowing or as surplus cash balances.
224 CHAPTER 10 FUNDING THE BUSINESS
Balance sheet and cash flow (2) – from accruals
Moving on from the previous example, suppose that you had agreed to pay
each December an annual staff bonus equivalent to one month’s salary. Strictly
speaking, you should show one-twelfth of the bonus as an accrued expense each
month, as follows (just three months are shown):
Expenditure account, whole month ... Oct Nov Dec
Employee bonuses ... 1,000 1,000 1,000
Now put the cash flow effects around this:
1 Starting with the January figures, record a matching $1000 accrual each month
(I have only shown three months here because of space constraints).
2 By November, the accruals have reached $11,000.
3 In December, the $11,000 balance on accruals plus the $1000 expenditure
charge for the month equals the $12,000 in bonuses that have to be paid from
cash (charge $12,000 to cash flow).
This is illustrated below. The plus and minus signs might appear confusing at first
glance, until you recall from Chapter 7 that an increase in liabilities is normally
a credit entry so the sign moves the opposite way to everything else. That’s
accountancy for you. The change in the balance sheet (the flow) is added to help
clarify what is going on. The first line of figures shows end-month balances (hence
balance sheet), all the other figures are monthly flows.
Balance sheet, end month Dec Oct Nov Dec
Liabilities: accrued bonuses 9,000 10,000 11,000 0
Memo: change in month ... +1000 +1000 –11,000
Expenditure account, whole month
Employee bonuses ... 1000 1000 1000
Cash flow, whole month
Employee bonuses 0 0 0 –12,000
But that would be misleading …
Balance sheets show balances on a specific date. Remember that the bank balance,
or inventory, or any other figure, might have been very different just a few hours
before the balance was struck. Excuse me for being cynical, but I wonder if anyone
ever massages balances on purpose?
t
BALANCE SHEETS AND CASH FLOW MECHANICS 225
Balance sheet and cash flow (3) – from prepayments
Now take a look at an expenditure that is prepaid. For simplicity, use the example
shown in Chapter 7 (see page 148). This is a situation in which:
your office rent is $1000 a month;
in June you pay the $3000 advance for the calendar months of July, August
and September.
For this case, when you prepared your spending forecast you would have recorded
the following entries under operating expenditure:
Expenditure, whole month Jul Aug Sep
Office rental payments 1,000 1,000 1,000
You can put the cash flow effects around this as follows.
1 Starting with cash flow, record the $3000 outflow in June. To be true to double
entry accounting procedures, you have to add a corresponding $3000 to the
balance-sheet asset-account called prepaid rents.
2 Then you should deduct $1000 from prepaid rents in each of July, August and
September to reflect the matching charge to the expenditure account office
rents paid.
This is illustrated below, with boxes around the matching entries. The change in
the balance sheet (the flow) is added to help clarify what is going on. The first line
of figures shows end-month balances (hence balance sheet), all the other figures
are monthly flows.
May Jun Jul Aug Sep
Balance sheet, end month
Assets: prepaid rents 0 3000 2000 1000 0
Memo: change in month ... +3000 1000 1000 –1000
Expenditure account, whole month
Office rental payments ... 1000 1000 1000
Cash flow, whole month
Office rental payments –3000 ... ... ...
Start
226 CHAPTER 10 FUNDING THE BUSINESS
Balance sheet and cash flow (4) – from capital outlays
The example shows how you allocate capital outlays to the balance sheet and cash
flow projections. Returning to the example in Chapter 9 (see page 198):
1 In October you acquire a clumping machine for $120,000.
2 It has an expected life of five years (60 months).
3 You are using the straight-line depreciation method.
4 Depreciation is therefore $2000 a month for 60 months.
For these transactions, your capital expenditure projections for this year are as
follows:
Sep Oct Nov Dec
Capital outlays, whole month
Acquisitions – machinery 0 120,000 0 0
Depreciation schedule, whole month
Machinery 0 2000 2000
This is the one instance where I have made you duplicate a little effort. The
expenditure forecasts that you created form part of the profit and loss account. But
the capital outlay account and depreciation schedule can be thought of as extracts
from the balance sheet – the same information twice. I did it this way because
capital outlays are regarded with special interest and you need this extract to wave
around in the boardroom or in your bank manager’s office.
The easiest approach is to copy the capital outlays and depreciation schedule to
the balance sheet (remember that these are changes or flows and the balance sheet
shows end-month balances). You then create the matching entries. Depreciation is
matched in the expenditure account (remember that you already put it here when
you produced your expenditure forecast). The acquisition is matched in the cash
flow account. This is how:
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