NACFB: By the book

By the book

Unravelling the mysteries of the balance sheet

Norman Chambers Managing Director NACFB

their adventures and deductive powers never fail to capture the imagination. Perhaps the fictional detectives’ most common trope is their unparalleled ability to enter a room and zero-in on the small clues that help unravel the mystery, focusing on those details that help unpick the nuance from the noise.

When I sit down and think about what to write for each issue of Commercial Broker, I often remind myself that some of the nuanced topics I deal with on a day-to-day basis don’t make for the most compelling copy. This article then is for the newcomers, those shorter in the tooth. It seeks to provide a basic but nonetheless helpful framework through which to assess SME clients.

Given this magazine is also being distributed at this month’s Commercial Finance Expo I thought perhaps it best to have a bit of fun and seek a tonal shift. So please permit me to don a cape, tip my deerstalker, raise one eyebrow and loosely cosplay as a police detective. And what great mystery must I first seek to solve, I hear you ask? Well, there isn’t one, but let’s see what happens when we apply forensic approaches to the examination of a typical small business balance sheet. Stay with me…

A mystery unravels

Enter the humble fictional detective. We all have our favourites, from lovable TV titans Lieutenant Columbo and Jessica Fletcher, to seeing – but never fully observing – through the eyes of Sherlock Holmes; But a balance sheet needn’t be a mystery to anyone. Indeed, when partnering with small business clients any funding pathfinder worth their salt will seek to cast eyes over it, and it really should form part of the value-added proposition brokers provide. A business’ balance sheet tells the story of the enterprise and whilst it may bluff and sometimes mislead, it seldom lies.

When seeking finance, many would-be borrowers tend to focus primarily on their income statement. Rightfully so, as that is the statement that shows their operations. However, the statement they don’t pay much attention to, and sometimes don’t truly understand, is the balance sheet. As finance professionals, we know the best way to view a balance sheet is as a representation both of what your client’s business is owed, and what they owe at a single point in time. And, just like a detective’s approach to a crime, the broker must seek to build as complete a picture as possible of their client’s current financial health. The balance sheet has fingerprints all over it and should provide a crisp snapshot of a fiscal moment.

The plot thickens

To help gather all evidence we must first construct our snapshot

starting with the basics, the broad brushstrokes. A typical balance sheet will detail a company’s assets (cash, inventory, property etc.), liabilities (rent, wages, utilities, taxes, loans etc.) alongside any equity (retained earnings). The textbook formula for any balance sheet is Assets = Liabilities + Equity. This is what makes a balance sheet, well, balance.

The reality is that at least half of the items on the balance sheet are really only there for accountants, and do not matter too much in the real world. However, the other half of the items can provide us with vital pre-lending clues. There are a handful of numbers which are really useful for solution seeking. The ones to watch are the items most closely connected to cash (and indeed cash itself), such as working capital and debt.

Working capital comprises trade debtors (the amount owed to the company by clients), trade creditors (the amount owed by the company to suppliers) and stock. Once cash has been properly considered, the other important part of the balance sheet for business owners is the company's debt position and in particular the value and status of any loans provided to the business.

By providing an insight into debt and its impact on a small business, the balance sheet can provide a useful guide to the stability of their financial position. It offers that by giving you an indication of a net debt position. You can calculate that simply by subtracting cash and cash equivalents from total liabilities. If your client has more debt than cash, that’s called a ‘net debt position’. But if the balance sheet indicates they have more cash than debt, their business is described as ‘net cash’. This position isn’t necessarily something for a client to worry about, it could well be that they are borrowing or using cash to finance growth, push through an important project or increase stock to take advantage of an important market opportunity. And, because of COVID-19, debt may well have increased owing to circumstances beyond their control and not simply through poor financial management.

Just like a detective’s ability to recall details from their rolodex of past cases, the broker too can add further value through their experience with other clients. Whilst too much debt can be risky, particularly if debt levels remain high over a long period, a useful way to assess your client’s existing debt position is to compare them with debt levels from similarly sized businesses in their sector. Debt levels typically vary from sector to sector, so don’t just make simple comparisons with other comparably sized operations.

Case closed?

NACFB Members are in the business of finding theories to suit facts, not facts to suit theories. Increasingly, the data-led decisions that brokers undertake are being enhanced by even greater computerised forensic analysis, namely the myriad opportunities that lie within open banking. Although the advances of forensic science have aided the modern fictional detective, it is but a tool in their arsenal. For much like any commercial intermediary, supporting technology works best when married with the years of experience, honed intuition, and the solution-based approach of a real professional.

Conan Doyle’s great literary detective once said that: “When you have eliminated all which is impossible, then whatever remains, however improbable, must be the truth.” Whilst I may have stretched the detective analogy far enough, within this nugget of wisdom lies a truth universal to all modern finance professionals. Stripping back the noise and constructing as clear a picture as possible of a client’s viability should leave you with little mystery. Perhaps brokers don’t need the refined skills of a famous sleuth to deduce funding solutions, for the art of broking is merely the art of the possible.