Balance sheet understanding

If you run a business or if you are looking to buy a business then it is not only important to understand the Profit and Loss Statement, but also to understand the Balance Sheet. This post is about understanding the basics of a balance sheet.

So whether you are in the UK or America, which have differing ways of representing a balance sheet, it does not matter really, but what does matter is the figures on the report and what they mean.

Essentially a Balance Sheet is made up on three elements – Assets, Liabilities and the Capital and Reserves – each of which I will explain further.

Balance Sheet Assets

Assets can be broken down into two sections and on a balance sheet these are termed – Fixed Assets and Current Assets. Fixed assets tend to be long-term assets and would include such things as freehold property and long-term leases (normally a lease of over 50-years). Other fixed assets include the assets needed to run the business, like plant and machinery, vehicles and office furniture, fixtures and fittings.

Essentially, Fixed Assets are those assets that cannot be converted into cash too easily or are termed illiquid – we all recognise that to convert a property into cash may take several months and especially with commercial property. Smaller assets, like motor vehicles are a bit easier to convert to cash, but it may still take some time to do so.

Current Assets are those assets that are more readily converted into cash and are term “Liquid Assets” and of course does include cash itself, which is either in the bank or cash in hand in the petty cash tin. Other current assets include “Trade Debtors”, which is the amount owed by the businesses customers and stock.

Balance sheet liabilities

Liabilities or creditors are those amounts that are owed by the business to a third party and are normally broken down into two types – Amounts Falling Due within One Year and Amounts Falling Due After One Year.

Amounts falling due within one year or short-term liabilities would include amounts owed to the businesses suppliers or “Trade Creditors”, as these are usually paid within weeks or months or when the liability is incurred so are deemed to be short-term. Other short-term liabilities would include payroll liabilities, short-term loans, the amounts of hire purchase agreements contracts falling due within the next 12-months and so on.

Amounts falling due after one year would include, longer-term loans and the amounts due on hire purchase agreements due after one year, plus any other liabilities that do not fall due until after 12-months.

Balance sheet capital and reserves

The reserves on the balance sheet would mostly include the cumulative profit and loss that the business has made to date and the capital is represented by in the case of a limited company the share capital or the amount put into the business in the first place when it is set up.

An example balance sheet is shown below:

XYZ Company Balance Sheet as at 30 April 2009
 
£
£
Fixed Assets  
75,000
Current assets    
Debtors
25,000
 
Stock
12,000
 
Cash at bank and in hand
45,000
 
 
________
 
 
82,000
 
Creditors:    
Amounts falling due within one year
38,000
 
 
_______
 
Net current assets  
44,000
   
______
Total assets less current liabilities  
119,000
Creditors:    
Amounts falling due after more than one year  
25,000
   
_______
   
94,000
   
======
Capital and reserves    
Share capital  
100
Profit and loss account  
93,900
   
_______
Shareholders funds  
94,000
   
======

 

Understanding a balance sheet

In the above example balance sheet there are a few things to explain and understand, as follows:

This particular company has fixed assets of £75,000 and if you were looking at this business with a view to buy it you will need to get a breakdown of these fixed assets and what they are and are they in fact worth the amount shown on the balance sheet.

The next important figure and one that is pivotal to a business and its balance sheet is the “Net Current Assets” figure, which in the above example balance sheet is £44,000. This is the difference between the businesses total current assets and total short-term liabilities (or those falling due within one year) and defines whether or not the business is solvent or not.

You would need to be worried if the current liabilities exceed the current assets – i.e. Net Current Liabilities and would imply that the business is in real difficulty and should all the short-term liabilities be called in the business would not be able to meet these and might then fold or be forced into liquidation. The term “Liquidation” is referring to the converting of assets in to cash – as noted above it was discussed about either illiquid or liquid assets and in general termed “Liquidity“, which itself refers to the ease at which an asset can be turned into cash.

You would also need to be a bit concerned if the net current assets figure was very low, as this might be an indication of a business starting to get into trouble. I would suggest that in our example XYZ company has not only got a comparatively high level of net current assets in relation to the short-term liabilities, but the cash balance of £45,000 is good.

The other relationship to pay attention to is the difference between Total Assets (Fixed assets added to current assets) and Total Liabilities (liabilities dues in less than one year added to liabilities due in more than one year) and in the above example this is £94,000 and is equal to the total capital and reserves. It is essential for a healthy business to have its total assets exceeding its total liabilities, which would normally indicate a profitable business or one whereby the owners have put in sufficient capital for the business to continue through start-up.

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