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.

Allstate, the US insurance giant, has brought in investment bank JPMorgan, alongside advisers Lehman Brothers, to arrange the financing for its estimated £7bn tilt at Royal Bank of Scotland’s insurance arm (RBSi).

Allstate is thought to be the front-runner in an auction for the unit, with Zurich pulling out of the running last week.

The interest of the remaining bidders, Germany’s Allianz and the American Travelers group, is thought to have cooled. Allianz’s sale of its Dresdner banking arm is thought to have scuppered its chances of making a serious offer.

However, sources close to the deal believe that Sir Fred Goodwin, chief executive of RBS, is increasingly likely to pull out of a sale, with indicative bids thought to be some way short of the asking price.

“This deal will only happen if Fred needs the extra cash to shore up the balance sheet further,” said a source.

The London-based corporate adviser Fenchurch, which counts Ian Chippendale, the former boss of RBS’s insurance division, among its number, is also part of the Allstate advisory team.

News reported by The Independent

Zurich Financial Services, one of the leading bidders for Royal Bank of Scotland’s insurance arm, has decided to pull out of the running.

RBS is seeking to sell its insurance business, including its Direct Line and Churchill brands, for £7bn.

The sale is part of a number of steps the bank is taking to strengthen its balance sheet amid the credit crunch.

Zurich said it had decided to withdraw from any further discussions following a review of the business.

An RBS spokesperson declined to comment.

RBS is looking to shore up its finances to cover losses inflicted by the credit crunch.

Last month, it raised £12bn after selling shares to existing shareholders in a rights issue.

It has also sold off the UK’s biggest train leasing firm, Angel Trains, for £3.6bn to a consortium.

News reported by BBC

Cash flow is the key to business success

The vast majority of business failures is down to bad cash flow, if not all failures for that matter!

If you want to run a good business and a successful one at that you must keep an eye on cash flow. Whilst profitability is important, profit is no good to any business unless the money you invoice to your customers is collected in full and in time!

Forget balance sheets and profit and loss accounts if you are not accounting minded, but get to grips with your business cash flow. If you lose control of your cash flow you will lose control of your business either to the bank and or the receiver/liquidator!

If anything, with most new ventures the cash flow is over optimised. It is always worth while being realistic when planning cash flow for your business.

These words are probably stating the obvious, but they are worth writng, as many a time the business owner (whether new or established) take their eye off the ball. So what was a promising venture becomes a statistic due to a lack of control over the life blood of the business – CONTROL CASH FLOW!

What can and does happen, and in particular with new businesses, is that the company over expands and the cash flow does not keep up with the businesses expansion. The new business is having to buy new stock to keep up with demand, but the customers are either not paying on time or the new business is not chasing it’s customers hard enough to pay! So although the business is showing a healthy growth and profit, there is not enough cash flow (or working capital) and the business faulters or fails!

Many a time when a business is in this situation, the business owners turn to factoring of the debt. However, be careful with this solution! Once you have factored your debtors you are into higher cash costs and it is almost like selling your sole to the devil! Don’t get me wrong factoring has it’s place and I have considered it’s use many a time, but be very careful with it and try where possible to look at how to get out of it as soon as possible.

In a start up situation the other factor that is almostly certainly under estimated is how much working capital a business needs. Working capital is the amount of cash needed to run the business and is the difference between the highest balance in your bank account and the lowest balance in your account (or if you have an overdraft facility, the highest point in your overdraft facility). To be sure your business is successful your working capital should also include a buffer over and above the above difference. The amount of this buffer is entirely up to you, but I would suggest at least 25-50% extra, if possible!

Don’t be an ostrich! Never bury your head in the sand when things are going wrong, always act right away. Make sure you have a good credit controller in your business or where possible don’t offer credit. There are many ways to get your customers to pay without letting them have credit, for example, I am a great believer in getting customers to set up a standing order or if your business is big enough a direct debit (banks will not normally allow you to set up a direct debit facility until your turnover exceeds somewhere between £2-5 million).

Some must do’s in business for good cash flow:

– Always make sure you meet your payroll, if you don’t pay your employees your business will faulter!
– Always keep your existing customers happy, don’t just focus on new business.
– Always collect your debts on time and consider reducing the credit period given to your customers to as low a period as possible or even to a zero period by introducing standing orders or direct debits.
– If your customers are not paying and bad debts are on the increase, review your customers services to see if all is well with the products or services you supply.
– Always pay your suppliers and tax bills on time- please note that the Government puts more businesses into liquidation than any other organisation! So always pay your tax on time!

Finally, make sure you plan your cash flow by producing a cash flow forecast yourself or by employing a good accountant to do it for you.

If you are a “Non-accountant” and want an easy way to produce a cash flow forecast then click this link: “Cash flow forecasts made easy”