Understanding Balance sheet with a balance sheet example

This article is about “understanding balance sheet” and includes a balance sheet example.This article is also about understanding the basics of a balance sheet.

What is a balance sheet and balance sheet definition…

A balance sheet is a financial statement included in company accounts. On this financial statement is included fixed assets, current assets, short term liabilities, long-term liabilities, provisions, capital and reserves.

A balance sheet is a set of numbers reported at a point in time, which is usually at the end of a month or at the year end. Normally, a balance sheet will consist of two columns, the current period and the preceding period, or comparative.

Why is a balance sheet important?

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.

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

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

Elements of balance sheet…

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 non-liquid assets. We all recognise converting a property into cash, i.e. selling it, may take several months. This is especially true of commercial property.

Smaller assets, like motor vehicles are a bit easier to sell and convert to cash, but it may still take some time to do so.

Current assets…

The business’s Current Assets are those assets that are more readily converted into cash and are termed “Liquid Assets“. Current assets includes cash, which is either in the bank or cash in hand.

Other current assets would include “Trade Debtors”, which is the amount owed by the businesses customers.

Stock and work in progress would also be included in current assets on the balance sheet too.

Balance sheet liabilities

Liabilities or creditors are amounts owed by the business to a third party and are normally broken down into two types. These two types are: 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 business’s suppliers or “Trade Creditors”. These are deemed short term, as these are usually paid within weeks or months, i.e. paid within 12 months of the date they are incurred.

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. Secondly capital also includes in the case of a limited company share capital. Share capital represents the amount invested into the business when it was first started.

A balance sheet example 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. If you were looking at this business with a view to buy it, you would need to get a breakdown of these fixed assets. your investigation would be to inquire about what these fixed assets were and to check the value. Are the worth the amount shown on the balance sheet.

Net current assets…

The next important figure and one that is pivotal to a business and its balance sheet is the “Net Current Assets” figure. In the above example balance sheet this 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 help defines whether or not the business is solvent or not.

Net current liabilities…

You should be worried if the current liabilities exceed the current assets – i.e. there are Net Current Liabilities on the balance sheet.

This implies that the business is in difficulty and may be suffering from cash flow problems. Should all the short-term liabilities be called in, the business would not be able to meet these with the cash reserves it has. If this were to be the case, the business may fold or be forced into liquidation.

Related: Solvency Ratio Formula – Understanding Solvency Ratios

The term “Liquidation” is referring to the converting of assets in to cash. As noted above it was discussed about either non-liquid or liquid assets and in general termed “Liquidity.” This term refers to the ease at which an asset can be turned into cash.

Low-net current assets figure…

You would also need to be concerned if the net current assets figure was 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 on a balance sheet 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).

In the above example this number is £94,000. This is equal to the total capital and reserves.

It is essential for a healthy business to have total assets exceeding its total liabilities. Normally this would 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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Related: Profit and loss formula for business owners, including taking a look at an Excel template; plus a pdf download