Balance Sheet


Balance Sheet

A balance sheet is a financial 'snapshot' that summarizes the value (assets less liabilities) of your business at a specific point in time, usually the end of the financial year. All businesses have to prepare a balance sheet as part of their annual accounts, but one can be prepared at any time.

The financial position of any business can be determined from three financial statements: the profit and loss account, the balance sheet, and the cash flow statement.

The balance sheet shows assets owned by the company, the liabilities it owes to others and accumulated investments of the owner or owners. The balance sheet shows these figures on a specific date. In simple terms it shows where everything is.

The balance sheet is a fundamental accounting report and forms the basis for many other reports. The following are some important considerations when examining your balance sheet:

  • The basic balance sheet formula is Assets= Liabilities+ Equity (owners) By definition the equation must balance. If the equation does not balance then an error has been made.

  • Assets are company resources. These include cash, inventory, accounts receivable, equipment, buildings, etc.

  • Liabilities are obligations the company must pay. These include accounts payable, bank debt, prepayment by customers, taxes and wages owed.

  • Equity is retained earnings, investment by owners and stock.

  • The standard of measure is the dollar. This means the balance sheet cannot place actual value on potential, good will or other intangibles.

  • The General Ledger is a system for tracking all of a business' transactions. General Ledger involves a system of credits and debits. This concept is a little hard to understand -- have your accountant or bookkeeper explain it to you.

  • Liquidity is an important aspect of the balance sheet. Liquidity means being able to convert something to cash in a short period of time. Liquidity is important from a cash flow standpoint since it shows if you can pay your bills. Liquidity problems have bankrupted many promising businesses. Liquidity is especially important for loans.

  • Working Capital is another useful part of the balance sheet. Working capital is simply the assets and liabilities that a company works with on a daily basis. This statement gives an indication of a company's solvency or 'what shape are we in right now.'

The balance sheet and the income statement are the primary accounting reports that any business needs. Try to get each report from your accountant or bookkeeper. Ask your accountant to explain the meanings of each set of figures. Remember that a balance sheet is a snapshot of what a company's resources and liabilities are over a specific time.







Reviewing Your Balance Sheet

The balance sheet is an excellent method for viewing your business' success.

A balance sheet is a good indicator of whether or not your business is solvent and able to trade on an ongoing basis.

It shows how your business is financed, how much capital is employed in the business and how quickly assets can be turned into cash.

A balance sheet shows all the assets of your business (anything owned by or owed to it), less its liabilities (all the money owed by you to your creditors). The resulting net asset value will always be equal to the capital and reserves of the business, plus the net profit that your business has accumulated from its trading activities. While the net asset value and the capital and reserves must 'balance', a balance sheet gets its name from the fact that it is a summary of all the balances of the individual accounts in a double-entry bookkeeping system.

It is important to remember that a balance sheet:

  • Does not show the profitability of your business. This is demonstrated by the profit and loss account. If you have balance sheets from two consecutive years, you may be able to calculate the level of profit a business has achieved by comparing the change in value of the profit and loss reserve. This can, however, understate the profit achieved if a business pays dividends.

  • Does not reflect the true market value of your assets, which may be more or less than the figures given on the balance sheet.

  • Does not show the market value of your business. This depends on profitability and the current values (as opposed to costs) of assets.

A balance sheet is different, but complementary, to the profit and loss statement produced in your annual accounts, and is critical to understanding the financial strength of your business. The balance sheet can show a very different perspective of your financial position from the profit and loss account in the short term. For example, you can be making good profits, but can be regarded as having a weak balance sheet, and hence as being potentially financially vulnerable, because of your low net asset value. Conversely, you can sustain a period of poor profitability when you have a strong balance sheet, as shown by a high net asset value.




Equity = Assets - Liabilities

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Balance Sheet - Key Terms

Fixed assets

Fixed assets are generally assets with a life longer than one year, such as equipment, buildings and motor vehicles. They are also known as tangible assets, because they physically exist. The cost of tangible fixed assets such as equipment is depreciated over the expected lifetimes of those assets. This accounts for the loss in value of those assets over time, and it is this depreciated value (net book value) that appears in the balance sheet.

Sometimes a balance sheet will show the acquisition value and the accumulated depreciation; sometimes it will show the net book value. In published accounts, there will be a note explaining how the depreciation has been calculated.

There is also a class of fixed assets known as intangible assets. Goodwill, for example, is an intangible asset. If a business is bought for more than its net worth, the difference is shown on the balance sheet as goodwill. Since the buyer can never be sure of recouping goodwill, it is good practice to write off (amortize) goodwill over an agreed period.

Current assets and current liabilities

  • Current assets and current liabilities usually have a life of less than one year. Current assets include stock, work in progress, debtors and cash at bank.

  • Trade debtors represent the amount of money owed to you by customers.

  • Current liabilities include overdrafts, loans due within one year, money owed under hire purchase agreements due within one year, any amounts owed in VAT or tax and PAYE.

  • Trade creditors represent the amount of money owed by you to suppliers.

Net current assets are simply the difference between current assets and current liabilities. This figure should be positive. A negative net current asset figure indicates that your business may not be able to meet its debts as they fall due. If this is the case, your business may be insolvent.

Deferred liabilities

Creditors falling due after more than one year are deducted to give the net assets. This will include the element of any bank loans and hire-purchase payments that are due to be repaid in more than one year's time.

Net assets

Deducting the figure for deferred liabilities from the net current assets gives the figure for the net asset value of your business.

Net worth

Your capital and the reserves together comprise the net worth of your business, which is equal to the net assets. Your capital is simply the money introduced by you (and your shareholders, if a company) and the reserves, which are normally the retained profits of the business. The capital and reserves are sometimes known as the 'equity' of the business.

Some accountants include long-term loans with the capital and reserves, though most financiers will include such loans as debt finance when they calculate the gearing (borrowings). The term 'equity' is not used if long-term (or any other) borrowings are included.

Capital employed

The total capital employed by your business is the net worth (the money introduced into the business by you and your shareholders, together with the accumulated profit retained within the business), as well as any debt finance used by the business. Some people argue that this should only be long-term finance, but for businesses that are heavily reliant on short-term finance, all loan finance should be included.

It should be remembered that reserves are not the same as cash. Reserves simply show from where the money has come. You have to look at the top part of the balance sheet to see how it has been used. Businesses should seek to build up the reserves, as this is the best source of working capital.

  • An accountant or business adviser can assist in the preparation of balance sheets.

  • All of the information required to write a basic balance sheet can be obtained from a trial balance, which is a summary of your business' accounting books and records.

  • Balance sheets can be compared over time - for example, current year against previous year - to identify changes in your business' financial strength.

Reading Your Balance Sheet

Being able to read and understand a balance sheet can be immensely helpful, not only in exercising effective financial control in your business, but also in assessing the standing of other businesses.

A balance sheet is a financial 'snapshot' which summarises the value (assets less liabilities) of a business at a specific point in time. All businesses have to prepare a balance sheet as part of their annual accounts, but a balance sheet can be prepared at any time.

The balance sheet shows:

  • How solvent the business is.

  • How the business is financed.

  • How much capital is employed in the business

  • How quickly assets can be turned into cash.

A balance sheet is made up of the assets of a business (anything owned by or owed to it) less its liabilities (all money owed by the business to its creditors). This resulting net asset value will then balance with (equal in value) the capital and reserves of the business plus the net profit accumulated by the business.

It is also important to remember what a balance sheet is not:

  • It does not show the profitability of a business; this is demonstrated in the profit and loss account.

  • It does not necessarily reflect the true market value of assets, which may be more or less than the figures given on the balance sheet.

  • It does not show the market value of a business; this depends on profitability and the current values (as opposed to costs) of assets.

A balance sheet is different, but complimentary to the profit and loss statement produced in the annual accounts, and is important to understanding the financial strength of the business. The balance sheet can show a very different perspective of the financial position of a business than the profit and loss account in the short term. For example, a business can be making good profits, but can be regarded as having a weak balance sheet, and hence potentially being financially vulnerable, because of its low net asset value. Conversely a business can sustain a period of poor profitability when it has a strong balance sheet, as shown by a high net asset value.

Fixed assets are generally assets with a life longer than one year, such as equipment, buildings and motor vehicles. These are also known as tangible assets because they physically exist. The cost of tangible fixed assets such as equipment is also depreciated over the expected lives of those assets. This accounts for the loss in value of those assets over time and it is this depreciated value (net book value) that appears in the balance sheet.

There is also a class of fixed assets known as intangible assets. Goodwill, for example, is an intangible asset. If a business is bought for more than its net worth, the difference is shown on the balance sheet as goodwill. This is a representation of the expectation of future earning power. Since the buyer can never be sure of recouping goodwill if they wish to sell, it is good practice to write off (amortise) goodwill as quickly as possible.

Current Assets and Current Liabilities

Current assets and current liabilities usually have a life of less than one year.

  • Current assets include stock, work in progress, debtors, cash at bank, etc.

  • Trade debtors represent the amount of money owed to the business by customers.

  • Current liabilities include overdrafts, loans due within one year, money owed under hire purchase agreements due within one year, any amounts owed in VAT or tax, etc.

  • Trade creditors represent the amount of money owed by the business to suppliers.

  • Net current assets are simply the difference between current assets and current liabilities. This should be positive; otherwise the business may not be able to meet its debts as they fall due. If so, then the business may be insolvent.






Net Assets

Creditors falling due after more than one year deducted to give the net assets. This will probably only include bank loans and HP payments due in more than 12 months, that is the proportion due after 12 months as opposed to the whole loan. Deducting this figure from the net current assets gives the net assets of the business.

Capital Employed

Some accountants include long term loans with the capital and reserves. Adding the two together gives the capital employed.

The financial position of any business can be determined from three financial statements: the profit and loss account, the balance sheet, and the cash flow statement.

A balance sheet is a financial 'snapshot' that summarises the value (assets less liabilities) of your business at a specific point in time, usually the end of the financial year. All businesses have to prepare a balance sheet as part of their annual accounts, but one can be prepared at any time.

A balance sheet is a good indicator of whether or not your business is solvent and able to trade on an ongoing basis.

It shows how your business is financed, how much capital is employed in the business and how quickly assets can be turned into cash.

A balance sheet shows all the assets of your business (anything owned by or owed to it), less its liabilities (all the money owed by you to your creditors). The resulting net asset value will always be equal to the capital and reserves of the business, plus the net profit that your business has accumulated from its trading activities. While the net asset value and the capital and reserves must 'balance', a balance sheet gets its name from the fact that it is a summary of all the balances of the individual accounts in a double-entry bookkeeping system.

It is important to remember that a balance sheet:

  • Does not show the profitability of your business. This is demonstrated by the profit and loss account. If you have balance sheets from two consecutive years, you may be able to calculate the level of profit a business has achieved by comparing the change in value of the profit and loss reserve. This can, however, understate the profit achieved if a business pays dividends.

  • Does not reflect the true market value of your assets, which may be more or less than the figures given on the balance sheet.

  • Does not show the market value of your business. This depends on profitability and the current values (as opposed to costs) of assets.






Using Your Balance Sheet

Using balance sheet assets (such as accounts receivable, short-term investments or inventory) to obtain a loan or borrow money - the borrower provides a security interest in the assets to the lender. This differs from traditional financing methods, such as issuing debt or equity securities, as the company simply pledges some of its assets in exchange for a quick cash loan.

A report should start with a description of the company in order to help investors understand the business, its industry, its motivation and any edge it might have over its competitors. These factors can prove invaluable in helping to explain why a company might be a profitable investment or not. A firm’s annual report, 10-K filing or quarterly 10-Q with the Securities & Exchange Commission provide ideal starting points; it is surprising how rare it is for industry experts to refer to original company filings for important details. More valuable detail can be obtained from industry trade journals, reports from key rivals and other analyst reports.

Specifically, the factors include the threat for new entrants to enter the market, the threat for substitute products or services, the extent to which suppliers are able to influence the company and the intensity of rivalry among existing competitors.

In the most common usage, the terms "asset-based lending" and "asset financing" refer to the same thing. Asset-based lending generally refers to a business using its assets as collateral for a loan. If the loan is not repaid and falls into default, the lender may seize and sell the collateral to pay off the loan amount.

Asset financing differs slightly from the common understanding of collateralized loans. Normally, when an individual borrows money to purchase a home or car, the house or the vehicle serves as collateral. Other assets, which may have been used for loan qualification purposes, typically are not considered direct collateral for the loan.

Businesses, however, often borrow against currently owned assets, such as machinery, accounts receivable (AR) and inventory. The money received from these loans against collateral often is used to fund short-term needs like employee payroll and raw materials purchases.







Balance Sheet - Back To Basics

The basic equation of accounting is reflected in the balance sheet.

Assets = Liabilities + equity

If you look at a balance sheet, you'll note that the total assets always equals the total of liabilities and equity. This reflects what the company owns (assets) and how what it owns came about, through the funding given it by liabilities (borrowings) and equity.
Layout

The balance sheet is either laid out in a side-to-side manner, with the assets on the left and liabilities and equity on the right, or in a vertical manner, with assets listed first, then liabilities, then assets.

Assets are listed in order of liquidity, starting with current assets (those which can be converted into cash within one full reporting cycle, usually one year) and starting those with cash, the most liquid of assets. As one moves down through the list, one comes across less liquid assets, such as:

accounts receivable which must be collected from customers before they are cash, and
inventory which must be converted into goods and / or sold before they become cash.

Long lived assets include plant, property, & equipment (usually net of accumulated depreciation), goodwill, long-term investments, etc.

Liabilities are listed in order of when they come due, starting with those due within an accounting period (usually one year), such as accounts payable and the portion of long term debt due within that period. Long term liabilities include borrowings from banks, bonds issued,

Finally, shareholder equity, is given. This includes:

  • retained earnings (earnings not paid out as dividends or used to repurchase shares),

  • stock at par value (the stated value of stock, such as $0.02 per share),

  • additional paid in capital (what was paid to the company for its shares in excess of par value), and

  • treasury stock (stock repurchased by the company on the open market, a negative number).

A strong Business Plan may not guarantee success; but it could certainly prevent failure!




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