Were you aware that the financial position of any business is determined by three key financial statements? These are the balance sheet, the profit and loss account, and finally the cash flow statement.
In today’s resource the main focus out of the three key financial statements; is the balance sheet.
The balance sheet, which can be known as a statement of financial position, is a snapshot which summarises the value of the business (the assets of the business less its liabilities) at a specific point in time.
Any limited company has to prepare a balance sheet as part of the annual accounts they submit to Companies House. A balance sheet can be done at any time.
To dive deeper into what a Balance Sheet is read on. This resource will cover key definitions alongside the main features of a Balance Sheet.
What does a Balance Sheet show?
A Balance Sheet helps to indicate whether a business is solvent (meaning that it can meet financial obligations) and if the business is able to trade on a continuing basis.
Other factors that can be seen through the balance sheet include:
- How the business is financed.
- How much capital is employed in the business.
- How quickly the assets of the business can be turned into cash.
Further, the balance sheet shows all the assets of a business (anything owned by the business or owed to the business) less its liabilities (all the money owed by the business to its creditors).
Remember, the resulting ‘net asset value’ will always be equal to the sum of the capital and reserves of the business, including any investments in the business as well as the net profit the business has accumulated from its trading activities.
Important factors to remember:
- The profitability of a business isn’t determined by a balance sheet. This can be seen in the profit and loss accounts.
- A balance sheet doesn’t represent the true value of the assets of a business. However, still include the value of any assets listed on the balance sheet. The true value may be more or less than what is stated on the balance sheet.
- The real market value of a business is not shown on the balance sheet.
The balance sheet is different from the profit and loss statement but can complement each other. It is critical to understand the financial strength of the business.
It can be confusing as a business could produce healthy profits but still be regarded as vulnerable if it has a weak balance sheet due to its low net asset value. Indifference, a business can potentially sustain a period of poor profitability when it has a strong balance sheet, due to its high net asset value.
A fixed asset is typically an asset that cannot be turned into cash quickly. Also, a fixed asset usually has a useful life of more than a year.
Can they be ‘tangible’? The answer is yes. A fixed asset is ‘tangible’, an example of this would be a property or equipment. Secondly, fixed assets can be ‘intangible’, these are intellectual property or goodwill.
The cost of tangible assets, like equipment, is depreciated over their expected useful life. This allows for the loss in value in those assets overtime and it is this depreciated value (the net book value) that is shown in the balance sheet. In the above example, the net book value of tangible fixed assets is £140,000.
If a business is developing a new product and a large amount of money is spent on it, this expenditure can then be capitalised (turned into an asset) and then shown on a balance sheet as an ‘intangible asset’.
A current asset is an asset that can be turned into cash within one year.
These assets surely include:
Stock and work in progress: Stock is typically valued at cost rather than its market value. Old stock may be written down as its ‘net realisable value’; that is, the price that it might attract if sold. Work in progress is the value of raw materials and components that are in the production process but are not yet finished goods.
Trade debtors: The value of trade debtors is the amount of money owed to a business by its customers. This does include Value Added Tax (VAT) if a business is registered for VAT and charges VAT on its invoices.
Cash at bank: Simply, this is the money deposited into the bank accounts on the date the balance sheet was created. The amount may be adjusted for any cheques that have been issued to pay suppliers but are still waiting to be cashed.
In the example provided above, the value of the current assets is £35,000.
This is the total amount that is owed by the business that is due to be repaid within a year; this includes:
Trade creditors: Total amount of money owed to suppliers. VAT will be included if the business is registered and has charged VAT to the customer.
Other creditors: Total amount of money owed for taxes including VAT, PAYE (pay as you earn), and corporation tax liabilities. Others could be provisions for costs that the business has incurred for products or services that haven’t yet been invoiced by suppliers.
Loans: The value of any loan or hire purchase repayments that’s due to be repaid within the next 12 months. Can include any overdraft balance, if the business has one. This figure is likely to be only a portion of the total loan or hire purchase repayments that are outstanding at the balance sheet date. Any repayments that are due after 12 months are included in the balance sheet as long-term liabilities.
In the example provided above, the value of the current liabilities is £32,000.
Net current assets
Simply, net current assets are the difference between current assets and current liabilities.
The example above shows net current assets are £3,000. A positive net current asset figure tells you that a business is able to meet its current cash needs. A negative net current asset figure tells you that a business may not be able to meet its debts as they fall due. If this is the case, the business may be insolvent.
Long-term liabilities include the balance of any bank loans and hire purchase payments that fall due later than 12 months after the balance sheet date. In the example balance sheet, long-term liabilities are £100,000.
The net asset value of a business is the total assets (both tangible and intangible) less the total liabilities (both current and long-term). In the example above, the balance sheet’s net assets are £43,000.
The net worth of a business is the sum of any capital and reserves.
- Capital is any money invested by the business owner or shareholders.
- Reserves are the retained profits of the business.
The capital and reserves are sometimes known as the ‘equity’ in the business. In the example, the total net worth of the business is £43,000.
Do remember that reserves are not the same as cash: they simply show where the money in the business has come from. A business should seek to build up its reserves (profit) as this is the best source of working capital.
The net worth of a business will always be equal to the net assets, and therefore the balance sheet will ‘balance’.
In the example balance sheet, the total net assets of £43,000 balance with the total net worth of £43,000.
If you have any queries about balance sheets or feel like you need a 121 with one of our business advisors contact us now!