A balance sheet is a statement of a firm's assets, liabilities and owners' equity at a specific date (i.e. it is a "snapshot" of the financial strength of a business at a particular moment in time).
It summarises the financial state of the business at that date. When added together, the liabilities and owners' equity represent the sources of capital (i.e. it tells us where the money came from) and the assets represent the uses of the capital (i.e. it tells us how the money was spent).
The two sides of the account must always balance, since every penny raised as capital must have been used for some purpose and must be accounted for.
A liability is the amount outstanding at the balance sheet date, which the business is under obligation to pay. Therefore, a liability is basically an item or money that the business owes to a third party.
There are two main types of classification of liabilities:
A current liability can be simply defined as amounts of money owing to third parties which will be settled within 12 months. They arise mainly through the process of day-to-day trading and there are five categories.
a) Bank overdraft.
b) Creditors (suppliers who the business has not yet paid).
c) Accruals (debts for which a bill has not yet been received).
There are several other items that appear on a Balance Sheet - most notably shareholders' funds (also called 'owners equity') and reserves.
These items show us where the business got its original capital from (i.e. the money it used to start-up), how much money the shareholders have a claim on within the business and what the business has done with any retained profits over the years.
It also shows us the effect of a rise in value (an appreciation) of any of the assets owned by the business.
In a sense, owners' equity is a liability of the business, in as much as it is a claim on the assets. However, it differs from other liabilities in that it does not have a definite date by which it is to be repaid and it is not a fixed amount.
The owners' equity is usually left in the business as long as it is required and it can fluctuate in value. Owners' equity is a residual claim on the business after all the other liabilities have been settled.
Using simple algebra, we can see that:
Assets = liabilities + owners' equity
Owners' equity = assets - liabilities
Therefore, the owners of the business own the assets of the business less what the business owes to other bodies.
Balance Sheet for 'My company PLC', as at 01/04/00
Total Current Assets
Less Current Liabilities:
Total Current Liabilities
Net Current Assets [=Working Capital]
Net Assets [=Assets Employed]
640 [200 + 250 + 190]
ASSETS EMPLOYED = CAPITAL EMPLOYED: the two parts MUST always balance.
Remember, a balance sheet shows what a company owns (assets), what it owes (liabilities) and where the company got its money (capital) from at a specific point in time.
One of the most important parts of a balance sheet is the 'net current assets' section. This is the day-to-day finance that is needed for running a business.
It is also referred to as 'working capital' and it is calculated by deducting current liabilities from current assets. Working capital is used to pay for expenses such as wages, raw materials and utility bills.
If a business does not have sufficient working capital then it can face problems when paying its short-term debts (current liabilities). It may be the case that the business suffers a liquidity crisis and has to sell off some fixed assets, for example, in order to raise the necessary cash to meet its debts.
It is vital, therefore, that close control is kept over working capital, and the business must ensure that it does all that it can to keep enough cash available to pay its current liabilities.
On the other hand, if the business has too much cash tied-up in working capital, then it can be argued that this cash is not being used productively to help the business grow and diversify into new products and markets.
The purpose of a Balance Sheet is to communicate information about the financial position of the business at a particular moment in time. It summarises information contained in the accounting records in a clear and understandable form.
It can give an indication of the financial strength of the business and can also indicate the relative liquidity of the assets.
It also gives some information on the liabilities of the business and when they will fall due. The combination of this information can assist the user in evaluating the financial position of the business.
It should be remembered, however, that the Balance Sheet is only one part of the financial statements required to give an accurate appraisal of the financial position of a business, and as such the importance of just one of these statements should not be over-emphasised.
It is only by collectively analysing the Balance Sheet, the Profit & Loss account and the Cash Flow Forecast of a business that an overall impression can be gathered on the financial strength of the business.
The lives of fixed assets are not limited to a single accounting period (i.e. to 12 months).
Depreciation represents the fall in the value of these fixed assets, either due to their use, due to time, or due to obsolescence. Essentially, depreciation divides up the historic cost of a fixed asset over the number of expected years that it will be used by the business.
The most common method of depreciation is the straight-line method -this method of depreciating a fixed asset charges an equal amount to each year of its expected useful life.
The formula for its calculation is:
The depreciation charge per year
If a new machine is purchased by a business for £100,000 and it is expected to have a useful life of 5 years, at the end of which it will be sold for a scrap value (residual value) of £10,000, then what is the depreciation charge per year?
The depreciation charge per year
This means that after 1 year, the fixed asset will have a net book value (historic cost minus depreciation) of £82,000.
After 2 years, the net book value will be £64,000.
After 3 years, it will be £46,000. After 4 years, it will be £28,000.
At the end of year 5, it will have a value of £10,000 (this is the same value as the residual or scrap value).
The depreciation charge per year will be entered in the profit and loss account of the business as an expense, since it represents that part of the cost of the fixed asset that has been used-up (i.e. expired).
Expenses are expired costs (i.e. costs from which all benefits have been extracted during an accounting period). Examples include wages, raw materials, and utility bills -often known as revenue expenditure.
It must be remembered that expenses are not necessarily the same as costs.
For example, if a business purchases a new fixed asset (such as a machine) then it will clearly incur the monetary cost of purchasing the machine (say £50,000).
However, this £50,000 will not be written-off as an expense, since the benefits from the machine will last for more than a single accounting period (i.e. for more than 12 months). Instead of writing-off the total cost of the machine, a portion of the £50,000 will be written-off as an expense each year over the useful life of the machine -this is known as a 'depreciation charge'.
The usual layout for a profit and loss account is as below:
Profit & Loss Account (01/04/99 - 31/03/00)
Cost of Sales:
Less selling expenses
Less administrative expenses
Trading [Operating] Profit
Add non-operating income
Profit before interest and tax
Less interest expense
Profit before tax [Net Profit]
Profit after tax
The first line gives the Sales Revenue for the business from selling its goods and services.
From this, we deduct the "Cost of goods sold" (costs directly associated with the production of the goods and services - such as the cost of the raw materials, the labour charges associated with the production, and the production overheads. These are sometimes referred to as direct materials, direct labour and direct overheads).
Sales revenue less C.o.G.S. is known as Gross profit.
However, we have not yet accounted for selling and administrative expenses (such as advertising costs, distribution costs, salaries, utility bills, etc.).
When these are deducted from the Gross Profit, the result is known as trading or operating profit. These refer to the profit made from normal trading activities.
The next adjustment is to add on any income from other activities, known as non-operating income (e.g. renting out premises). The resulting figure is known as profit before interest and tax.
We then deduct a figure for interest charges. The resulting figure is known as profit before tax or net profit.
The final part of the account is known as the appropriation account. It provides information on the way in which the profit is dispersed.
Some is taken in corporation tax and goes to the Inland Revenue, some is drawn from the business as dividends to be distributed to the shareholders and the remainder is retained within the business for re-investment.
This is a form of creative accounting and it basically involves manipulating various figures in the financial accounts of a business, so to flatter its financial position.
There are two key variables that a business may like its shareholders (and other stakeholders) to believe are stronger than they really are:
liquidity (the ease with which a business can raise cash quickly)
If a business is experiencing a deteriorating liquidity situation, then it can temporarily improve this figure either by selling off fixed assets, or by using a 'sale and leaseback' scheme. This involves a business selling a fixed asset (often land and buildings) to a third party, and then paying a sum of money per year to lease it back.
The business still retains the use of the asset, but no longer owns it.
The cash from the sale of the asset will improve the liquidity of the business, and it will imply to the readers of the accounts that cash is readily available. However, there are two drawbacks to this:
The 'fixed asset' figure on the balance sheet will have fallen after the sale of the land and building.
The business is not tackling the cause of the liquidity problem.
Profitability can be improved by bringing some of the revenue for the next financial year's confirmed orders into the current financial year.
This artificially boosts the 'sales revenue' figure for the current financial year and, therefore, also boosts the profit figure for the business. Again, however, there are two drawbacks:
The business will not be able to count the money again for the next financial year when the orders are dispatched -therefore the profit figure for the following year will be depleted of this revenue.
The business is not tackling the cause of the low profit figure.
Having a positive cash flow is vital for the survival of a business, since without the ability to pay workers and suppliers then the business will soon have to cease trading.
This potential problem is compounded by the fact that businesses often have to pay many expenses several weeks or even months before any cash actually flows into the business.
For example, wages and salaries will have to be paid to employees, suppliers will have to be paid for any raw materials, and the rent or mortgage payments will have to be paid before the products can be manufactured and sold to customers.
Further to this point, if the products are sold on credit to customers, then the time delay between the cash outflows and the cash inflows will be even longer.
The major causes of cash flow crises for a business are:
Overtrading -where the business attempts to expand too rapidly, without a sufficient financial base.
Having too much money invested in stocks.
Allowing too much credit to their customers.
Unexpected changes in demand for their products.
Overborrowing -therefore having large monthly loan repayments, which have to be met.
There are many actions that a business can take when it is experiencing a liquidity crisis:
Offering price discounts to boost sales and sales revenue.
Selling off fixed assets.
A 'sale and lease back' arrangement.
Chasing debtors for the monies owed to the business.
Selling off stocks.
Whatever action is decided upon, the business must ensure that it is implemented quickly and that a careful eye is kept on the liquidity (cash flow) position in the future.
A cash flow statement is a Financial Accounting document, which shows the cash inflows and the cash outflows for a business over the past 12 months.
It indicates those months in which the business suffered a cash flow crisis (where cash outflows were greater than cash inflows) and it will also highlight those months in which the business was cash-rich (i.e. more cash inflows than cash outflows).
It allows a business to prepare a cash flow forecast for the forthcoming year, by basing the estimated cash inflows and outflows on the results from the previous year.
A cash flow forecast is a Management Accounting document, which outlines the forecasted future cash inflows (from sales) and the outflows (raw materials, wages, etc) per month for a business over an accounting period.
Total cash inflows
Total cash outflows
Net monthly cash flow
The business forecasts that in January it will experience cash inflows of £1,100 and cash outflows of £700, leaving a positive net monthly cash flow of £400.
This is added to the £200 bank balance which existed at the end of December, to give a forecasted bank balance at the end of January of £600.
In February, the forecasted cash inflows are only £100 more than the forecasted outflows, leaving a bank balance of £700.
However, in the months of March and April, the business is forecast to experience negative net monthly cash flows (i.e. its cash outflows are forecast to be greater than its cash inflows).
This gradually reduces the bank balance to just £300 by the end of April.
It is important for a business to produce a cash flow forecast, so that it can prepare for those months in which it is forecast to experience a cash flow crisis (i.e. the business needs to arrange extra borrowing or overdraft facilities to provide extra cash).
Alternatively, in the months where the business is forecast to be cash-rich, it can use this money profitably elsewhere within the business (e.g. new product development).
This is an item that a business owns - it can either be a fixed asset (owned for more than 12 months) or a current asset (owned for less than 12 months).
This is the present value of all the assets of the business minus current liabilities.
This is a snapshot at a given point in time, showing the assets, liabilities and capital of a business. It essentially shows the net worth of a business
This is the total of all the long-term finance of the business. Essentially it shows where the business raised its money from (loans, share capital and reserves). Capital employed equals assets employed.
This is expenditure on items of capital and new fixed assets (e.g. land and buildings, vehicles, machinery).
Cash flow forecast
This is a Management Accounting document which outlines the forecasted future cash inflows (from sales) and the outflows (raw materials, wages, etc) per month for a business.
Cash flow statement
This is a Financial statement which shows the cash inflows and the cash outflows for a business over the past 12 months.
Cost of sales
This is often referred to as 'Cost of goods sold'. It represents the direct costs of manufacturing a given level of output.
These are any monies which the business owes to its suppliers, which will be settled within the next 12 months (e.g. payment for raw materials purchased on credit).
This is an item that a business owns for less than 12 months (e.g. cash, debtors, stock).
This is an item that a business owes to an external body, which will be settled within 12 months (e.g. creditors, overdraft, corporation tax to the Inland Revenue).
These are the people who owe the business money (e.g. customers who have purchased goods on credit).
This is the fall in the value of fixed assets, either due to their use, due to time, or due to obsolescence. Essentially, depreciation divides up the historic cost of a fixed asset over the number of expected years that it will be used by the business.
This is the total amount of 'profit after tax' that the business will issue to shareholders at the end of the financial year. The remainder of the 'profit after tax' will be retained in the business for re-investment.
Items of a monetary value which have a long-term function and can be used repeatedly. These determine the scale of the firm's operations. Examples are land, buildings, equipment and machinery. Fixed assets are not only useful in the running of the firm, but can also provide collateral for securing additional loan capital.
This measures the proportion of capital employed that is funded by long-term liabilities (e.g. loans, mortgages, etc). It is calculated by dividing long-term liabilities by capital employed and multiplying by 100.
This is the sales revenue of a business minus the cost of sales (i.e. minus the direct costs incurred in manufacturing the products which have been sold).
Gross profit margin
This is the gross profit figure expressed as a percentage of the sales revenue figure. It shows the proportion of sales revenue that remains after all direct costs have been accounted for.
This is the original price which was paid for an asset.
These are fixed assets which are not physical (e.g. brand names, goodwill, patents). They are of long-term value to the business and will exist for more than 12 months.
This is the ability of a business to meet its short-term debts. The current ratio and the acid-test ratio can measure this.
This refers to a situation where a business does not have enough liquid resources (i.e. cash) to meet its current liabilities and short-term debts.
This is fixed assets + current assets - current liabilities. It is often used instead of the term 'assets employed'.
Net current assets
This is also referred to as working capital and it is calculated by deducting current liabilities from current assets. It represents the finance that is available for the day-to-day running of the business.
Net profit margin
This is the net profit figure expressed as a percentage of the sales revenue figure. It shows the proportion of sales revenue that remains after all expenses have been accounted for.
Profit and loss account
This is a financial statement listing all the revenues and expenses of a business over a period of time (normally 12 months).
These consist of retained profit from previous trading periods and any increase in the value of fixed assets such as land and buildings, which form part of the long-term capital of the business.
This refers to any expenditure on all items other than fixed assets (e.g. raw materials, wages, utility bills, etc). These are usually day-to-day expenditure that the business incurs when it tries to create sales revenue.
This is the capital invested by the shareholders plus the reserves which have been accumulated over the years. It represents the total capital which the shareholders have a claim on within the business.
This method of depreciating a fixed asset charges an equal amount to each year of its expected useful life.
This is a form of creative accounting and it involves presenting the accounts of a business in such a way as to flatter its financial position.
This is the day-to-day finance that is needed for running a business. It is also referred to as 'net current assets' and it is calculated by deducting current liabilities from current assets. Working capital is used to pay for expenses such as wages, raw materials and utility bills.
Give yourself marks for mentioning any of the points below:
a) A cash flow forecast is a financial statement which shows all expected receipts and expenses of a business over a future time period which shows the expected cash balances at the end of each month.
b) It shows the cash position of the firm month by month, and will show when it may or may not need to borrow money. Stake holders who may be interested will be those considering lending funds to the firm, such as banks.
(Marks available: 10)
3. Look at the data below and answer the questions which follow.
Mr and Mrs Roberts own a small hotel in the Lake District. They run the hotel and employ labour from the local town. They are considering expanding the business by increasing the number of bedrooms.
What is meant by:
a) (i) Fixed assets; Leasehold premises;
(ii) Current assets?
b) comment on the Liquidity position of the company.
c) Mr and Mrs Roberts are considering expanding the business by increasing the number of bedrooms. What factors would they have to take into account if they had the opportunity to receive a cash injection from an investor?
d) what factors, other than those shown in the balance sheet, should a potential investor take into account?