Balance sheets: the basics

A balance sheet is a financial statement at a given point in time. It provides a snapshot summary of what a business owns or is owed. It states what assets the business ownes and what it owes liabilities, at a particular date. The balance sheet is uded to show how the business is being funded and how those funds are being used. The balance sheet is used in three ways:

for reporting purposes (limited company's annual accounts) help interested parties assess the worth of your business at a given moment such as investors, creditors or shareholders

helps you analyse and improve the management of your business

!ou must consider who is the best person to produce balance sheets and when. This document shows the different elements to inlude in a balance sheet and and how to use the information from to assess and manage business performance. Who must produce a balance sheet? Limited companies and limited liability partnerships must produce a balance sheet as part of their annual accounts. The balance sheet will then need to be submitted to:

"ompanies #ouse

#$ %evenue & "ustoms (#$%") shareholders unless agreed otherwise

The other annual document you must produce is the profit and loss account. 'ther parties who may wish to see the accounts are:

potential investors or lenders (ban(s) potential purchasers of the business employees trade unions

There are strict deadlines for submitting annual accounts and returns to "ompanies #ouse and #$%" section. Other business structures +elf employed people, partners and partnerships are not re,uired to submit formal accounts and balance sheets on their ta- return. !ou should still produce a balance sheet so that you are aware of your business activity. Contents of the balance sheet A balance sheet shows: .. fi-ed assets long term short term what the business owes and must repay in penalties will apply if they are received late. Their websites can be found in the )useful lin(s*

/. current assets

0. current liabilities the short term

1. long term liabilities

including owner's

or shareholders' capital

The balance sheet is so called because there is a debit entry and a credit entry for everything, so the total value of the assets is always the same value as the total of the liabilities. Fixed assets

tangible assets

eg buildings, land, machinery, computers,

fi-tures and fittings. +how them at their resale value.

intangible assets

eg goodwill, intellectual property

rights (such as patents, trademar(s and website domain names) and long term investments Current assets These are short term assets whose value can fluctuate from day to day. 2or e-ample:

stoc( wor( in progress money owed by customers cash in hand or at the ban( short term investments pre payments eg advance rents

Current liabilities These are amounts owed to you and due within one year. These include:

money owed to suppliers short term loans, overdrafts or other finance ta-es due within the year 6ational Insurance 3AT, 4A!5 (4ay As !ou 5arn) and

Long-term liabilities include:

creditors due after one year finance agreements

the amounts due to be repaid in

loans or financing after one year, eg ban( or directors' loans,

capital and reserves

share capital and retained profits, after

dividends (if your business is a limited company), or proprietors capital invested in business (if you are an unincorporated business) 7y law the balance sheet must include the elements shown above in bold. #owever, what each includes will vary from business to business. The firm's e-ternal accountant will usually decide how to present the information, although if you have a ,ualified accountant on staff, they may ma(e this decision.

nterpreting balance sheet figures A balance sheet shows:

how solvent the business is how li,uid its assets are how much is in the form of cash or

can be easily converted into cash, ie stoc(s and shares

how the business is financed how much capital is being used

A balance sheet is only a snapshot of a business' financial position on one particular day. The individual figures can change dramatically in a short space of time but the total net assets (assets less liabilities) would only change dramatically if the business was ma(ing large profits or losses. 2or e-ample:

If you hold large inventories of finished products, a change in mar(et conditions might mean their value is reduced. !ou may even need to sell at a loss.

"ustomers sometimes have payment problems. If they are unable to pay, you may need to revalue your assets by ma(ing allowances for bad debts.

Current liabilities - money you o!e This section might include money owed for goods or services received but not yet paid for. "ebtors - money o!ed to you This figure assumes that debtors will pay up on time. 8here there are doubts about being paid, a provision can be made to reduce the value of the debts in the business' accounts. ntangible assets The value of goodwill, patents and intellectual property can fluctuate with mar(et trends, so the balance sheet value should be updated annually. Fixed assets These are shown at their depreciated rates. There are two main approaches to calculating depreciation of an asset:

8rite off the same charge over the calculated life of the asset. 2or e-ample, you may decide that a computer bought for 9/,::: has a useful life of five years and that you will write off /: per cent of its value each year.

Apply a steeper depreciation rate in the first few years of an asset's value. 2or e-ample, you may decide to offset 0: per cent of the value of the same computer in the first two years, /: per cent in the third year and .: per cent in the final two years. This method may allow your business to (eep pace with trends in the mar(et value and replacement cost of assets where value falls rapidly at the beginning.

;epreciation costs must be realistic and you may wish to approach your accountant for further help. !ou cannot offset the annual depreciation charge against ta-able profits, but you can claim capital allowances, using rates fi-ed by #$ %evenue & "ustoms. #elationship bet!een balance sheet and profit and loss account The profit and loss (4&<) account summarises a business' trading transactions income, sales and e-penditure and the resulting profit or loss for a given period. The balance sheet, by comparison, provides a financial snapshot at a given moment. It doesn't show day to day transactions or the current profitability of the business. #owever, many of its figures relate to or are affected by the state of play with 4&< transactions on a given date. Any profits not paid out as dividends are shown in the retained profit column on the balance sheet. The amount shown as cash or at the ban( under current assets on the balance sheet will be determined in part by the income and expenses recorded in the 4&<. 2or e-ample, if sales income e-ceeds spending in the ,uarter preceding publication of the

accounts, all other things being e,ual, current assets will be higher than if e-penses had outstripped income over the same period. If the business ta(es out a short-term loan, this will be shown in the balance sheet under current liabilities, but the loan itself won't appear in the 4&<. #owever, the 4&< will include interest payments on that loan in its e-penditure column and these figures will affect the net profitability figure or bottom line. $sing balance sheet and %&L figures to assess performance $any of the standard measures used to assess the financial health of a business involve comparing figures on the balance sheet with those on the 4&<. Compare balance sheets to assess business performance There are some simple balance sheet comparisons you can ma(e to assess the strength or performance of your business against earlier periods, or against direct competitors. The figures you study will vary according to the nature of the business. +ome comparisons draw on figures from the profit and loss (4&<) account. nternal comparisons If in'entory (stoc)* le'els are rising from one period to the ne-t, but sales in your 4&< are not, some of your stoc( might be out of date. !ou may also have a cashflow problem developing. If the amount trade debtors owe you is growing faster than sales, it could indicate poor internal credit controls. 2ind out whether any of your customers are having problems with cashflow, which could pose a threat to your business.

A positive relationship with your trade creditors is essential. =ey to this is managing your cashflow well, so that payments can be made on time. 2or e-ample, trade creditors are more li(ely to be fle-ible about e-tending terms of credit if you have built up a good payment record. $a(ing early payments may ,ualify you for a discount. #owever, early payment for the sa(e of it will have a negative impact on your cashflow. >ood payment controls will help prevent imbalances in what you owe suppliers and in levels of stoc( and inventory. Borro!ing as a percentage of o'erall financing (gearing* is important the lower the figure, the stronger your business is financially. It's common for start up businesses to have high borrowing re,uirements, but if the gearing figure reaches ?: per cent you may have difficulty getting further loans. +xternal comparisons !ou can also compare the above balance sheet figures with those of direct or successful competitors to see how you measure up. This e-ercise will highlight wea(nesses in your business operation that may need attention. It will also confirm strong business performance.

$se accounting ratios to assess business performance %atio analysis is a good way to evaluate the financial results of your business in order to gauge its performance. %atios allow you to compare your business against different standards using the figures on your balance sheet.

Accounting ratios can offer an invaluable insight into a business' performance. 5nsure that the information used for comparison is accurate otherwise the results will be misleading. li,uidity, solvency,

There are four main methods of ratio analysis efficiency and profitability. Li,uidity ratios There are three types of li,uidity ratio:

Current ratio

current assets divided by current liabilities.

This assesses whether you have sufficient assets to cover your liabilities. A ratio of two shows you have twice as many current assets as current liabilities.

-uic) or acid-test ratio are high

current assets (e-cluding stoc()

divided by current liabilities. A ratio of one shows li,uidity levels an indication of solid financial health. li,uid assets divided by daily operating

"efensi'e inter'al

e-penses. This measures how long your business could survive without cash coming in. This should be between 0: and @: days. .ol'ency ratios /earing is a sign of solvency. It is found by dividing loans and ban( overdrafts by e,uity, long term loans and ban( overdrafts. The higher the gearing, the more vulnerable the company is to increasing interest rates. $ost lenders will refuse further finance where gearing e-ceeds ?: per cent. +fficiency ratios There are three types of efficiency ratio:

"ebtors0 turno'er

average of credit sales divided by the

average level of debtors. This shows how long it ta(es to collect payments. A low ratio may mean payment terms need tightening up.

Creditors0 turno'er

average cost of sales divided by the

average amount of credit that is ta(en from suppliers. This shows how long your business ta(es to pay suppliers. +uppliers may withdraw credit if you regularly pay late.

.toc) turno'er

average cost of sales divided by the

average value of stoc(. This ratio indicates how long you hold stoc( before selling. A lower stoc( turnover may mean lower profits. %rofitability ratios ;ivide net profit before income ta- by the total value of capital employed to see how good your return on the capital used in your business is. This can then be compared to what the same amount of money (loans and shares) would have earned on deposit or in the stoc( mar(et.

1ccounting periods A balance sheet normally reflects a business' position on its 1ccounting #eference "ate (A%;), which is the last day of its accounting reference period. The accounting reference period, also (nown as the financial year, is usually ./ months. #owever, it can be longer or shorter in the first year of trading, or if the A%; is subse,uently changed for some reason. "ompanies #ouse automatically sets the first A%;. Thus the end of the first financial year is the first anniversary of the last day of the

month in which the company was formed. If you decide to change this, you will need to notify "ompanies #ouse. !ou should also notify #$ %evenue & "ustoms (#$%") if you change your A%;. nternal accounts !our business may decide to draw up accounts to help you monitor business performance as fre,uently as monthly. In this case the figures #$%". often (nown as management accounts are for internal use only. !ou do not need to file them with "ompanies #ouse or