Balance Sheets - Simply Put

Before you get started

A Balance Sheet is one of the four key pieces of financial information for any business.

Understanding a Balance Sheet is essential for anybody owning or managing a business. A Balance Sheet is not something for you to ask your Accountant to do and then allow it to be consigned to a drawer.

This Marstan Guide takes you through the basics of a Balance Sheet and explains the various components and terminology of a set of accounts.

Before you embark upon this exercise of understanding, make sure you have read our Marstan Guide which shows how the Balance Sheet relates to other key pieces of information. This can be found in:

• Business Finance - Simply Put!

What is a Balance Sheet?

The Balance Sheet is a snapshot of your financial position at a moment in time and sits alongside the Profit and Loss Account.

The Balance Sheet Simply Put shows two main things:

1. The Assets and Liabilities of the business
2. The sources and amounts of money used by the business.

(Assets are things which you own and have a monetary value. Liabilities are obligations where you have to pay money to other people. We will say more about them later.)

Many people in business fail to understand the importance of the Balance Sheet in controlling their business. However, it is imperative that you make the effort to understand the Balance Sheet in order to make your business more secure.

There are other things to learn about Balance Sheets such as: what is the difference between Fixed Assets and Current Assets, Creditors, Share Capital, Cash, Reserves? These will be covered in more detail elsewhere, so it is enough to know at the moment that a balance sheet shows the assets and liabilities of the business and the way in which it is financed.

From the point of view of the Assets and Liabilities, the simplest balance sheet looks something like this:

We will come back later to the other function of the balance sheet, which is the source and amounts of money used by the business.

In the meantime, keep this simple diagram in mind:

In this diagram the scales are shown in perfect balance because the figures for “Total Assets less Liabilities” is exactly the same as the figure for “Financed By”.

Simply Put – this is why it is called a Balance Sheet.

We will come back later to a worked example. In the meantime, we need to take a closer look at the Assets and Liabilities part of the Balance Sheet.

The first thing to bear in mind is that there are two types of assets; Fixed Assets and Current Assets.

What are Fixed Assets?

Fixed Assets include:

1. Land
2. Buildings
3. Major plant for the buildings
4. Fixtures & fittings
5. Computers

Essentially, they are tangible things in which you have invested Capital Expenditure. (Capital Expenditure is long term finance, which you invest in items which are to be used over the long term).

The other type of expenditure is Revenue Expenditure. This is the costs of the day to day running of your Fixed Assets.

For example:

• Computers, printers & cabling etc. = Capital Expenditure
• Print cartridges, paper & maintenance of computers = Revenue Expenditure

How are Fixed Assets valued?

For those assets which have an estimated life span, the assets are valued at cost, less the accumulated depreciation since they were purchased.

Land and buildings, however, are subject to potentially large market variations rather than their purchase price. They are, therefore, best dealt with by a periodic valuation by a professional valuer.

What are Current Assets?

These include:

1. Raw materials
2. Any finished goods; unsold but in stock
3. Work-in-Progress (See Profit & Loss Accounts – Simply Put
4. Debtors – i.e. the money due on invoices as yet unpaid
5. Cash
6. Money in bank accounts on relatively short term deposit
7. Any investments which could be sold in the short term to realise cash, e.g. stocks and shares

How are Current Assets valued?

The majority of the current asset items referred to above can be valued easily as they are a matter of fact. However, the value of short term investments may be subject to market price and should be valued separately at each Balance Sheet period.

There is one important point to note, however. Cash and Bank deposits are not necessarily all that they seem. If you have short term borrowings, such as an overdraft facility, they may be renewable at a given period and may be repayable on demand. Your Cash or Bank account position may also be artificially high because it does not take account of any loan repayments or bills due to the tax authorities.

Therefore, a Balance Sheet should make adjustment for this.

What do I need to know about Liabilities?

Liabilities are sums of money which you owe to other parties. The other parties are usually called creditors because the fact that you owe them money effectively means that they are giving you “credit”; i.e. lending you money for a short term.

There are two types of Creditor (or liability) and they are treated separately in a balance sheet:

1. Short term creditors

   These are creditors for which payments are due now, or within one year

2. Long term creditors

What type of creditors can be classified as short term?

Short term creditors include the following:

1. Amounts owed on invoices which you have already received from suppliers
2. Amounts owed on goods you have ordered or received but, for which you have not yet received invoices
3. Dividends to shareholders
4. Current instalments of any loans
5. Payments to tax authorities
6. Overdraft facilities. (They are not long term credit because overdrafts can often be “called-in”, i.e. repayable on demand.)

What types of creditors can be classified as long term?

Long term creditors include the following:

1. Secured and unsecured loans repayable over a period of years. (The payments in the first year will go in short term creditors and the remainder in long term creditors
2. Obligations under finance leases for the purchase of fixed assets

How are assets and liabilities (creditors) included in the Balance Sheet?

From an assets and liabilities point of view, the Balance Sheet should be composed as follows:

So that deals with the Assets and Liabilities side of the Balance Sheet; one side of the scales!

What about the “Financed By” part of the scales?

What does the expression “Financed By” mean?

You have calculated the left hand side of the scales; total assets less liabilities. This is a matter of fact and clearly, it must be financed in one way or another.

There are three main sources of funding for a business:

1. Share Capital
2. Loan Capital
3. Retained profits

What is Share Capital?

Effectively, this is an amount of money put into the business by the Owner or Shareholders.

The expression “shares” need not be taken too literally. If your business is a Limited Company you will provide share certificates and the owners will pay for the shares. The money raised from the owners is then used to finance the business.

If your business is a Partnership you might not issue formal shares but there will typically be a Partnership Agreement setting out what capital has been introduced by each partner and the percentage of profits which they are entitled to receive.

If you are a Sole Trader, it may just be a sum of money which you introduced from personal funds to get the business started.

What are the implications of Share Capital?

If somebody is investing in a business, they want to see a return on it; otherwise why risk their capital?

It is clear that it is also desirable to provide a greater return than, say, depositing their capital in an investment account.

There are two main ways in which a shareholder will get a return:

1. They will receive a dividend on each share (if the company is making profits it can allocate some of it to re-invest in the business and some to allocate to the shareholders to realise their profit)
2. They will seek growth in the price of the shares so that they can, in the future, sell their stake in the business and invest elsewhere

It should also be borne in mind that shareholders want (and need) an element of control of the running of the business in order to ensure that their interests are protected.

What is Loan Capital?

This is a long-term loan from a bank, financial institution or group of investors.

It does not involve ownership of the business but it does require a loan agreement setting out the terms of the loan, such as the amount, the interest rate and the repayment period.

Unlike an overdraft arrangement, it is not something which can be “called in” overnight, providing the terms of the repayment are satisfied.

What are the implications of Loan Capital?

In order to secure a loan you will have to commit to paying back the sum at the agreed times, with the agreed interest payments.

Another implication of loan capital is that lenders may want some form of security or collateral. This might typically take the form of a charge against property.

What are Retained Profits?

If a company makes a profit, it pays the tax on it and then leaves it in the business to fund expansion.

What are the implications of Retained Profits?

This is a good way of funding expansion because it does not have “any strings attached”. It requires no interest payments and no dividend payments.

Appendix

Balance Sheet

Downloads

• Balance Sheet - Working Example.xls (29 KB)