The Basics of A Balance Sheet
The Balance Sheet (B/S) shows a snapshot of the status of an organisation at a particular time. It is made up of three parts: Assets, Liabilities & Shareholders Equity - we’ll explain these in more detail later.
The balances of the Shareholders Equity and the Liabilities will always match the Assets. This is called the ‘Accounting Equation’ (Liabilities + Shareholders Equity = Assets). Now don’t switch off just because we started talking maths, we’ll make sure this is valuable for the business leader too!
Even at this early stage, we can identify that if the shareholders equity is a positive figure (i.e. there are more assets than liabilities) then the company has a positive value. The company cannot pay dividends if this value is negative so at a minimum, business leaders will want to keep track to ensure they know the balance of their Shareholders Equity.
Getting to Grips with Balance Sheet Terminology
However, each of these three areas have components that make up their overall value and this is where most people switch off, because this is where all the accounting Jargon comes in. It’s impossible to understand the B/S without understanding these first, so we’ll look to explain them in terms that are relevant to the business leader.
Assets are things the company owns that have value, sometimes this is cash, other times this might be a building. It’s helpful to know the total value of assets, but it’s also useful to know how easy it would be to get hold of that cash if the business needed it (covid was a great example of a time where having access to quick cash was important for many businesses). However, some things are difficult to convert into cash, such as selling a building; this is why the term ‘current’ is used to show the difference between assets that can be turned into cash within 12 months (current assets) and assets that take over 12 months (non-current assets). The term ‘Fixed’ assets is sometimes used instead of non-current assets.
The term ‘liquid’ can then be applied to this, so we can say that current assets are more ‘liquid’ than non-current/fixed assets. We’ll come back to this term ‘liquid’ a little later.
We can also describe an asset depending on whether we can touch and feel it (tangible) or whether it’s something we can’t touch or feel (intangible). This is where we can distinguish between something like a business van (tangible) versus a licence to trade under a specific brand name for a period of time (intangible). Tangible and Intangible are generally used alongside Fixed Assets; for example, a building would be a Tangible Fixed Asset.
When looking at assets that are ‘current’ (remember that means there is an expectation that they can be converted to cash within 12 months) the asset every business should have is cash in the bank. Bank accounts are sometimes grouped together and referred to as ‘Cash at Bank and In Hand’, but this could mean everything a Business Current Account, to a Savings Account, to a till float (money left in a till), to petty cash (physical cash made available to pay for items in cash).
But other ‘current’ assets could also include a business’s Stock (sometimes referred to as Inventory). If we take the example of a shop that sells electronics like TV’s, at any time they will have some TV’s on show in their store and also some stock ready for immediate purchase. They may also have stock available in a nearby warehouse. All of this Stock has a value and there is an expectancy that the business will sell it within 12 months.
We can then look at the asset that is a customer's promise to purchase a specific good or service. The customer may make the promise via a signed contract or written confirmation, at which point, particularly in B2B sales, an invoice will be raised and there will be a period of time in which the customer must pay that invoice. An example would be 30 day terms; that is, that the customer must pay for the goods or services within 30 days. There is a delay between when the invoice is raised and the customer pays, so if someone was to look at their balance sheet during this time it would show a balance that this customer and any other owes. This is referred to as Receivables or Debtors and is a ‘current’ asset. This allows a business to identify how much they are owed at any given time.
Liabilities are things an organisation owes to someone else; this is represented in financial terms on the balance sheet.
In exactly the same way as when we discussed assets, we can use the terms ‘current’ and ‘non-current’ for these liabilities also. This is particularly useful when looking at debts to determine if, for example, a debt the business owes to the bank is due this year or in a future year.
A business will inevitably have other organisations (suppliers) that they need to buy things from, and if they are given payment terms so they can pay after an agreed period of time, then the business will want to record this so they know how much they owe. This is represented under the heading Payables or Creditors.
Sometimes though, these creditors are not customers, the business may have been loaned money from its directors through a Directors Loan* or it may owe money to HMRC for taxes such as VAT, PAYE or Corporation Tax. All of these are current liabilities that are recorded on the balance sheet until they are paid.
*If a director has taken money from the business and owe the business this would be an asset to the business in just the same way a debtor (a customer owing money) is.
Shareholders equity represents the balance after a businesses liabilities are deducted from their assets and this can be made up in various ways.
In the UK, when a business is incorporated (created) the shareholder(s) must add a certain amount of cash into the business as starting capital. Let’s say a shareholder started their business with £100, this would be represented on the balance sheet as Called Up Share Capital. So at the start of this business we would see the following:
· The bank has £100 in, i.e. an asset of £100.
· There are no liabilities.
· The shareholders Equity under the category Called Up Share Capital has £100 in it.
So our equation of Assets – Liabilities = shareholders Equity would be demonstrated in numbers as £100 - £0 = £100. So this is ‘Balanced’.
We would also see the term Current Year Earnings or Profit From Current Year, which as it suggest is the profit made during the current year. This figure should always match the profit showing on your annual Profit and Loss report. You can delve deeper into this report by reading our blog on How to Read and Understand the Profit and Loss Report.
Once a business reaches its second year there will be two profit figures, one representing the current year earnings and one representing Retained Profit From Previous Years (sometimes called Retained Profit or Retained Earnings). If there are any funds that are unused from previous years they will be displayed in this category.
Hopefully along that businesses journey, they will be able to issue some dividends. If the dividends are owed, but not paid, they will appear in the Liabilities area, but once they are paid they will appear in the Shareholders Equity section under a term such as Dividends Paid.
The total amount of all these breakdowns in Shareholders Equity is sometimes grouped as a total under the name Total Capital and Reserves.
Now You Understand How to Read the Balance Sheet, How is it Useful?
Hopefully, as you’ve learnt more about the Balance Sheet you’ve already begun to think about how you can use it to answer financial questions you may have, but if not, don’t fret, here’s a few ways you can use it.
One of the responsibilities of a business leader is to mitigate risk, and the B/S is one report that can help to do this. We’ve already learnt that your remaining Shareholders Equity is the value of your Assets less your Liabilities and we want this figure to be positive to be able to pay dividends, so one simple check we can do is to identify if we have more Assets than Liabilities.
However, this comparison is also important to identify if we are able to convert our assets into cash if we ever needed to pay off our liabilities; this is called Liquidity.
Liquidity: a business's liquidity is its ability to convert assets to cash quickly and cheaply in order to pay off its liabilities.
We can then identify our Asset to Liability ratio. If we have £100,000 in assets and £100,000 in liabilities we have a 1:1 ratio. This tells us, that we can pay off our liabilities using our assets, but there’s nothing left for the shareholders. So in an ideal world we would want more assets than liabilities, for example, we may choose to run our business on a 1.2:1 ratio, meaning that for every £100,000 of liabilities we would want to ensure we had £120,000 of assets. We can use a ratio like this to inform our decision making around how much debt to get in the business.
So, this is a useful starting point, but you may have spotted the issue with this ratio; we wouldn’t want to include all our assets as some Fixed/Non-Current are quite difficult to convert to cash quickly, and equally we may not care too much about analysing our ability to pay our long term (non-current) liabilities. This is where the quick ratio is used which measures our Current Assets against our Current Liabilities. This can tell us whether we have enough assets capable of being converted in the next 12 months to cover our debts due in the next 12 months. And obviously, if we had £100k in current liabilities, we would want to have at least £100k in current assets to be able to pay for this, but preferably quite a bit more.
And we can continue analysing using this method even further, for example, we may have some current assets that include cash in the bank, but also some inventory items. We may want to know if we can afford to pay our debts, even if we cannot sell these. We can simply take the value of our inventory items from our other current assets and use this to compare against our current liabilities. This is called the Acid-Test Ratio or Quick Ratio.
When we look at these various comparison methods we will want to identify what a ‘good’ ratio is for our business and there’s no hard and fast rule. It’s good to look around your industry to benchmark against what others are doing and speak to your accountant for what you should be aiming for in your business.
Another example of how to use the use the B/S is that you may have a business with a lot of debt and high interest rates. It can be worth comparing how much operating income (net earnings before interest and tax are deducted) a business makes compared with how much interest there is on their debt. If a business is making £100k in operating income, but they spend £110k on interest is clearly not in a good position. What constitutes a good ratio is subjective and depends on many factors including the industry, where the business is in it’s lifecycle and recent activities, but it’s normally agreed that operating income should be at least twice your interest figure to avoid major vulnerabilities. So a business making £100k in operating income wouldn’t want debt interest to be above £50k. This ratio could be used to decide on whether taking debt out to grow or expand is an appropriate course of action or if it will create too much risk.
Hopefully, these examples have demonstrated the value a Balance Sheet can have in helping a business leader to identify risk and inform decision making. But we’ve just touched the surface.
If you want to get help with interpreting your balance sheet through our Finance Director services, please call 0330 043 4589.