A balance sheet is a financial 'snapshot' that summarises the value (assets less liabilities) of a business at a specific point in time. All businesses have to prepare a balance sheet as part of their annual accounts, but a balance sheet can be prepared at any time.
A balance sheet is one of the three major financial statements used in the business world. The others are the Income Statement
and the Cashflow Statement
- How solvent the business is;
- How the business is financed;
- How much capital is employed in the business; and
- How quickly assets can be turned into cash.
Understanding a balance sheet
A balance sheet is made up of the assets of a business (anything owned by or owed to it) less its liabilities (all money owed by the business to its creditors). This resulting net asset value will then balance with (equal in value) the capital and reserves of the business plus the net profit accumulated by the business.
It is also important to remember what a balance sheet is not:
- It does not show the profitability of a business; this is demonstrated in the profit and loss account;
- It does not necessarily reflect the true market value of assets, which may be more or less than the figures given on the balance sheet; and
- It does not show the market value of a business; this depends on profitability and the current values (as opposed to costs) of assets.
A balance sheet is different, but complementary to the profit and loss statement produced in the annual accounts, and is important to understanding the financial strength of the business. The balance sheet can show a very different perspective of the financial position of a business than the profit and loss account in the short term. For example, a business can be making good profits, but can be regarded as having a weak balance sheet, and hence potentially being financially vulnerable, because of its low net asset value. Conversely a business can sustain a period of poor profitability when it has a strong balance sheet, as shown by a high net asset value.
An example of a balance sheet
|Balance sheet as at 28 Feb 2005
|Cash in the bank
|Net current assets
|Total assets less current liabilities
|Creditors falling due after one year
|Capital and reserves
Key balance sheet terms
Fixed assets are generally assets with a life longer than one year, such as equipment, buildings and motor vehicles. These are also known as tangible assets because they physically exist. The cost of tangible fixed assets such as equipment is also depreciated over the expected lives of those assets. This accounts for the loss in value of those assets over time and it is this depreciated value (net book value) that appears in the balance sheet.
There is also a class of fixed assets known as intangible assets. Goodwill, for example, is an intangible asset. If a business is bought for more than its net worth, the difference is shown on the balance sheet as goodwill. This is a representation of the expectation of future earning power. Since the buyer can never be sure of recouping goodwill if they wish to sell, it is good practice to write off (amortise) goodwill as quickly as possible.
Current assets and current liabilities
Current assets and current liabilities usually have a life of less than one year. Current assets include stock, work in progress, debtors, cash at bank, etc. Trade debtors represent the amount of money owed to the business by customers. Current liabilities include overdrafts, loans due within one year, money owed under hire purchase agreements due within one year, any amounts owed in VAT or tax, etc. Trade creditors represent the amount of money owed by the business to suppliers.
Net current assets are simply the difference between current assets and current liabilities. This should be positive, otherwise the business may not be able to meet its debts as they fall due. If so, then the business may be insolvent.
The example shows the creditors falling due after more than one year deducted to give the net assets. This will probably only include bank loans and HP payments due in more than 12 months, that is the proportion due after 12 months as opposed to the whole loan. Deducting this figure from the net current assets gives the net assets of the business.
Some accountants include long-term loans with the capital and reserves. Adding the two together gives the capital employed.
The net assets should be equal to the total capital and reserves, that is, the net worth. Capital is the money introduced by the shareholders or owners (what, in effect, the company owes them) and the reserves which are normally the retained profits of the business. The capital and reserves is sometimes known as the 'equity' of the business. The term 'equity' is not used if long-term (or any other) borrowings are included.
In the example:
- The total assets are R175,000;
- The capital employed, equal to the total assets less current liabilities is R143,000;
- Net assets are R43,000, ie. total assets less current liabilities and long-term debt;
- The net worth is R43,000, ie. total assets less current liabilities, less long-term debt - equal to shareholders' capital plus reserves.
- An accountant or business counsellor at a can assist in the preparation of balance sheets, but you have to understand it.
- All of the information required to write up a basic balance sheet can be obtained from a trial balance, which is a summary of the business's accounting books and records. See Understanding Accounting.
- Balance sheets can be compared over time, eg current year against previous year, to identify changes in the business and its financial strength.
'Balance Sheet Basics for Non-Financial Managers
' by Joseph Simini (Wiley, 1990)
'Understanding Balance Sheets
' by George T Friedlob and George Thomas (Wiley, 1996)
by Anthony Rice (Financial Times Prentice Hall, 1999)
Managing your assets: Keeping Account