Getting the Balance Right: how to understand balance sheets
Understanding balance sheets is key to assessing the health of your business.
In the second of our series Business Fundamentals, Mathew Forshaw looks at how to understand balance sheets.
A Profit & Loss Account is all about financial performance, showing the totals of the ‘ins and outs’ of a business over a period of time.
The balance sheet on the other hand is a picture of the health of a business on any given day. It shows a summary of all the Assets (things a business owns) and the Liabilities (amounts the business owes), which is then balanced off by the Equity of the business – the difference between the assets and the liabilities. This is sometimes called net worth.
Assets can are generally split into two categories. Anything that is expected to be owned by the business for the long term (generally more than one financial year) are called Fixed Assets and can include things such as land and buildings, equipment, vehicles, office furniture etc.
Then there are Current Assets. These are expected to be held over a shorter period – less than one year – such as stock for resale, amounts owed by customers and cash in the bank. Current assets are all about generating revenue, such as stock which will be sold, or cash that will be used to buy more stock, pay the bills and so on.
As with assets, liabilities are split into long and short-term. Current Liabilities are debts that need to be paid within one year and will include suppliers, bank overdrafts and tax bills. Long-term liabilities are payable after more than one year and are usually confined to finances such as loans, HPs and leases.
The equity is made up of share capital (in a limited company) and reserves such as the Profit & Loss Account reserve. The share capital is the amount paid by the shareholders to own a stake in the company. The P&L Reserve is the total of all the accumulated profits over the years, less amounts paid out to the shareholders as dividends.
The best way to understand balance sheets is to look at some examples.
A limited company balance sheet might look like this:
|Cash at bank||5,000|
|Creditors Due within 1 year||(5,000)**|
|Net current assets||5,000 #|
|Total assets less current liabilities||15,000 ##|
|Creditors due within 1 year||(5,000)|
|Net Assets||10,000 ~|
|Equity & Reserves|
|Profit & Loss Account||9,000|
|Total Equity||10,000 ~~|
* The total of the above
** Brackets mean the figure is a negative, ie money owed out of the business
# Net current assets means short term assets less short term liabilities. If the liabilities are higher then this figure is negative. It could mean the business doesn’t have enough funds to pay its short-term debts.
## Long + short-term assets – short term liabilities
~ As above less long-term liabilities. This figure will always balance with the bottom figure
~~ Total equity is the investment in the business by the owners.
Do YOU understand balance sheets? Get in touch if you have any questions about how to understand balance sheets.