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How to read a Balance Sheet
If you are starting to learn about accountancy,
you could be forgiven for thinking that the financial progress or
current position of a business can be assessed by a study of its
Profit & Loss account. Not so. The Profit & Loss Account has been
accurately described as merely a "snapshot" of a result at a point
in time that will already have passed. Aside from that, just about
any individual item of disclosed income or expense may be
challengeable since the business might be trying to portray the best
impression it can of its results, or conversely it might be in the
current interests of the Board to show the most downside aspects. In
the former case perhaps because it is looking for a buyer of the
business or to raise extra finance and in the latter case perhaps
because there is a new MD who wants to "clear the decks" from the
last management regime and have a clean and low base start.
The best way to form a view of the financial health of a business is
to understand and be able to pull apart its Balance Sheet. The
Balance Sheet is where the chickens come home to roost, assuming you
can find the chickens that is.
A Balance Sheet is what it says on the tin. It is the summation of
all the financial balances on every account the business keeps and
due to the magic of "double entry bookkeeping" it will be in balance
since every debit posting will have an equal and therefore
compensation credit entry. That is, unless the mechanised accounting
system has gone bananas. Let us take a look at what is revealed when
we open up a typical Balance Sheet. The fundamental feature is that
every business has assets and it has liabilities. The excess of the
first over the second is its capital or put another way, how it is
being financed. The Balance Sheet is stated as being struck at a
specific date, namely the last day of the accounting period. It is
customary when interpreting a Balance Sheet to use well tried and
tested "ratios" that compare one balance with another balance and
assess the result against rule of thumb standards for each such
ratio. This form of interpretation is the subject of a separate
piece that can be found elsewhere on this website.
The assets
So called fixed assets will be shown first. These are categorised
under headings such as Land & Buildings, Plant & Machinery, Fixtures
& Fittings and Office Equipment. What will be shown first is the
original cost of purchase of the asset (in some instances there may
be a revaluation of this original cost) and then the depreciation
both incurred in the past and for the current period and then the
difference, being the written down balance of the asset.
Depreciation may be couched in different terminology such as
impairment but the objective is the same; to write off the original
cost over a period of time that is intended to approximate to the
lifetime of the asset in question.
What rate of depreciation has been used and whether it is
"straight-line" (a % of the original cost) or "reducing balance" (a
% of the previous written down balance) will be given as a note to
the accounts. There may be a category called "Intangible Assets". If
so, it will comprise Goodwill and possibly other things such as
Patents and Trade Marks. These items arose as the difference between
what was actually paid and the value placed in the books. They are
intangible in the sense of representing such a difference rather
than a specific physical thing. Intangibles will be subject to
depreciation over time just as the other fixed assets are.
The second position in the asset block is taken by current assets.
These assets are reckoned to be more liquid (that is, turnable into
cash) than the fixed variety and indeed are normally listed in order
of ascending liquidity. First will be the "stock" of the business
and may have a number of subcategories dependent upon the type of
activity undertaken. For example, a manufacturing business will have
raw materials, piece parts, sub-assemblies, final assemblies and
finished stock. Stock will normally be valued at the lower of
purchase price, replacement price or realisable value. The notes to
the accounts will make this clear. Next will be debtors, that is the
sales value gross of vat of the business’s turnover. Debtors will be
shown net of any bad debts and any general provision against future
bad debts. Usually there will be so-called "prepayments" as a
separate category if expenses have been paid that relate to a future
time period. Notes to the accounts will describe in more detail the
composition of debtors and other sub-categories. Finally the current
assets will show the bank and cash balances although if the bank is
in overdraft, this is likely to be listed later on as a liability.
The liabilities
The liabilities of a business are normally expressed in terms of
those that must be paid off in the short-term and those that are not
due for more than one year and being longer-term are considered as
part of the financing of the business. The largest short-term
liability is usually the trade creditors, that is, the cost of
purchases of goods and services and expressed gross of vat. In this
same category of current liabilities will come the heading
"accruals". Accruals are known liabilities of the accounting period
but for which the supplier invoice has not yet been received. They
represent delayed costs but these costs are appearing in the profit
& loss account or as assets.
In presenting the Balance Sheet, the current liabilities are usually
deducted from the current assets to produce what is normally styled
"working capital". It will be negative if current liabilities exceed
current assets. Fixed assets plus the working capital gives the
"Financing" of the business.
In effect, the financing is the final liability that supplies the
ultimate "balance". Typically it is made up of long-term creditors
(over 12 months to pay), bank loans, debentures, other external
loans and then what is due to the shareholders or proprietors. This
final block will consist of the issued share capital (if any) and
the revenue reserves built up from the profit made both this period
and in the past. |
