Balance sheets
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The Balance Sheet
The balance sheet is a picture of the financial position of a business at a particular point in time. Businesses usually produce one balance sheet every 12 months. It contains information about what the business owns and what the business owes. By law limited companies must produce a balance sheet every year.
The balance sheet contains information about assets, liabilities and capital. As well as providing a simple picture of the value of the business it is a way of checking that all the money received to finance the business has been accounted for.
Assets are the resources that the business owns. These resources are used in the production of goods and services. Assets are divided into fixed and current assets. Fixed assets have a life span of more than one year, for example, machinery, buildings, cars, tables and chairs. Current assets are assets that will be changed into cash within a year, examples are:
- Cash in the bank – this is money that the business has in the bank.
- Stocks – these are raw material, components, semi-finished goods and finished goods. Stocks will hopefully be sold in the near future.
- Debtors – these are the customers that owe money to the business. The cash should be received in the near future.
Liabilities are the debts of the business, in other words, the money it owes. Liabilities are divided into current and long term liabilities. Current liabilities are debts the business has to pay within one year, for example, money owed to suppliers (trade creditors), tax owed to the Government and money owed to the bank for an overdraft. Long term liabilities are the debts the business must pay after one year, for example, mortgages and loans owed to banks.
Capital is the money given to the business by the owners. This money is usually in the form of shares, therefore capital is also called shareholders’ funds. The value of shares is calculated using the price they were sold at, not using their present value. Retained profit is also included with the capital as it is money owed to the owners, but the business has kept it to help with cash flow problems or to help pay for assets.
The Balance Sheet Must Balance
In every balance sheet the value of the assets must equal the value of the liabilities and capital. It is possible to write the following formula which shows this:
Capital + Liabilities = Assets
If the formula “Capital + Liabilities = Assets” must balance an increase in assets must be funded by an increase in capital or liabilities, or other assets have to be sold. Any asset the business purchases must have been funded by:
- the owners buy more shares which increases the capital of the business
- using retained profit which leads to an increase in the capital of the business.
- borrowing money which leads to an increase in the liabilities.
- credit that the suppliers offer, which is a liability for the business.
- selling assets of the same value as the new asset.
If we want Capital on its own in the formula, we have to change the side and the sign of Liabilities. The new formula which we will look at later is written as follows:
Capital = Assets – Liabilities
The Layout of the Balance Sheet
A balance sheet will be laid out as follows:
As you can see the value of capital must balance with the value of net assets (assets – liabilities). This agrees with the formula we wrote earlier:
Capital = Assets – Liabilities
An important calculation on the balance sheet is working capital or net current assets (current assets – current liabilities). Working capital is the cash that the business can get quickly. If the business runs out of working capital it will not be able to pay its workers or suppliers.
