Access the essential membership for Modern Managers
Like all financial documents, a balance sheet can appear quite daunting at first but it will make more sense once you understand the principles behind it. It is unlikely that you will ever be asked to produce a balance sheet but you may need to understand the main points it makes. This article will help you understand how to read a balance sheet.
A balance sheet is a snapshot of the financial status of an organization at a particular time and it has two sides that balance each other, which explains the name. Today the two sides are seldom shown opposite each other, but one below the other. For the purposes of understanding the balance sheet we will use the old ‘opposite each other’ format. You can then think about it being even, or balanced, when the two sides are equal.
On one side of the balance sheet are the overall assets of the organization and on the other are the claims on the organization. In a company these are known as shares or equities. So, at its most simple, a balance sheet can said to be overall assets=equities.
An example is the easiest way to explain a balance sheet.
Suppose the owners of a new business invest £100,000 and place all the cash in the bank. On day one the balance sheet looks like this:
Assets
£(000)
Equities
£(000)
Cash at bank
100
Owners equity
100
Now suppose that after one year in business the following position exists:
- cash at the bank has reduced to £65,000 (an asset)
- the business owns an inventory of stock or goods worth £20,000 (an asset)
- the business has sold goods and is awaiting payment from debtors for the sum of £45,000 (an asset)
- the business is due to pay creditors £10,000 (a liability as the business will have to pay this out in the future)
- during the course of the year the business has earned a profit of £20,000. This profit figure is added to the owners’ equity. Similarly any loss would have been used to reduce the value of the equities
The balance sheet at the end of first year would therefore look like this:
Assets
£(000)
Equities
£(000)
Cash at bank
65
Owners equity
100
Stock
20
Profit for year
20
Debtors
45
Total Assets
130
Less Creditors
10
Total
120
Total
120
(Note how we have marked the columns to show that the figures are in thousands, e.g. £65,000 becomes 65.)
To give you a more likely scenario let’s also suppose that in the first year the company had bought some new machines and patented a new invention. Both are assets to the business. The new machines are tangible assets because they are physical in nature and can clearly be valued while the patent is called an intangible asset [1]. Both tangible and intangible assets are also termed as fixed assets as they are required on an ongoing basis for the business and will not in themselves be sold to generate profits.
To purchase the machines the business took a bank loan for which payments have been delayed for two years.
The change to the balance sheet is all on the ‘assets’ (left-hand) side. The ‘fixed assets’ are an addition while the bank loan is liability and is therefore subtracted from the total. As the loan is due for repayment outside the normal operating cycle of one year it is recorded separately.
This allows the easy calculation of one of the more important computations in a balance sheet: working capital or net current assets. Working capital is the difference between the current assets and the current liabilities. If this is negative then this is a major concern as the organization does not have the ability to meet its obligations without either raising additional funding or disposing of fixed assets.
In the example below the level of working capital is £120,000 and the organization is well able to meet its obligations:
Assets
£(000)
Equities
£(000)
Fixed Assets
Owners equity
100
Tangible
40
Profit for year
20
Intangible
15
Total Fixed Assets
55
Current Assets
Cash at bank
65
Stock
20
Debtors
45
Total Current Assets
130
Current Liabilities
Creditors
10
Working Captial
Current assets (130) less current liabilities (10) = 120
120
Creditors Due After One Year
Bank loan
55
Total
Total fixed assets (55) + current assets (130) = 185
less
current liabilities (10) plus creditors due after one year (55) = 65
185 less 65 = 120
120
Total
120
On its own, a balance sheet does not tell you a huge amount but when compared to previous periods it can be a revealing document. It can be used to look for trends or calculate a variety of ratios that can tell you about the financial performance of the organization. It can also be used to compare one organization with another.
References[1] While an intangible asset can and should be valued for the purposes of the balance sheet, it is likely to be viewed much more skeptically by investors and banks as a source of reliable value. This is because it is difficult to determine its value in the open market.
While
