Why a Balance Sheet is vital.... #39
- Adrian Dionisio - business737 owner
- Oct 11, 2021
- 5 min read
Updated: Apr 14, 2024
Why do you need a balance sheet?
A balance sheet is also known as
statement of financial position
statement of financial condition
This financial statement is very important for any business owner. Nothing happens financially for a business that does not end up on the balance sheet. It provides a snapshot of the financial position of a business at a moment in time. It shows how much money the business has at this specific date.
It is the easiest & best form of accounting
Outlines what a business is really worth
Shows assets & liabilities
Shows what the business owns
Displays net worth & equity
Highlights the financial strength of a business
Provides valuable insights about a business
It determines risk & return
It can be used to secure Business Loans and other Capital
It provides helpful ratios
Why must a Balance Sheet "balance"?
The Balance Sheet "balances" because, at any moment, each side of the below equation must "balance out".
Assets = Liabilities + Owners' equity
The statement shows what the business owns (assets) and how much it owes (liabilities), as well as the amount invested in the business (equity).
This information is more valuable when the balance sheets for several consecutive periods are grouped together, so that trends in the different line items can be viewed and compared
*Equity is the net amount of funds invested in a business by its owners, plus any retained earnings re-invested.
*Assets are expenditures that have utility through multiple future accounting periods.
*Liability are legally binding obligations payable to another entity
It shows the balance between what we own and what we owe
How to compose a balance sheet
1) Long Term (Fixed) Assets |
Machinery £400 |
Office Equipment £90 |
Motor Vehicles £400 |
Land |
Buildings |
Total Long Term Assets £890 |
2) Short Term (Current) Assets |
Cash & cash equivalent £300 |
Inventories (stock) £60 |
Accounts Receivable (debtors) £150 |
Total Current Assets £510 |
|
3) Current Liabilities |
Accounts Payable £50 |
Notes Payable £200 |
Accrued Payroll £50 |
Total Current Liabilities £300 |
4) Long Term Liabilities £200 |
5) Equity (net worth) |
Assets (890 + 510) - Liabilities (300 + 200) = £900 |
*Long Term (non current) Assets purchased to allow the business to operate continuously for example; land / building / machinery / equipment / vehicles (these are often noted as PPE - plant, property and equipment). Note all of these are subject to depreciation (apart from land).
Intangible fixed assets, which may or may not be identifiable, are also included here. Identifiable intangible assets include patents, licenses, and secret formulas. Unidentifiable intangible assets include brand and goodwill.
*Short Term (current) Assets can be easily converted to cash within 1 year e.g. cash / bank balance / stock /
Accounts Receivable - money owed to the business (customers / suppliers / vendors)
Notes Receivable - Written promise to receive money at a future date e.g. interest and principal.
*Current Liabilities are debts of business scheduled for repayment within 1 year.
Payables (creditors) - suppliers, service providers, gas, electric, phone, trade suppliers
Accounts Payable - owed to creditors, suppliers, vendors
Notes Payable - Vehicle payments, bank notes
Accrued Payroll - wages owed to employees but not yet paid
*Long Term Liabilities are debts for repayment after 1 year or more e.g. long term loans, mortgage etc
Problems with Balance Sheets
The problem, which is rarely mentioned, is that very often entries are not analysed in a functional and accurate way. To correctly verify the financial position of a business, values on the balance sheet must be accurate. Here are a few examples;
Long Term Assets - have depreciation and amortisation been accounted for?
Accounts Receivable - the true value needs to be verified. How much is realistically collectible? How much has to be written off as bad debts?
Inventory- the true value needs to be verified. How much of the inventory can realistically be sold? How much still has vale? How much is slow moving or obsolete? How much has to be written off?
Another cause for concern is that many accountants do not implement live accounting. Often the balance sheet that the prepare is historical. It maybe be based on info provided 6 moths ago. The business in question maybe in a totally different position to that shown in the last prepared balance sheet.
Think of a balance sheet as a picture of a moment in time. The most accurate and realistic picture is the one closest to the present moment.
Important but easy to calculate financial ratios
There are some important financial performance metrics that can be calculated using the information from the balance sheet.
These ratios are very useful in providing a realistic and accurate assessment of the health of your business. They will verify whether or not a business is in good shape.
Liquidity Ratios
Working capital ( or current) ratio:
current assets ÷ current liabilities
This measures whether the business can pay its short-term debt obligations with its current assets.
A current ratio below 1.00 could indicate that a company might struggle to meet its short-term obligations, whereas ratios of 1.50 or greater would generally indicate ample liquidity.
Quick ( or acid test) ratio:
current assets - (inventory ÷ current liabilities).
This measures whether the firm can meet its short-term debt obligations
without selling any inventory.
A result of 1 is considered to be the normal quick ratio. ... A company that
has a quick ratio of less than 1 may not be able to fully pay off its current
liabilities in the short term, while a company having a quick ratio higher
than 1 can instantly get rid of its current liabilities.
Cash ratio:
cash + (cash equivalents ÷ current liabilities)
This indicates the ability of the firm to pay off all its current liabilities
without liquidating any other assets.
A high cash ratio is preferable because it indicates that a company can easily pay off its debt. Although there is no ideal figure, a ratio of not lower than
0.5 to 1 is usually preferred.
Solvency Ratios
The solvency ratios gauge how much debt financing the firm uses as compared to either its retained earnings or equity financing. There are two major solvency ratios:
Total debt ratio:
total liabilities ÷ total assets
This measures the percentage of funds for the firm's operations obtained by a combination of current liabilities plus its long-term debt.
Debt ratios of 0.4 or lower are considered better. A higher ratio, especially above 1.0, indicates that a company is significantly funded by debt and may have difficulty meetings its obligations.
Debt-to-equity ratio:
debt ÷ equity
This indicates how a company is funded, in this case, by debt. The higher the ratio, the more debt a company has on its books.
The Balance Sheet Summary
The Balance Sheet will help an owner understand the nature and scale of their business. It will help identify trends and indicates the significance of change over time.
Regularly formulating Balance Sheets can help a business expand in numerous ways (e.g. if you should increase cash reserves or if receivables should be collected more aggressively). It is a good reality check and an integral part of getting to know your numbers (read about the importance of knowing the language of your business).
As we have seen a Balance Sheet is easy to compose and very useful for any business owner. Consider doing one every 3 months, every year at the very least.
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