Balance Sheets

A balance sheet is a statement of a firm's assets, liabilities and owners' equity at a specific date
(i.e. it is a "snapshot" of the financial strength of a business at a particular moment in time).

It summarises the financial state of the business at that date. When added together, the liabilities and
owners' equity represent the sources of capital (i.e. it tells us where the money came from) and the assets
represent the uses of the capital (i.e. it tells us how the money was spent).

The two sides of the account must always balance, since every penny raised as capital must have been used
for some purpose and must be accounted for.

 Assets

An asset is an item that will give present or future monetary benefits to a business as a result of economic
events. Therefore, an asset is basically an item or money that the business owns.

There are two main types of classification of assets - fixed assets and current assets.

a) A fixed asset

b) A current asset

 Fixed Assets

A fixed asset is acquired for the purpose of use in the business and is likely to be used by the business for
a considerable period of time (more than 12 months).

There are three categories of fixed assets:

a) Tangible fixed assets (physical items such as land, buildings, machinery, and vehicles, the purchase of
which is known as 'capital expenditure').

b) Intangible fixed assets (non-physical items, which are very difficult to place a value on, such as brand
names, goodwill and patents).

c) Financial fixed assets (investments that the business has, such as shares and debentures in other
companies).

 Current Assets

A current asset is either part of the operating cycle of the enterprise or is likely to be realised in the form
of cash within 12 months.

There are five categories of current assets:

a) Cash in the bank.

b) Cash on the premises ("petty cash").

c) Debtors (customers who have purchased goods on credit, and have not yet paid).

d) Stock (raw materials, work-in-progress and unsold finished goods).

e) Prepayments (where the business has paid in advance for the use of an item, rent for example).

 Liabilities

A liability is the amount outstanding at the balance sheet date, which the business is under obligation to
pay. Therefore, a liability is basically an item or money that the business owes to a third party.

There are two main types of classification of liabilities:

a) Long-term liabilities

b) Current liabilities

 Long-term liabilities

A long-term liability is a source of long-term borrowing and will exist on the balance sheet for more than
12 months. There are three categories of long-term liability:

a) Bank loans.

b) Mortgages (essentially a long-term loan to purchase land and buildings).

c) Debentures.

 Current Liabilities

A current liability can be simply defined as amounts of money owing to third parties which will be settled
within 12 months. They arise mainly through the process of day-to-day trading and there are five
categories.

a) Bank overdraft.

b) Creditors (suppliers who the business has not yet paid).

c) Accruals (debts for which a bill has not yet been received).

d) Corporation tax (owed to the Government).

e) Dividends payable.
  Shareholders funds

There are several other items that appear on a Balance Sheet - most notably shareholders' funds (also
called'owners equity') and reserves.

These items show us where the business got its original capital from (i.e. the money it used to start-up),
how much money the shareholders have a claim on within the business and what the business has done
with any retained profits over the years.

It also shows us the effect of a rise in value (an appreciation) of any of the assets owned by the business.

In a sense, owners' equity is a liability of the business, in as much as it is a claim on the assets. However, it
differs from other liabilities in that it does not have a definite date by which it is to be repaid and it is not a
fixed amount.

The owners' equity is usually left in the business as long as it is required and it can fluctuate in value.
Owners' equity is a residual claim on the business after all the other liabilities have been settled.

Using simple algebra, we can see that:

If Assets = liabilities + owners' equity

The
Owners' equity = assets - liabilities
n

Therefore, the owners of the business own the assets of the business less what the business owes to other
bodies.

 Balance sheet format

The usual layout for a balance sheet is as below:

Balance Sheet for 'My company PLC', as at 01/04/00

£(000) £(000)

Fixed Assets 500

Current Assets:
Cash 100

Debtors 150

Stock 50

Total Current Assets 300

Less Current Liabilities:

Overdraft 20

Creditors 140

Total Current Liabilities 160

Net Current Assets [=Working Capital] 140 [300-160]

640 [500+140
Net Assets [=Assets Employed]
]

Represented by:

Long-Term Liabilities 200

Share Capital 250

Reserves 190

640 [200 + 250 +

Capital Employed
190]

ASSETS EMPLOYED = CAPITAL EMPLOYED: the two parts MUST always balance.
Remember, a balance sheet shows what a company owns (assets), what it owes (liabilities) and where
the company got its money (capital) from at a specific point in time.

One of the most important parts of a balance sheet is the 'net current assets' section. This is the day-to-
day finance that is needed for running a business.

It is also referred to as 'working capital' and it is calculated by deducting current liabilities from current
assets. Working capital is used to pay for expenses such as wages, raw materials and utility bills.

If a business does not have sufficient working capital then it can face problems when paying its short-term
debts (current liabilities). It may be the case that the business suffers a liquidity crisis and has to sell off
some fixed assets, for example, in order to raise the necessary cash to meet its debts.

It is vital, therefore, that close control is kept over working capital, and the business must ensure that it
does all that it can to keep enough cash available to pay its current liabilities.

On the other hand, if the business has too much cash tied-up in working capital, then it can be argued that
this cash is not being used productively to help the business grow and diversify into new products and
markets.

 The purpose of a Balance Sheet

The purpose of a Balance Sheet is to communicate information about the financial position of the business
at a particular moment in time. It summarises information contained in the accounting records in a clear
and understandable form.

It can give an indication of the financial strength of the business and can also indicate the relative liquidity
of the assets.

It also gives some information on the liabilities of the business and when they will fall due. The combination
of this information can assist the user in evaluating the financial position of the business.

It should be remembered, however, that the Balance Sheet is only one part of the financial statements
required to give an accurate appraisal of the financial position of a business, and as such the importance of
just one of these statements should not be over-emphasised.

It is only by collectively analysing the Balance Sheet, the Profit & Loss account and the Cash
Flow Forecast of a business that an overall impression can be gathered on the financial
strength of the business.

Depreciation
The lives of fixed assets are not limited to a single accounting period (i.e. to 12 months).
Depreciation represents the fall in the value of these fixed assets, either due to their use, due to time, or
due to obsolescence. Essentially, depreciation divides up the historic cost of a fixed asset over the number
of expected years that it will be used by the business.

 Straight-line depreciation

The most common method of depreciation is the straight-line method -this method of depreciating a fixed
asset charges an equal amount to each year of its expected useful life.

The formula for its calculation is:

The depreciation charge per year

Example:

If a new machine is purchased by a business for £100,000 and it is expected to have a useful life of 5 years,
at the end of which it will be sold for a scrap value (residual value) of £10,000, then what is the
depreciation charge per year?

The depreciation charge per year

=£18,000

This means that after 1 year, the fixed asset will have a net book value (historic cost minus depreciation) of
£82,000.

After 2 years, the net book value will be £64,000.

After 3 years, it will be £46,000. After 4 years, it will be £28,000.

At the end of year 5, it will have a value of £10,000 (this is the same value as the residual or scrap value).

The depreciation charge per year will be entered in the profit and loss account of the business as an
expense, since it represents that part of the cost of the fixed asset that has been used-up (i.e. expired).
 Profit and Loss Account
The profit and loss account is a financial statement which represents the revenue that the business has
received over a given period of time, and the corresponding expenses which have been paid.

It also shows the profit that the business has made over a period of time (usually 12 months) and the uses
to which the profits have been put.

 Revenue

Revenue is the inflow of money to the business in the course of the ordinary activities of the enterprise.

There are a number of different sources of revenue;

 cash sales
 credit sales (i.e. where the business has sold goods to customers, but has not yet received the
cash)
 interest
 royalties
 dividends that the business receives on its investments or
 fees for hiring-out the resources of the business to a third party.

Revenue is recognised at either the receipt of the cash OR at the point of sale (if the goods are sold on
credit).

 Expenses

Expenses are expired costs (i.e. costs from which all benefits have been extracted during an accounting
period). Examples include wages, raw materials, and utility bills -often known as revenue expenditure.

It must be remembered that expenses are not necessarily the same as costs.

For example, if a business purchases a new fixed asset (such as a machine) then it will clearly incur the
monetary cost of purchasing the machine (say £50,000).

However, this £50,000 will not be written-off as an expense, since the benefits from the machine will last for
more than a single accounting period (i.e. for more than 12 months). Instead of writing-off the total cost of
the machine, a portion of the £50,000 will be written-off as an expense each year over the useful life of the
machine -this is known as a 'depreciation charge'.

 Format of the Profit and Loss account

The usual layout for a profit and loss account is as below:

Profit & Loss Account (01/04/99 - 31/03/00)

£00
£000
0

Sales Revenue 1,000

Cost of Sales:

Materials 300

Direct labour 200

Production overheads 100

(600)

Gross profit 400

Less selling expenses 100

Less administrative expenses 120

(220)

Trading [Operating] Profit 180

Add non-operating income (10)

Profit before interest and tax 190

Less interest expense (30)

Profit before tax [Net Profit] 160

Less taxation (60)

Profit after tax 100

Less dividends (20)

Retained Profit 80

The first line gives the Sales Revenue for the business from selling its goods and services.

From this, we deduct the "Cost of goods sold" (costs directly associated with the production of the goods
and services - such as the cost of the raw materials, the labour charges associated with the production, and
the production overheads. These are sometimes referred to as direct materials, direct labour and direct
overheads).

Sales revenue less C.o.G.S. is known as Gross profit.

However, we have not yet accounted for selling and administrative expenses (such as advertising costs,
distribution costs, salaries, utility bills, etc.).

When these are deducted from the Gross Profit, the result is known as trading or operating profit. These
refer to the profit made from normal trading activities.

The next adjustment is to add on any income from other activities, known as non-operating income (e.g.
renting out premises). The resulting figure is known as profit before interest and tax.

We then deduct a figure for interest charges. The resulting figure is known as profit before tax or net profit.

The final part of the account is known as the appropriation account. It provides information on the way
in which the profit is dispersed.

Some is taken in corporation tax and goes to the Inland Revenue, some is drawn from the business
asdividends to be distributed to the shareholders and the remainder is retained within the business for
re-investment.

 Window Dressing

This is a form of creative accounting and it basically involves manipulating various figures in the financial
accounts of a business, so to flatter its financial position.
 There are two key variables that a business may like its shareholders (and other stakeholders) to believe are
stronger than they really are:

 liquidity (the ease with which a business can raise cash quickly)
 profitability.

If a business is experiencing a deteriorating liquidity situation, then it can temporarily improve this
figure either by selling off fixed assets, or by using a 'sale and leaseback' scheme. This involves a business
selling a fixed asset (often land and buildings) to a third party, and then paying a sum of money per year to
lease it back.

The business still retains the use of the asset, but no longer owns it.

The cash from the sale of the asset will improve the liquidity of the business, and it will imply to the readers
of the accounts that cash is readily available. However, there are two drawbacks to this:

1. The 'fixed asset' figure on the balance sheet will have fallen after the sale of the land and
building.
2. The business is not tackling the cause of the liquidity problem.

Profitability can be improved by bringing some of the revenue for the next financial year's confirmed
orders into the current financial year.

This artificially boosts the 'sales revenue' figure for the current financial year and, therefore, also boosts the
profit figure for the business. Again, however, there are two drawbacks:

1. The business will not be able to count the money again for the next financial year when the orders
are dispatched -therefore the profit figure for the following year will be depleted of this revenue.
2. The business is not tackling the cause of the low profit figure.

Cash is the most liquid of all the assets of a business -it represents the bank balance and the cash that the
business has available on the premises (otherwise known as 'petty cash').

Cash Flow
 Cash Flows

Cash flow refers to the difference between the cash flowing into the business (e.g. through sales revenue)
and the cash flowing out of the business (e.g. bills and wages).

 Cash flow problems

Having a positive cash flow is vital for the survival of a business, since without the ability to pay workers
and suppliers then the business will soon have to cease trading.
 This potential problem is compounded by the fact that businesses often have to pay many expenses several
weeks or even months before any cash actually flows into the business.

For example, wages and salaries will have to be paid to employees, suppliers will have to be paid for any
raw materials, and the rent or mortgage payments will have to be paid before the products can be
manufactured and sold to customers.

Further to this point, if the products are sold on credit to customers, then the time delay between the cash
outflows and the cash inflows will be even longer.

The major causes of cash flow crises for a business are:

1. Overtrading -where the business attempts to expand too rapidly, without a sufficient financial
base.
2. Having too much money invested in stocks.
3. Allowing too much credit to their customers.
4. Unexpected changes in demand for their products.
5. Overborrowing -therefore having large monthly loan repayments, which have to be met.

There are many actions that a business can take when it is experiencing a liquidity crisis:

1. Offering price discounts to boost sales and sales revenue.

2. Selling off fixed assets.
3. A 'sale and lease back' arrangement.
4. Chasing debtors for the monies owed to the business.
5. Selling off stocks.

Whatever action is decided upon, the business must ensure that it is implemented quickly and that a careful
eye is kept on the liquidity (cash flow) position in the future.

 Cash flow statement

A cash flow statement is a Financial Accounting document, which shows the cash inflows and the
cash outflows for a business over the past 12 months.

It indicates those months in which the business suffered a cash flow crisis (where cash outflows were
greater than cash inflows) and it will also highlight those months in which the business was cash-rich (i.e.
more cash inflows than cash outflows).

It allows a business to prepare a cash flow forecast for the forthcoming year, by basing the estimated cash
inflows and outflows on the results from the previous year.

 Cash flow forecast

A cash flow forecast is a Management Accounting document, which outlines the forecasted future
cash inflows (from sales) and the outflows (raw materials, wages, etc) per month for a business over an
accounting period.

Example:

Total
Jan Feb Mar Apr
£

Sales revenue 2850 900 850 750 350

Other revenue 650 200 200 100 150

Total cash inflows 3500 1100 1050 850 500

Total cash outflows 3400 700 950 1200 550

Net monthly cash flow 100 400 100 (350) (50)

Bank balance 300 600 700 350 300

The business forecasts that in January it will experience cash inflows of £1,100 and cash outflows of £700,
leaving a positive net monthly cash flow of £400.

This is added to the £200 bank balance which existed at the end of December, to give a forecasted bank
balance at the end of January of £600.

In February, the forecasted cash inflows are only £100 more than the forecasted outflows, leaving a bank
balance of £700.

However, in the months of March and April, the business is forecast to experience negative net monthly
cash flows (i.e. its cash outflows are forecast to be greater than its cash inflows).

This gradually reduces the bank balance to just £300 by the end of April.

It is important for a business to produce a cash flow forecast, so that it can prepare for those months in
which it is forecast to experience a cash flow crisis (i.e. the business needs to arrange extra borrowing or
overdraft facilities to provide extra cash).
Alternatively, in the months where the business is forecast to be cash-rich, it can use this money profitably
elsewhere within the business (e.g. new product development).