I always feel like the balance sheet is the ugly duckling of the accounts. The bold and brash profit and loss account gets all the glory while the poor old balance sheet is ignored and misunderstood. It’s time to bring the ugly duckling balance sheet out of the dark corner, dust it off and show you how it can be a beautiful swan for your business.
How is the balance sheet different to the profit and loss account?
The balance sheet is a snapshot, showing how the company stood at a particular moment in time, usually your year end. This is different from the profit and loss which shows the sum of all the transactions in the year; all of your sales less all of your expenses.
The balance sheet shows the overall financial position of the company at that point in time. It about more than just profit. It shows what the company owns and is owed (assets) versus what it owes to others (liabilities).
Why is it called a balance sheet?
It’s called a balance sheet because it balances! There are three section to the balance sheet, the assets, the liabilities and the equity. They always balance in the same way.
assets – liabilities = equity.
But what do these terms means?
Assets are what the company owns such as plant and machinery, property, vehicles, cash in the bank, stock inventory and also what it is owed e.g. unpaid customer invoices (at that point in time). It can also include prepayments – see here for more details.
Liabilities are what the company owes to other people such as unpaid supplier invoices, bank overdrafts and loans. It can also include accruals – see here for more details.
Equity is probably the least familiar of the three terms. The company belongs to it’s shareholders and the equity section represents the value from the company that is available to the shareholders. It consists of the shares, plus any profit left over after tax (including retained profit from previous years), less any dividends that have been declared.
A positive balance sheet means that there is value in the company for the shareholders. A negative balance sheet means that there have been more liabilities than assets so overall there is no value in the company available for the shareholders. A company can have made a profit for a particular financial year and still have a negative balance sheet if there have been a run of bad years before.
How does the P&L fit in with the balance sheet?
The profit after tax (or the loss) from the P&L becomes part of the equity figure on the balance sheet. That profit can be distributed to the shareholders as dividends or carried forward for future years as retained profit.
Why is the balance sheet useful to me?
The balance sheet can help you work out what dividends the company can afford, using the equity figure. The maximum dividends available is the equity figure less the value of the shares. So if equity on your balance sheet is £3,500 and the share value is £100, then you could declare up to £3,400 in dividends.
The balance sheet is also used by investors trying to assess the value or potential of a company. If you are applying for finance such as a loan, the bank or investment company will look carefully at your balance sheet. Investors look for a positive balance sheet and also look at particular ratios of assets versus liabilities.
What should I look for on my balance sheet?
We’ve already talked about how you can use the balance sheet to work out your dividends but what else can you look for to help your business?
Take a look at your assets. They are listed in order of how easy they would be to release the cash. Property, plant and machinery are at the top (fixed assets). Cash in the bank is at the bottom. Are your assets evenly spread or is all the money all tied up in the fixed assets? The distribution of your assets can give you a clue as to why you might be having cash-flow issues.
Take a look at your liabilities. Like the assets they are listed in order. The most urgent liabilities or debts are at the top (current liabilities) and longer term loans are lower down. Again looking at the distribution of short term versus long term liabilities can give insight into your cashflow. You might spot that the biggest liability is you. If you (as the company director) have lent money to the company then it’s largest creditor could well be the director’s loan account.
You can look at the Quick Ratio which shows how liquid (solvent) the company is. Take the figure for current assets (not including inventory) and then divide this by the current liabilities. If the answer is 1 or more then you’ve got enough cash and liquid assets to cover your short term debt.
The end of this bedtime story
The balance sheet is so much more than just the second page of your accounts. Once you get familiar, you’ll grow to love the balance sheet for the many ways it can be used within your business and of course for it’s dependable and inevitable balance. So embrace your balance sheet, let it blossom and turn from an unwanted ugly duckling into a beautiful swan.