8.2 Understanding the 'balance sheets'

10/10 Key terms to understanding the balance sheet

1. Balance sheets - this lists the value of a company's assets and liabilities
2. Assets - items of value owned by a business
3. Liabilities - debts owed by a business
4. Liquidity - how easy it is for a business to pay its short term debts (turn its assets into cash if and when required)
5. Fixed assets - these are items owned by the business with a lifespan of more than one year and are assets that are harder to liquidate into cash e.g. buildings and machinery
6. Current assets - these are assets owned by the business that are either in a cash form or are likely to be turned into cash within the year e.g. stock, cash in the bank, cash in hand. 
7. Current liabilities - short term debts of the business which have to be repaid within the year e.g. money owed to suppliers for goods received
8. Net current assets - If the business has short term debts greater than current assets it may have difficulty paying these debts and continuing to trade
9. Net assets - the value of assets after all liabilities have been subtracted
10. Capital and reserves - the cash available to run the business and will include retained profits and the values of shares issued and purchased by shareholders 

In the news In autumn 2008 customers of Northern Rock started panicking and queuing up to withdraw all their savings.  The company could not find cash quick enough and eventually to stop the panic the government launched a rescue attempt by NATIONALISING the bank to guarantee the savers deposits. Much of the lack of confidence was due to the items not visible on the balance sheet. The bank had lent money to some who where a high risk of defaulting.  These high risk debts were liabilities and should have appeared on the balance sheet but were hidden.  If they had have been visible they would have shown how much risk was being carried by the bank.  The riskiest of these debts were so well hidden on the balance sheet no one in the public could see them as they were kept 'off balance sheet' These debts were held under another company name in offshore accounts which was legal to do at the time.

Web based activity All public limited companies have to produce a balance sheet and make it available to the public.  Often these are available online.  Go to the corporate website of a company in which you are interested and look at its balance sheet.  What judgments can you make about the business from the balance sheet. What else do you need to know to support your judgement?

Did you know Assets do not always keep the same value.  As they get older they will fall in value or depreciate.  A £900 computer might be considered to have a limited life so may be considered to be worth £900 in year one, £600 in year 2 and £300 in year 3 and nothing in year 4.  Stakeholders need to know which assets are likely to loose value and how this is calculated in the accounts.   

The balance sheet shows what the business has in the way of possessions and how these have been financed.  It therefore shows the business how much it owns as against how much it owes - simples !

Assets The balance sheet may be divided into THREE parts:

1. ASSETS, 
2. LIABILITIES, and how 
3. CAPITAL has been raised.  

The first part ASSETS measures the assets of the business or all the things that the business OWNS.  These are either FIXED and include things like building s or machinery used in production or CURRENT items like STOCK , finished PRODUCTS or MONEY owed that can be easily turned into CASH.  Some assets may be difficult to put a figure on.  When a business is sold, a value is often put on it's 'goodwill' This values its reputation and standing with its customers.  Assets include everything that a business owns to which a value can be attached so in some cases items like goodwill will be included.  Such assets cannot be physically touched and are so called 'intangible' assets.  In most cases an 'asset' entry also means a 'liability' entry in order to keep the balance e.g.if a business buys £10,000 of stock it must have spent £10,000 in cash or have a debt or credit with the supplier of £10,000.  Hence these suppliers are called CREDITORS making sure that the STOCK (asset) and its COST (creditor) both appear.

Liabilities The second part of the balance sheet shows liabilities - these are all the things that a business owes.  These are either CURRENT debts that need to be paid back within a year such as a bank overdraft or creditors or LONG TERM - debts that a business has more than a year to repay, such as long term loans and mortgages.  These are separated out in the account.

Working capital is calculated as current assets minus current liabilities.  This figure is important as it shows the ability of the business to repay its short term debts.  If there is a positive working capital balance then it is possible for the business to meet its day to day needs. Suppliers, banks, and other creditors will be confident that they will not only be paid but they will be paid on time.  If working capital is negative the business will struggle to pay its bills

Net assets employed shows fixed assets (in this case £200,000) plus working capital (£40,000) .  From this figure the business then takes away its long term liabilities to show its NET ASSETS.  This is what the business is worth at this moment in time. 
These assets have been financed in various ways, including loans, retained profit, and share issues.  This is shown on the final part of the balance sheet - the CAPITAL ACCOUNT

Using the balance sheet The balance sheet has limited use as it can only be used to represent a situation at a particular moment in time.  It is therefore looking at FLOWS of FINANCE and changes in such flows. To show trends you would need to compare one balance sheet at one point in time with another taken earlier or later.  It is therefore often referred to as a SNAPSHOT. It is however very important to:

• investors
• creditors
• mangers and 
• competitors

Discussion Each person in the group should take the role of one different stakeholder group and say why the balance sheet of a company might be of particular importance to that group 

Exam questions based around understanding assets and liabilities on a balance sheet

1. What is meant by an 'asset'?
2. Explain the difference between fixed assets and current assets.
3. A strong brand name would be considered to be what sort of asset?
4. Define 'creditor'
5. What is meant by 'liability'?
6. Explain the difference between current liabilities and long term liabilities.
7. Define 'debtor'
8. What is meant by 'capital'?
9. Explain what is meant by 'working capital'
10. Outline what is shown on the capital account.

Worksheets click here to get you head around the principles

Nine mark question