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The Balance Sheet, and What It Tells Us: Learning Objectives
The Balance Sheet, and What It Tells Us: Learning Objectives
1
1
Introduction
The word ‘balance sheet’ is widely used, although most people have never
seen one and have little idea what it shows. This chapter provides a gentle
introduction to balance sheets by showing how individuals can prepare
their own personal balance sheets, and how similar these are to company
balance sheets. It also gives some indication of the usefulness of balance
sheets: they can give an indication of what an individual or company is
worth (but with severe limitations). They also show what liabilities there
are, which can help to predict future bankruptcy.
Illustration 1.1
£,00
What I own
House 300,000
Furniture 4,000
Car 10,000
Premium Bonds and shares 6,000
Food and drink 200
Cash and bank w w w4v,w8w0w0
Total w3w2w5v,w0w0w0
What I owe
Mortgage 222,000
Bills (gas and electricity etc.) 1,000
Credit card w w w2v,w0w0w0
Total w2w2w5v,w0w0w0
be much more interested in your future earning power than they are in a
pile of second-hand clothes and some CDs.
Three main problems arise in trying to establish what any individual or
business is worth:
1 What items are we going to list? Are we going to include our 5-year-old
computer, our vinyl records, all the food in the kitchen, our educational
qualifications and our children? We might think of these as being some
of the best things we have, but we would probably exclude them. We
need some basis, or principle, for deciding what to include and what to
exclude.
2 How do we establish what particular items are worth? We attempt this in
several different ways, for example by looking at what they originally
cost, or what the second-hand value is, or what it would cost to replace
them.
3 What is our future earning power worth? Whether we look at an indi-
vidual, or a company, in many cases the money that they can earn in the
future is worth a lot more than a collection of bits and pieces that they
own. If you want to borrow money, you could tell your bank that you
expect to earn at least a million pounds during your working life, and ask
to borrow the million pounds now. The bank’s response is likely to be
short and not very sweet.
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You can, of course, make up your own rules, and decide that you are
worth £100,000. But if you want to compare your own wealth with
someone else’s, then you need to agree how the calculation is to be made.
Are you going to show your house at the amount you paid for it, or at the
market value now? Are you going to show your car at the amount you paid
for it, or allow for the fact that it has depreciated since you bought it? If you
attempt any comparisons like this you will soon find that you need some
agreed rules on what to include, and the basis of valuation to be used. You
will need accounting principles.
It is difficult to know what something is really worth until you sell it. I
might boast that my house is worth £500,000, but we might agree that it is
more objective to show it at cost; and it cost £300,000 a few years ago. The
accounting principle would be to list everything that we own, and show
everything at the original cost price.
Deciding what principle to adopt for furniture and for a car is more dif-
ficult. They have only a limited life, and are likely to depreciate over time as
we ‘use them up’. We could decide that a car has a 5-year life and write it
down by one-fifth each year.
Illustration 1.2
Assets
Long-term assets are called ‘fixed assets’. (It would be too simple just to call
them long-term assets!) But there is nothing ‘fixed’ about them. They
include cars, ships and aeroplanes, just as much as they include land and
buildings which seem to be more fixed!
Within the Fixed Assets section there are three main categories:
2 Tangible fixed assets: things like land and buildings; plant, machinery
and equipment; vehicles; furniture, fixtures and fittings.
We can say that things like vehicles or furniture are usually fixed assets, but
that is not always the case. If a business intends to use them for a period of
years, then they are fixed assets. But if someone is in business to buy and
sell vehicles, or furniture, then any items held short term, awaiting sale, are
not fixed assets.
The same arguments apply with investments. Any surplus funds invested
in shares, or loaned to someone or another business, might be intended to
be long term, and so are fixed assets. Or they might be intended to be short
term, and so are not fixed assets.
Short-term assets are called ‘current assets’. (Again, it would be too
simple just to call them short-term assets!) They include:
Liabilities
Liabilities are also categorized as short term and long term. It might be
tempting to call short-term liabilities ‘current liabilities’, and the term is
widely used. But on published balance sheets we have the following terms:
1 ‘Creditors: amounts falling due within one year’. This includes most
ordinary trade creditors – amounts due for goods and services bought
on credit.
Illustration 1.3
2 ‘Creditors: amounts falling due after more than one year’. This includes
long-term borrowings such as mortgages and debentures.
The balance sheet that we have been using so far can now be shown under
these four headings, which separate assets from liabilities, and long term
from short term (Illustration 1.3).
The distinction between what is short term and what is long term is
important in assessing the financial strength or solvency of a business – in
assessing whether or not it is likely to go bust!
3 There are occasions when crooked accountants and directors omit liabilities com-
pletely, or seek to hide them as some form of ‘off balance sheet finance’. This issue is
examined later in relation to ‘Creative Accounting’.
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A company’s current assets include money in the bank, debtors4 that are
due to become money in the bank within a few months, and stocks of
goods which the company plans to sell and convert into money in the bank
within a matter of months. If a company has a lot more current assets than
current liabilities, it should be able to pay its current liabilities when they
fall due. If their current assets are two or three times as much as their
current liabilities, then they appear to be fairly strong; or in the termi-
nology of accounting, they have a high current ratio.
In Illustrations 1.1 to 1.3 above, current assets are £5,000, and short-term
liabilities are £3,000. The current ratio is 1.67 : 1.5 This is not particularly
high, but it looks as if there is enough cash and near cash available in the
short term to be able to pay the short-term liabilities as they fall due.
It should be possible for all current assets to become cash within a matter
of months, but this is more difficult with some items than others. Not all
stocks of goods are easily and quickly turned into cash. A half-baked loaf
will probably be finished and sold for cash within a matter of hours. A half-
built house, in an area where no-one wants to live, could remain unsold for
a long time. If most of a company’s ‘current assets’ are actually stocks of
goods, their ability to pay creditors quickly may be less than their current
ratio suggests. A useful approach to assessing a company’s ability to pay its
short-term liabilities would be to exclude stocks from current assets, and
assess the company’s ‘liquidity’, by comparing their ‘liquid assets’ with
their short-term creditors. This is known as the liquidity ratio, or acid test,
or quick assets ratio.
Long-term debts are also important – a company or individual can go
bankrupt because of the weight of long-term liabilities. It is difficult to say
how much debt is too much – some people, and some companies, seem to
manage with huge debts, whereas others (like Marconi, and a number of
airlines recently) collapse. An individual who has lots of money can afford
to borrow lots of money. Similarly, a company with a large amount of
equity, or shareholders’ funds (the company’s ‘own’ money) can afford to
borrow more money than a company with very little equity. In Illustrations
1.1 to 1.3 above the amount of equity is £100,000, so it would seem reason-
able to borrow another £100,000. If a business is financed half by bor-
rowing, and half from its own shareholders’ funds, then the borrowing is
high, but probably not excessive. But in the above illustrations the bor-
rowing is much more than the equity. If we add together all of the long-
term funds (shareholders’ funds, plus long-term creditors # £322,000),
4 Debtors are customers who have not yet paid for the goods or services with which
they have been supplied.
5 £5,000 2 £3,000 # 1.67.
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then we can see that the assets of the business are mainly6 financed by
borrowing. In accounting terminology such a company is ‘high geared’,
which usually means high risk.
But high gearing, or high amounts of long-term debt, does not particu-
larly matter if the individual or company has a substantial amount of
income with which to pay the interest, and to repay the creditors (or
borrow more!) when repayment is due. Individuals who have to pay mort-
gage interest of £20,000 a year should have no problems if their annual
income is £100,000 a year or more. Someone who has to pay £20,000 a year
mortgage interest from an annual income of £25,000 is likely to have real
problems! It is worth comparing the amount of interest that has to be paid
each year, with the income available to pay that interest. If the interest is
covered, say, 5 times by the income, then it is probably all right. But if the
interest is covered only 1.25 times by the available income, then there are
likely to be problems.
In assessing the financial strength of a company, or how likely it is to go
bankrupt, it is worth calculating the current ratio, the liquidity ratio, the
capital gearing ratio, and the interest times cover.
It is important that all three of these can be found on the balance sheet, or
in notes to the balance sheet: the cost of an asset, the cumulative deprecia-
tion, and the net book value. As the above example shows, the net book
value is not an attempt to show what the asset is really worth now. We
decided to write off the initial cost of the car, down to an estimated trade in
value when we have finished with it, and to charge the same amount of
depreciation each year8 for 4 years.
In Illustrations 1.1 to 1.3 above depreciation has been ignored to simplify
it. The car is shown at £10,000. If we decided that a depreciation charge, or
expense, of £2,000 is appropriate, there would be two effects on the balance
sheet: the car would be reduced by £2,000; and the equity, or net worth
would be reduced by £2,000. We saw that the basic balance sheet equation is
Assets 0 Liabilities # Equity9
Depreciation is an expense and we can now say that assets minus expenses
minus liabilities equals equity: a new equity figure emerges after expenses
have been deducted. Ilustration 1.4 shows how the balance sheet changes as
a result of charging expenses, earning income, and making a profit.
If we take the balance sheet at the end of one year, and compare it with
the balance sheet at the end of the next year, we can get a fairly good idea of
the amount of profit that was made in the period between the two dates. All
we do is compare the figure for equity, or net assets, or shareholders’ funds
on the most recent balance sheet with the equivalent figure a year ago. This
is shown in Illustration 1.4. The amount of equity or shareholders’ funds
has increased by £25,000 during Year 2: it looks as if the company has made
£25,000 profit. The profit has shown up in additional stocks, debtors and
cash: they have increased by £29,000. But fixed assets have gone down by
£2,800 (depreciation), and there are additional liabilities of £1,200; the
increase in net assets is £25,000.
Without more evidence we cannot always be sure that the increase in net
assets is the profit for the year, for three main reasons:
1 It could be that the amount of equity has increased because shareholders
have put more money into the business; there has been a new issue of
shares. Any extra coming in from the issue of shares does not count as
profit, and so should be deducted from the increase in equity shown on
the balance sheet to arrive at the profit figure for the year.
2 All of the profits that have been made do not necessarily stay within the
business. Most companies pay out dividends. They can make a substan-
tial profit, and pay most of it out as dividends. Dividends do not reduce
profits. But they do mean that any increase in equity is not the whole of
the profit. Dividends must be added to the increase in equity in calcu-
lating the profit for the year.
3 Sometimes companies revalue their assets. This does not seem to have
happened in Illustration 1.4. If the freehold land and buildings were really
worth £350,000, the company could add £50,000 to the figure shown on
the balance sheet for freehold land and buildings; and they would have to
add £50,000 to equity; it would probably be separately labelled as a
‘Capital reserve’. The company would then appear to be £50,000 better
off, but we would probably not think of this as being profit.
A balance sheet is not the most convenient way of calculating profit, but
it can be done! Profit for the year is the increase in equity during the year,
minus any additional shares that have been issued, plus any dividends that
have been provided.
The third of these is more problematic. Are we going to use the term
‘profit’11 for the whole of the increase in equity (after making the two
11 Profit is very British. The more international term is ‘income’. Or you can use the
term ‘earnings’ when you want to keep changing the terminology in order to
impress, and confuse the enemy. Be careful, though; they might know more about
accounting than you do.
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Illustration 1.4
Current assets
Stocks 200 9,000
Debtors – 20,000
Cash and Bank w w w4v,w8w0w0 w w w5v,w0w0w0
5,000 34,000
Current liabilities
Creditors
w w w3v,w0w0w0 w w w4v,w2w0w0
Net current assets w w w2v,w0w0w0 w w2w9v,w8w0w0
Total assets less current liabilities 322,000 347,000
12 Because they have more stocks than debtors, since they sell mainly for cash, not on
credit.
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Illustration 1.5
25 January 26 January
2003 2002
CONSOLIDATED BALANCE SHEET
At 25 January 2003 Notes £’000 £’000
Fixed assets
Tangible assets 11 15,375 12,167
Investments 12 349 446
15,724 12,613
Current assets
Stocks 13 13,937 12,318
Debtors 14 6,975 5,711
Cash at bank and in hand 2,778 3,875
23,690 21,904
Creditors: amounts falling due
within one year 15 (16,456) (14,333)
Net current assets 7,234 7,571
Total assets less current liabilities 22,958 20,184
Creditors: amount falling due
after more than one year 16 (4,000) (4,000)
Provisions for liabilities and charges 17 (123) (461)
Net assets 18,835 15,723
Capital and reserves
Called-up share capital 18 2,072 2,064
Share premium 19 1,412 978
Profit and loss account 19 15,411 12,638
Equity shareholders’ funds 20 18,895 15,680
Minority interests – equity 19 (60) 43
Total capital and reserves 18,835 15,723
The gearing is relatively low, which means that the company is not heavily
dependent on long-term borrowings. The gearing has also fallen, which
means that their already low risk in 2002 was even lower in 2003.
The total of capital and reserves increased by about £3 million during the
year which suggests that the company’s retained profit for the year was
about £3 million. The profit and loss account (Illustration 2.3 in Chapter 2)
shows that they made about £6.6 million profit; £3.6 million was paid out
as dividends; this left about £3 million as retained profit.
The total for net assets (or total capital and reserves) is shown as being
nearly £19 million. This is sometimes referred to as the ‘balance sheet value’
of the company. But the market value of a successful company should be
much higher than its balance sheet value. The ‘market capitalization’ of the
shares of a company is shown in the Financial Times on a Monday.
In September 2003 the market capitalization of Ted Baker plc was about
£145 million.
Published accounts show a lot more detail than the simplified balance
sheets included in this chapter. A great deal of additional information is
shown in notes to the accounts.
that one checks the other. The balance sheet approach to measuring
profit is one of the two main approaches, and one that may become
much more important.
balance sheet which shows the amount of capital employed. The ratio of
profit to capital employed is a key ratio in assessing and improving a
company’s financial performance.
7 Financial accounting is a whole system, and the balance sheet is an essen-
tial part of the system in checking, balancing and controlling other parts
of the system. If a company’s balance sheet does not balance, there is
definitely something wrong! Accountants are only (or nearly!) human,
and inevitably some mistakes are made with figures. The financial
accounting system is designed to show up errors, and to find where they
occurred. An accounting system can also show up fraud and theft. When
a balance sheet does balance, we cannot be sure that there is no fraud or
error. If it does not balance we can be sure that something is wrong; and
if we do make a mistake, it will probably show up during the accounting
processes before producing a balance sheet.13
But we should not expect too much from balance sheets. They were never
properly designed to achieve anything very useful. When double entry
bookkeeping first became widely used, the balance sheet was just a matter
of bookkeeping convenience. It was not even necessary to produce one
every year. Until the eighteenth century a balance sheet was often not pro-
duced until the ledger was full; then a balance sheet was a summary of the
assets and liabilities that were transferred to the new ledger. Any remaining
old balances, mostly revenues and expenses, were written off. The balances
shown on the balance sheet are items that are continuing, but they tend to
be shown at the cost price when they are first entered in the business’s
books.
By the end of the eighteenth century the production of balance sheets on
an annual basis became normal. During the nineteenth century it became a
requirement for companies to publish annual balance sheets; and during
the twentieth century legislation became increasingly specific about what
should be shown on a balance sheet. Towards the end of the twentieth
century accounting standards laid down more detailed requirements, and
by 2005 the European Union will require the application of International
Accounting Standards in the same way as many other countries.
The main limitations of balance sheets have already been referred to:
1 What items are we going to include?
2 How do we establish the value of particular items?
3 The value of a company as a whole is likely to be very different from the
total net value of the individual assets and liabilities.
SUMMARY 19
Summary
A balance sheet shows the liabilities of a company, and solvency ratios can
give an indication of whether a company is likely to become insolvent.
Assets are not usually shown at their current value, and care is needed in
using balance sheets as an indication of the value of a company. A business
as a whole, as a going concern, is usually worth much more than the total
of its net assets.
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Self-testing Questions
1 Which of the following are shown on a balance sheet?
Assets; Expenses; Liabilities; Sales; Share Capital; Profit for the year
2 What is the difference between a fixed asset and a current asset?
3 Give examples of fixed assets. In what circumstances would some of the items you have listed
be current assets?
4 Arrange the three main balance sheet items (Assets, Liabilities, Equity) as an equation.
5 A balance sheet appears to show what a business is worth. What are the main problems with
this statement?
6 You are given the following simplified balance sheet of the Sandin Castle Company:
£00 £00
Fixed assets 50,000
Current assets
Stocks (at cost) 24,000
Debtors 12,000
Cash w w9v,w0w0w0
45,000
Creditors w2w2v,w0w0w0 w2w3v,w0w0w0
w7w3v,w0w0w0
Share capital 50,000
Retained profits w2w3v,w0w0w0
w7w3v,w0w0w0
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SELF-TESTING QUESTIONS 21
(a) How much profit does it at first seem that the company made during Year 2?
(b) How would your answer to (a) be affected if you found out that the company had paid
£10,000 in dividends; that additional shares with a value of £20,000 had been issued; and
that fixed assets had been revalued upwards by £30,000?
8 You are given the following simplified balance sheets of the Domer Castle Company and the
Warmer Castle Company as at 31 December Year 1:
Domer Castle Warmer Castle
Fixed assets £,00 £,00 £,00 £,00
Tangible assets
Freehold land and buildings (at cost) 300,000 100,000
Furniture (at cost less depreciation) 4,000 80,000
Vehicles (at cost less depreciation) w w1w0v,w0w0w0 w w9w0v,w0w0w0
314,000 270,000
Investments – 314,000 w w4w4v,w0w0w0 314,000
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Current assets
Stocks 8,000 19,000
Debtors 12,000 10,000
Cash and Bank w w1w4v,w0w0w0 w w w5v,w0w0w0
34,000 34,000
Current liabilities
Creditors
w w1w7v,w0w0w0 w1w7v,w0w0w0
Net current assets w w1w7v,w0w0w0 w w1w7v,w0w0w0
Total assets less current liabilities 331,000 331,000
Creditors: amounts falling due after more than
one year
10% Debentures w1w0w0v,w0w0w0 w2w0w0v,w0w0w0
w2w3w1v,w0w0w0 w1w3w1v,w0w0w0
Capital and reserves
Share capital 100,000 100,000
Retained profits w1w3w1v,w0w0w0 w w3w1v,w0w0w0
w2w3w1v,w0w0w0 w1w3w1v,w0w0w0
During Year 1 the operating profit (earnings before interest and taxation14) of the Domer
Castle Company amounted to £31,000. The operating profit of the Warmer Castle Company
amounted to £32,000.
Which of the two companies appears to be financially weakest, and why? You should calcu-
late the current ratio, the liquidity ratio, the capital gearing ratio, and the interest times cover.
9 You are given the following simplified balance sheet of the Stonefolk Company as at 31 March
Year 4:
£00, £00,
Fixed assets 158,000
Current assets
Stocks (at cost) 110,000
Debtors 120,000
Cash w w2w0v,w0w0w0
250,000
Creditors w1w2w0v,w0w0w0 w1w3w0v,w0w0w0
w2w8w8v,w0w0w0
Share capital 250,000
Retained profits w w3w8v,w0w0w0
w2w8w8v,w0w0w0
14 ‘EBIT’ is a widely used measure. It is not always the same as operating profit.
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ASSESSMENT QUESTIONS 23
(a) The following transactions took place in April Year 4. Show how each would affect the
balance sheet. (Each transaction must affect two or more figures, and the balance sheet
must continue to balance.)
(i) A building which had cost £80,000 was sold for £100,000 which was immediately
received in cash.
(ii) Stocks which had cost £30,000 were sold to Mr Spliff for £80,000. Mr Spliff agreed
to pay for the goods by the end of May Year 4.
(iii) The company paid £40,000 of the amount that it owed to creditors.
(b) Show how the balance sheet would appear after these transactions have been recorded.
Assessment Questions
1 What are the main functions of a balance sheet?
2 You are given the following simplified balance sheet of the Hackin Company as at 30 June Year 9:
£00 £00
Fixed assets 250,000
Current assets
Stocks (at cost) 60,000
Debtors 40,000
Cash w1w2w0v,w0w0w0
220,000
Creditors w1w0w0v,w0w0w0 w1w2w0v,w0w0w0
w3w7w0v,w0w0w0
Share capital 250,000
Retained profits w1w2w0v,w0w0w0
w3w7w0v,w0w0w0
3 You are given the following simplified balance sheets of the Fourpine Company as at
31 December:
Simplified Balance Sheet of Fourpine Company as at 31 December
Year 1 Year 2
£00, £00, £00, £00,
Fixed assets 520,000 450,000
Current assets 45,000) 55,000)
Deduct: Creditors: amounts falling
due within one year v(w3w0v,w0w0w0v) v(w3w5v,w0w0w0v)
w w1w5v,w0w0w0 w2w2w0v,w0w0w0
535,000 470,000
Deduct: Creditors: amounts falling
due after more than one year w2w0w0v,w0w0w0 w1w0w0v,w0w0w0
w3w3w5v,w0w0w0 w3w7w0v,w0w0w0
Shareholders’ funds
Share capital 300,000 310,000
w w3w5v,w0w0w0 w w6w0v,w0w0w0
w3w3w5v,w0w0w0 w3w7w0v,w0w0w0
(a) How much profit does it at first seem that the company made during Year 2?
(b) How would your answer to (a) be affected if you found out that the company had paid
£25,000 in dividends?
4 You are given the following simplified balance sheets of the Port Andrew Company and the
Port Edward Company as at 31 December Year 1:
ASSESSMENT QUESTIONS 25
Current liabilities
Creditors w w7w0v,w0w0w0 w w8w0v,w0w0w0
Net current assets w w6w0v,w0w0w0 w1w1w0v,w0w0w0
Total assets less current liabilities 660,000 540,000
Creditors: amounts falling due after more
than one year
10% Debentures w3w0w0v,w0w0w0 w1w0w0v,w0w0w0
w3w6w0v,w0w0w0 w4w4w0v,w0w0w0
Capital and reserves
Share capital 300,000 300,000
Retained profits w w6w0v,w0w0w0 w1w4w0v,w0w0w0
w3w6w0v,w0w0w0 w4w4w0v,w0w0w0
During Year 1 the operating profit of the Port Andrew Company amounted to £61,000. The
operating profit of the Port Edward Company amounted to £40,000.
Which of the two companies appears to be financially weakest, and why? You should calcu-
late the current ratio, the liquidity ratio, the capital gearing ratio, and the interest times cover.
5 You are given the following simplified balance sheet of the Whiting Company as at 31 August
Year 6:
£0,0 £00,
Fixed assets 350,000
Current assets
Stocks (at cost) 90,000
Debtors 80,000
Cash w w3w0v,w0w0w0
200,000
Creditors w1w3w0v,w0w0w0 w w7w0v,w0w0w0
w4w2w0v,w0w0w0
Share capital 380,000
Retained profits w w4w0v,w0w0w0
w4w2w0v,w0w0w0
(a) The following transactions took place in September Year 6. Show how each would affect
the balance sheet. (Each transaction must affect two figures, and the balance sheet must
continue to balance.)
(i) A new machine costing £10,000 was purchased and paid for in cash.
(ii) Stocks which had cost £50,000 were sold to Mrs Fish for £90,000 and paid for
immediately in cash.
(iii) £30,000 was received from debtors.
(b) Show how the balance sheet would appear after these transactions have been recorded.
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