Understanding a Balance Sheet

“I run a small creative business and every year my accountant sends me my tax return and accounts which include a profit and loss account and a balance sheet. I understand my profit and loss account but find my balance sheet a mystery. Can you help me understand what a balance sheet is and how it can help me.”

Understanding a Balance Sheet

Answer, July 2016

You are not alone – many people understand what a profit and loss account is, but find it much trickier when it comes to a balance sheet.

A balance sheet represents a businesses financial strength at the balance sheet date.

International terminology now refers to a balance sheet as a ‘statement of financial position’, however we will continue to refer to it as a balance sheet in this article, as that is the term still commonly used.

If your business year end is 31 March 2016, the balance sheet for that year will represent the financial position of the business at the close of play on 31 March 2016.

This differs to a profit and loss account, which will detail the income and costs for the whole period in question.

The top section of a balance sheet represents the businesses assets and it’s liabilities, giving an overall ‘net asset’ position.

The bottom section of the balance sheet shows how the financial position has been attained, through a combination of cumulative retained profit and equity (share capital), in the case of companies.

Let’s work through an example of a simple balance for a limited company:

 

Balance Sheet Example 2

Fixed assets

Fixed assets are assets held by the business that typically have a useful life  beyond a year.

In our example, these are computer and office equipment purchases that have been booked to the balance sheet and will then be ‘depreciated’ to the profit and loss account over their useful lives – this will typically be 3 – 5 years.

The £2,500 value on this balance sheet report is the ‘net book value’ of the assets, which is the purchase price less the depreciation to date.

Current assets

Current assets are day-to-day assets held by the business, for example:

Trade debtors – the value of monies owed to the business by its customers

Stock – goods that have been purchased for re-sale but which had not been sold at the balance sheet date

Cash – the total value of the businesses cash holding which may include business current accounts, deposit accounts and petty cash.

Current liabilities

The opposite to current assets, these are day-to-day liabilities of the business, including:

Trade creditors – unpaid supplier invoices

Corporation tax – in our example the business is a limited company, so this is the balance of corporation tax owed to HMRC at the balance sheet date.

VAT – the current amount of VAT owed to HMRC

 

Net assets

The net assets figure is the total of fixed assets plus current assets less current liabilities.

This represents the amount of retained earnings that are left within the business once it factors in paying all liabilities and converting all assets.

If you were to draw a line under the business at the balance sheet date, the net assets figure would be the amount of money left within the business once all positions were settled.

A strong business will have a positive and growing net asset position as this will mean it has capital to support future investment and to help get through tough trading conditions.

Capital and reserves

The bottom section of the balance sheet shows the same total as the net assets figure but it is broken down by:

Share capital – how much money has been put into the company as payment for shares

Profit and loss – this is the running profit/loss position over the life of the business from day 1, after factoring in corporation tax and any dividends paid.

The advice in this article covers a simple balance sheet – larger businesses will have more complicated balance sheets with different classifications.