The balance sheet: a snapshot of business health

2008-07-14 00:00

Over recent weeks, we have been looking at the importance of cash to business and both its relation to and differences from “profit” and how these are reported in our management accounts.

This touched on how some activities are accounted for in the balance sheet differently, or separately, to the profit and loss statement.

I also mentioned that there are times when a specific need for funding may arise. If you are looking for cash, a loan or an investment, you will have to produce a balance sheet. It can also be used as a management tool.

The balance sheet is a snapshot taken at a particular point in time that reflects a business’s health, particularly when compared to the income statement.

This snapshot is usually produced to accompany monthly management accounts and annual audited accounts and is taken at the end of the last day in the trading period.

Although the balance sheet won’t give detail of trading activities (as with the income statement), it will show the nature of that trading period in respect of the business’s ability to generate profit and cash — and what the business did with them.

The balance sheet tells us how much money there is in the business and how it is being used. It also shows what a business owns; is owed (the assets) and what the business owes (the liabilities).

As its name implies, there are two fundamental aspects to a balance sheet that must balance out: the assets and the liabilities.

In other words, what a business owns or is owed (assets) will always balance with what it owes (liabilities).

So what is positioned where, in our snapshot of the business?

On the assets side, the items break into either fixed or current assets.

Fixed assets include buildings, plant, land, machinery, equipment, etc, and also, intangible assets such as trademarks, intellectual property and long-term investments.

Current assets are short-term assets, where values can fluctuate daily dependent on trading performance. These would include stock, debtors (money owed to you by your customers), cash in the bank or on hand, etcetera.

The liabilities also break into two groups: current and long-term liabilities.

Current liabilities are amounts owed or payable within one year and includes trade creditors (money owed to your suppliers), VAT and PAYE, short-term loans, overdrafts and company tax.

Long-term liabilities includes loans and financing repayable after one year, such as members’ or directors’ loans and finance agreements (often for purchases of fixed assets like buildings or vehicles). Also included under long-term liabilities are share capital and retained profits, both of which the business is liable to pay to its shareholders/owners in the future.

Many measurements of the business’s health involve comparing the balance sheet with the income statement.

What you want to measure and why will determine the questions you need to ask of the balance sheet and which “measurement ratios” you would apply.

For example, a bank manager considering increasing an SME’s overdraft will ask: What is the nature of the fixed assets? Were they good investments? Are they being maintained? If they were sold today, how much money could they realise? What is the nature of the current assets? Is there lots of stock they won’t sell for a long time? What is the size of the overdraft? Is it increasing and can they afford it?

In terms of establishing the health of your business and interpreting your balance sheet assets and liabilities, these will relate to monitoring the level of your current assets and liabilities: stocks, debtors, creditors, cash reserves, loan balances and so on. If your stock levels are increasing each month but sales are flat, you may be buying too frequently or too much or the wrong type of stock.

If the amount of debtors compared against sales is steadily increasing, this is your money sitting in your customers’ banks. You should be chasing that money into your business.

You can also benchmark your measurements against industry standards. Used regularly, the balance sheet will give that instant picture of how healthy your business is today.

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