Understanding your Financial Statements Part 3 – Balance Sheet
While the profit and loss statement tells you your business’s financial performance over a period, the balance sheet tells you your business’s financial position at one point in time. Your balance sheet tells you what your business:
- Owns (its assets)
- Owes to third parties (its liabilities)
- Owes to its owners (its owners’ equity)
The Balance Sheet in summary is:
Assets = Liabilities + Equity
The balance sheet summarises your business’s worth in financial terms. Let’s look at the above three terms in more detail.
Assets are items of value that your business owes. Assets will bring economic benefits to your business in future. A business bank account with $1,000 in it, is a $1,000 asset. Business equipment, financial investments and intellectual property are all assets.
Assets can be tangible or intangible. Tangible assets are physical such as office equipment while intangible assets are not physical such as the rights to use a tradename or a client database.
A firm may work hard and spend money building a brand that is valuable to the firm. The brand is an asset because it will attract clients and generate revenue. However, it is often hard to objectively value the brand, or goodwill, so it will usually not appear in the balance sheet.
If a brand, or other intangible asset had been purchased, then there is an objective value that will be brought into the balance sheet. This could happen if a firm buys another established firm and pays for the goodwill of the purchased firm. The portion of the purchase price allocated to the goodwill has been valued by the buyer and seller during negotiations.
Liabilities are amounts owed by the business to outside parties. Liabilities are obligations for future economic outflows. They include loans from banks or other financiers, bills owed to the firm’s suppliers, and overdrawn bank accounts.
Equity, or owners’ equity, is the net worth of the business to the owners. If the business were to sell all its assets for their values on the balance sheet, and pay off all its liabilities at the values on the balance sheet, the remaining money is the owners’ equity.
To look at it another way, a business needs assets to operate. Most businesses require at least some equipment and money to pay ongoing bills. These assets must be paid for and they can only be funded from two sources: liabilities from outsiders or equity from owners. The more the assets of the business increase, and the less liabilities the business has, the higher the owner’s equity, or net worth of the business.
Equity can take different forms. A company’s share capital is money paid by owners to the company to purchase their shares in the business. Share capital will generally remain the same unless the company issues more shares or buys some its own shares back.
When a business makes a profit, and retains the profit within the business, it is added to owners’ equity as “retained profits”. When part of those retained profits are paid out to owners, owner’s equity is reduced.
Date of Balance Sheet
As mentioned, a balance sheet shows the financial position of your business at a specified point in time. A business can prepare a balance sheet at any time, but would typically produce one for management purposes at a month end, or quarter end. Annual financial statements, as discussed in these articles, will include a balance sheet dated the last day of the financial year, typically 31 March.
What to look for in your Balance Sheet
Within the assets, liabilities and equity amounts, a balance sheet may contain a complicated list of numbers and sub-classifications. To find answers and meaning, we will focus on two aspects of the balance sheet:
The overall financial position, being the level of equity both as an absolute value and relative to total assets, and
short term (or current) financial position being the business’s ability to meet its short-term financial commitments.
Both assets and liabilities can be classified as current or non-current, and most balance sheets will separate individual asset and liability amounts into these categories.
Current assets and liabilities
Current generally means within one year.
A current asset will be expected to be utilised within the following year, such as money in the bank which is immediately available, or amounts owed by clients (debtors) which are usually due within a few weeks.
A current liability is due to be paid within the following year. A bank overdraft, amounts owed to suppliers such as subcontractors or a phone bill are current liabilities.
Working capital is a term often used for your short term financial position. When we say we require some funding for working capital, we mean we need funds to pay for day-to-day operations, as opposed to funding long-term assets such as machinery or equipment.
Working capital = current assets – current liabilities
As a measure, working capital is the excess of current assets over current liabilities. If your balance sheet shows current assets of $30,000 and current liabilities of $10,000, you have working capital of $20,000. This means, you should realise the $30,000 of current assets during the following 12 months, be able to pay the $10,000 of current liabilities, and have an excess of $20,000.
If current liabilities exceed current assets you have a shortfall in your ability to fund your operations and will need to find short-term funding. Funding can be generated internally with profits or introduced from external sources – either debt or equity.
Total assets and liabilities
Non-current assets bring benefits over more than one year. Examples are motor vehicles, long-term investments and goodwill.
Non-current liabilities are liabilities that will be settled more than a year from now. A bank loan may be payable over the next five years. This will be split in the balance sheet with the portion due within the following 12 months under current liabilities, and the remaining amount, to be paid during years 2 – 5, under non-current liabilities.
Total assets and liabilities, including current and non-current, measure the overall financial health of your business as at the balance sheet date. The amount of equity the business has is a measure of the long-term financial position. More equity, both as an absolute number and relative to total assets, indicate a secure position with sufficient assets to service liabilities.
Liabilities (or debt) are not necessarily bad. Businesses borrow funds from outsiders believing they can use the funds to generate a return greater than the cost of the funds. If a business takes out a bank loan with 10% interest, and uses the funds to increase profits by 20% of the funds, the business will grow.
The key to long-term financial health is to get the balance right. A business needs to finance its assets and, as above, this finance can come from equity or liabilities (or debt). Raising debt provides some advantages over raising equity, as we will see in later articles, but the more debt we have the more risk we take on. Debt entails a legal obligation to pay interest and repay principal per the agreement terms. Investors of equity share in the risk of the business and only receive a return if the business makes profits and other gains.
So, debt can increase business value and is usually required for growth, but too much debt will put the business at risk of not being able to service it.
Your balance sheet shows your financial health at a point in time. We will focus on the short-term (current) health and the long-term (non-current) health of the business.
A fundamental purpose of business is making money. In the next article, we return to the Profit and Loss Statement and see how to analyse your business’s profitability.