Tax & admin · 31 January 2018

What is a balance sheet and how can I interpret one?

Reading another firm’s balance sheet could help you understand this key financial document

As a small business owner, you’ll probably own lots of assets, owe people money and have shareholders. Here, Business Advice expert Rob Drury explains what is a balance sheet, and how all of these get summarised within it.

What is a balance sheet?

Every business owner operates with three core financial documents: the balance sheet, the profit and loss statement and the cash flow statement.

It’s the balance sheet that summarises the company’s assets, liabilities and the shareholder’s equity at a particular point in time. The so-called “balance” being that the assets must equal the sum of the liabilities and the equity.

For example, if a business owner has borrowed £10,000 from the bank (a liability) and has had £10,000 invested by its shareholders (shareholder equity), then the business has £20,000 of cash at its disposal (an asset).

What is classed as an asset?

There are many things that would be classed as assets in a business sense, and a common way of categorising them is to split them between “current assets” (assets that can easily be turned into cash), and “long-term assets” (assets that would take time to be able to turn into cash).

Current assets can include:

  • Cash, and other things that are similar to cash, such as certificates of deposits or treasury shares
  • Accounts receivables, or money owed to you which you can chase to get paid
  • Inventory, which is stock that you can sell

Long-term assets can include:

    • Land, buildings, equipment, machinery and other big capital expenditure items
    • Intangible things, like intellectual property
    • Investments which have a time limit on when they can be cashed in

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What is classed as a liability?

As you’d expect, liabilities are things that the business is liable for, and like assets, they can be classified as either current or long-term.

Current liabilities can include:

      • Bank overdrafts
      • Interest payable
      • Operational costs like rent or utilities
      • Tax
      • Salaries for your staff
      • Dividends

Long-term liabilities can include:

      • Pension fund contributions
      • Deferred tax
      • Debts which aren’t due within a shorter time period

What is shareholder equity?

As with assets and liabilities, shareholder equity is made up of a few elements. These can include:

      • Investments by shareholders through common and preferred shares in the business (equity)
      • Earnings that have been kept back for future investment (retained earnings)

Shareholder equity can be calculated in a number of ways. For example, assets minus liabilities equals shareholder equity, or share capital plus retained earnings minus treasury shares.
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What does it all mean?

A balance sheet is only a snapshot in time, and constantly changes as the elements that make up the balance sheet are in regular movement.

A new sale adds an asset, a new member of staff adds a liability, and a new share issue adjusts the shareholder equity, for example.

Because of this snapshot nature, it’s important to compare balance sheets with other balance sheets over time. In terms of reading the balance sheet, there are a number of ratios that can be used to give business owners greater insight. 

Debt to equity ratio (total liabilities divided by total shareholder funds)

A business that has a high debt to equity ratio is described as “highly geared” or “highly leveraged”, which makes them less attractive to lenders. Payments for the debts can be requested within a short time frame, whereas shareholder equity is a longer-term form of finance.

The ratio can never be perfect, as it can depend on industry-wide factors. If you are running a comparison, then do so against comparable businesses in the same industry. The kind of questions owners should ask are:

      • Is the business’s sales revenue predictable and generating cash?
      • Are the debts likely to be require payment quickly?
      • Is the business vulnerable if the economy takes a downturn?
 

Current ratio (current assets divided by current liabilities)

This is a relatively quick and easy approach to calculating whether a business is likely to be able to meet its short-term requirements and pay its bills.

With this, a ratio of more than one would indicate that if a firm’s obligations became due all at once and immediately, the business could pay them with funds they had available. The business would not need to raise funds in another way, such as through a loan or shared issue.

What now?

If you’re wanting to find more about what is a balance sheet, a good place to start is to head to Companies House, find the accounts of comparable businesses to your own, and in them find their balance sheets.

You can the balance sheets of other businesses to review and assess their ratios and help you understand the ins and outs of this key financial document.

Read more: A handy guide for paying off your tax bill to HMRC

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ABOUT THE EXPERT

Former footballer and cinema manager Robert Drury has been a digital professional since 2000, specialising in project management, client services, and product management. He supported global brands such as Kraft Foods, Peugeot Citroen, and Lloyds Banking Group with their online presence before moving into startups. He was a founding team member at Ormsby Street, a small business financial information tool, before moving to Qudini to oversee the development of that firm's customer experience software product.

Q&A

If you’ve found the article above useful, but have a more detailed and bespoke question, then please feel free to submit a query to our expert. We at Business Advice will get in contact with them on your behalf and arrange for a personalised response. These questions and answers will then be collated on the site for any other readers who have similar queries.

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