In this series, I will use a real case study to teach you how to interpret and analyse a balance sheet and what steps MDR Solutions developed and implemented for improving one of our customers businesses.
The Balance Sheet is a financial document illustrating the financial position of an individual or organization at a specific point in time. It is a snapshot of the financial position and establishes the net worth of an organization or individual.
In this article we will deal specifically with a business balance sheet and provide an understanding of its construction and interpretation.
History of the balance sheet
The balance sheet is credited to Franciscan monk Luca Pacioli who was a friend of Leonardo da Vinci in the 15th century and published a book in 1494 which, listed resources separate from claims against those resources. He therefore created the balance sheet with debits and credits separated.
In over 30 years of working with Small and Medium businesses, I have found that the least understood and even disregarded financial document, by the business owner, is the balance sheet.
The common mistake
Most entrepreneurs guide their efforts using the Profit & Loss Statement (P&L) or Income Statement, and totally ignore the other critical financial information provided by the balance sheet and the cash flow statement. This oversight is a major cause of financial distress for businesses because the cash flow position is not evident in trading results contained in the P&L.
The information contained in the Balance Sheet is absolutely critical in managing the financial affairs of the business and should not be ignored or overlooked.
A business that is making a profit is not necessarily solvent or able to survive a downturn.
As the well-known saying goes ” Turnover is vanity, profit is sanity and cash is reality”. The only 2 financial reports that show cash is the Balance Sheet and the Cash Flow statement.
The accounting equation
The balance sheet is the illustration method for the accounting equation, namely, ASSETS = LIABILITIES + OWNERS EQUITY
The equation of debits (Assets) on the left and credits (Liabilities+OE) on the right, basically show what the business owns versus what the business owes and what is owed to the owners.
In other words, what the business has and where it came from!
In order to grasp the balance sheet it is important to explain its composition.
What are Assets?
It is composed of Assets which are split into 2 categories, namely, Fixed and Current Assets, and these are the resources the business has at a point in time. In accounting, assets are shown as debits.
All the Assets in a business have either been acquired by debt or equity (cash), which is composed by Owners Equity or Liabilities (the other side of the balance sheet)
Liabilities are also split into 2 categories, namely, Long Term and Current liabilities. In accounting these are shown as credits.
Fixed assets are typically fixed property, equipment, machinery, vehicles which are used for generating income. These assets are not tradeable, remain a resource in the business for the long term and are depreciated over their lifetime.
Current assets are typically accounts receivable (Trade Debtors), stock on hand and cash balances at a specific point in time. These assets are the result of trading and change daily.
The total of these 2 categories (Fixed and Current Assets) is called Total Assets and in order for a business to be solvent, this amount has to be greater than the Total Liabilities.
What are Liabilities?
Total Liabilities is the total of another 2 categories namely, Long Term Liabilities and Current Liabilities.
Long Term Liabilities are any debt payable beyond the present financial year. Mortgage bonds, equipment or vehicle leases and external loans are typical examples.
Current Liabilities are accounts payable (Creditors), taxation and bank overdrafts.
Lastly, in order for the balance sheet to balance, there is Owners’ Equity (OE). This amount is comprised of share capital, retained profits and shareholders loans. The amount of Owners Equity is critically important in determining a variety of factors, such as shareholder commitment to the business and profitability.
I have placed the statement below and will discuss it’s interpretation in the next chapter.