the balance sheet, and what it tells us · 1 1 the balance sheet, and what it tells us learning...

1

1The Balance Sheet,

and What it Tells Us

Learning objectives

After studying this chapter you should be ableto:

◆ Explain the structure and terminology ofstraightforward balance sheets

◆ Understand how balance sheets canindicate financial weaknesses and strengths

◆ Demonstrate how transactions and profitsaffect balance sheets

◆ Discuss the uses and limitations of balancesheets

Chapter contents

1.1 An Individual’s Balance Sheet

1.2 A Company’s Balance Sheet

1.3 Short-term and Long-term

Classification

1.4 Balance Sheets: Financial

Strength and Weakness

1.5 Depreciation and Balance

Sheet ‘Values’

1.6 Balance Sheets and Profit

1.7 A Company’s Published

Balance Sheet

1.8 Role and Limitations of

Balance Sheets

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Introduction

The word ‘balance sheet’ is widely used, although most people have neverseen one and have little idea what it shows. This chapter provides a gentleintroduction to balance sheets by showing how individuals can preparetheir own personal balance sheets, and how similar these are to companybalance sheets. It also gives some indication of the usefulness of balancesheets: they can give an indication of what an individual or company isworth (but with severe limitations). They also show what liabilities thereare, which can help to predict future bankruptcy.

1.1 An Individual’s Balance Sheet

If you want to know how much you are worth as an individual you wouldprobably start by drawing up a list of everything that you own, and then tryto put a value on each item. After working for a few years you might own ahouse, some furniture, a car, some premium bonds and shares which youintend to keep on a long-term basis, and perhaps some short-term invest-ments. You might also have a good stock of food and wine in the kitchen aswell as some money in the bank. But you may have debts: a mortgage owedto your bank or building society, an overdraft, money you owe on yourcredit card, and bills not yet paid for such things as electricity, gas, tele-phone and council tax.

It is easy to produce a list of what you own, and a list of what you owe.You can then deduct what you owe from what you own to show your ‘networth’. An example is given in Illustration 1.1.

We can summarize this as:

What I own 0 What I owe # What I am worth

If you are a full-time student this might be more difficult, or more embar-rassing. It may be that the most valuable things that you own are items suchas CDs, clothes, books, a stereo and a computer. You may have paid a lotfor them, but their value now is questionable – especially if you suddenlyneeded to sell them. They would cost a lot to replace, and if they were allstolen you would probably claim quite a high value for them if they wereinsured. But if you try to sell them, their second-hand value would prob-ably be very disappointing: it is likely to be only a small fraction of what youpaid for them. Worse still, you may well have a student loan and an over-draft and owe other amounts of money which means that your net worth iszero, or even negative: you owe more than you own. But it is all worth it,you tell yourself, because all the time you are spending money on your edu-cation; that is an investment; and what you are really worth is your futureearning power. If you go to your bank wanting to borrow money, they will

CHAPTER 1 THE BALANCE SHEET2

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be much more interested in your future earning power than they are in apile of second-hand clothes and some CDs.

Three main problems arise in trying to establish what any individual orbusiness is worth:

1 What items are we going to list? Are we going to include our 5-year-oldcomputer, our vinyl records, all the food in the kitchen, our educationalqualifications and our children? We might think of these as being someof the best things we have, but we would probably exclude them. Weneed some basis, or principle, for deciding what to include and what toexclude.

2 How do we establish what particular items are worth? We attempt this inseveral different ways, for example by looking at what they originallycost, or what the second-hand value is, or what it would cost to replacethem.

3 What is our future earning power worth? Whether we look at an indi-vidual, or a company, in many cases the money that they can earn in thefuture is worth a lot more than a collection of bits and pieces that theyown. If you want to borrow money, you could tell your bank that youexpect to earn at least a million pounds during your working life, and askto borrow the million pounds now. The bank’s response is likely to beshort and not very sweet.

1.1 AN INDIVIDUAL’S BALANCE SHEET 3

Illustration 1.1

£,00

What I own

House 300,000Furniture 4,000Car 10,000Premium Bonds and shares 6,000Food and drink 200Cash and bank w w w4v,w8w0w0Total w3w2w5v,w0w0w0

What I owe

Mortgage 222,000Bills (gas and electricity etc.) 1,000Credit card w w w2v,w0w0w0Total w2w2w5v,w0w0w0

What I am worth 100,000

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You can, of course, make up your own rules, and decide that you areworth £100,000. But if you want to compare your own wealth withsomeone else’s, then you need to agree how the calculation is to be made.Are you going to show your house at the amount you paid for it, or at themarket value now? Are you going to show your car at the amount you paidfor it, or allow for the fact that it has depreciated since you bought it? If youattempt any comparisons like this you will soon find that you need someagreed rules on what to include, and the basis of valuation to be used. Youwill need accounting principles.

It is difficult to know what something is really worth until you sell it. Imight boast that my house is worth £500,000, but we might agree that it ismore objective to show it at cost; and it cost £300,000 a few years ago. Theaccounting principle would be to list everything that we own, and showeverything at the original cost price.

Deciding what principle to adopt for furniture and for a car is more dif-ficult. They have only a limited life, and are likely to depreciate over time aswe ‘use them up’. We could decide that a car has a 5-year life and write itdown by one-fifth each year.

1.2 A Company’s Balance SheetA company’s balance sheet is very much like an individual’s balance sheet,except that a standard layout is used, and more impressive terminology isused.

The layout and terminology probably look quite confusing at first and itmay be hard to believe that Illustration 1.2 really is the same balance sheetas Illustration 1.1. By using standardized terminology and presentationaccountants say that they are making it easier to compare one companywith another. You might think that they are just making it more compli-cated so that it is ‘impenetrable’ to non-accountants. But professionalscan no longer hide behind their terminology, conventions and so called‘expertise’. These days many patients question their doctor’s recommenda-tions (perhaps by looking things up on the internet and being instantlymore ‘expert’ than the doctor). Similarly, you are learning to questionaccountants (and other management ‘experts’), and now is the timeto make sure that you understand the basic terminology of financialstatements.

In accountant’s jargon, what a company owns and what they owe arecalled assets and liabilities, and the statement showing assets and liabilities(and net worth, or equity, or capital) is called a balance sheet.

In everyday English we have seen that what I am worth is the total ofwhat I own, less the total of what I owe. In accountancy terms we would saythat the balance sheet value of a company is the total of assets less liabilities.


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We could call this ‘equity’, or net assets, or capital, or net worth.Accountants sometimes talk about ‘the balance sheet equation’, which issimply this:

Assets 0 Liabilities # Equity

It is easy enough to establish the ‘balance sheet value’ of a company, or its‘net asset value’, or ‘equity’, or ‘net worth’. In Illustration 1.2 it would be£100,000. It is much more difficult to establish what a company is reallyworth – because of the same three problems already identified:

1 What items are we going to include on the list?

2 How do we establish what particular items are worth?

1.2 A COMPANY’S BALANCE SHEET 5

Illustration 1.2

Balance Sheet of A. Reader Company Limited as at 31 December Year 1

Fixed assets £,00 £,00 £00

Tangible assetsFreehold land and buildings (at cost) 300,000Furniture (at cost) 4,000Vehicles (at cost) w w1w0v,w0w0w0

314,000Investments w w w6v,w0w0w0 320,000

Current assetsStocks 200Cash and bank w w w4v,w8w0w0

5,000Current liabilities*

Creditors 1,0002,000 w w w3v,w0w0w0

Net current assets w w w2v,w0w0w0Total assets less Current liabilities 322,000

Creditors: amounts falling due after more thanone year

Mortgage w2w2w2v,w0w0w0w1w0w0v,w0w0w0

Capital and reserves w1w0w0v,w0w0w0w1w0w0v,w0w0w0

* ‘Creditors: amounts falling due within one year’ is now the correct term, but ‘Current lia-bilities’ is still widely used.

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3 What is the future earning power of the company as a whole worth?

These problems will be addressed more fully later in the book.

1.3 Short-term and Long-term

Classification

There is a standard format for balance sheets which makes it easier tocompare one company with another. Both assets and liabilities are classi-fied as being long term or short term. Anything which is intended to bearound for more than a year is long term. Anything which changes withina year is short term.

Assets

Long-term assets are called ‘fixed assets’. (It would be too simple just to callthem long-term assets!) But there is nothing ‘fixed’ about them. Theyinclude cars, ships and aeroplanes, just as much as they include land andbuildings which seem to be more fixed!

Within the Fixed Assets section there are three main categories:

1 Intangible fixed assets: things like goodwill, patents, trade marks,licences.

2 Tangible fixed assets: things like land and buildings; plant, machineryand equipment; vehicles; furniture, fixtures and fittings.

3 Investments, or financial assets: things like shares in other companies orloans that have been made.

We can say that things like vehicles or furniture are usually fixed assets, butthat is not always the case. If a business intends to use them for a period ofyears, then they are fixed assets. But if someone is in business to buy andsell vehicles, or furniture, then any items held short term, awaiting sale, arenot fixed assets.

The same arguments apply with investments. Any surplus funds investedin shares, or loaned to someone or another business, might be intended tobe long term, and so are fixed assets. Or they might be intended to be shortterm, and so are not fixed assets.

Short-term assets are called ‘current assets’. (Again, it would be toosimple just to call them short-term assets!) They include:

1 Stocks of raw materials, work in progress, finished goods, and goodsheld for resale;


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2 Debtors – money owed to the business by customers and others;�1

3 Investments (those which are not fixed assets); and

4 Cash.�2

One way of looking at current assets is to say that they are all cash, or thingsthat are intended to become cash within a matter of months. We intendthat our stocks will all be sold; even raw materials and components will beincorporated into things which are sold. Investments which are shown ascurrent assets are assumed to be temporary, and so will be sold and con-verted into cash. And debtors should pay up within a matter of months.

Liabilities

Liabilities are also categorized as short term and long term. It might betempting to call short-term liabilities ‘current liabilities’, and the term iswidely used. But on published balance sheets we have the following terms:

1 ‘Creditors: amounts falling due within one year’. This includes mostordinary trade creditors – amounts due for goods and services boughton credit.

1.3 SHORT-TERM AND LONG-TERM CLASSIFICATION 7

1 And even prepayments, and accrued income, if you want to be technical!

2 Cash includes money in the bank, and petty cash in hand. Obviously the two arequite distinct, and a bookkeeper needs to account for them separately and properly.But, for the sake of simplicity and clarity, the two items will be lumped together andjust called cash.

Illustration 1.3

Simplified Balance Sheet of A. Reader Company as at 31 December Year 1

£,00 £00

Fixed assets 320,000

Current assets 5,000Deduct: Creditors: amounts fallingdue within one year w3v,w0w0w0 w w w2v,w0w0w0

322,000

Deduct: Creditors: amounts fallingdue after more than one year w2w2w2v,w0w0w0

w1w0w0v,w0w0w0w0 w0 w v w w w0

Capital or equity shareholders’ funds w1w0w0v,w0w0w0

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2 ‘Creditors: amounts falling due after more than one year’. This includeslong-term borrowings such as mortgages and debentures.

The balance sheet that we have been using so far can now be shown underthese four headings, which separate assets from liabilities, and long termfrom short term (Illustration 1.3).

The distinction between what is short term and what is long term isimportant in assessing the financial strength or solvency of a business – inassessing whether or not it is likely to go bust!

1.4 Balance Sheets: Financial Strength

and Weakness

A balance sheet may suggest that a business is financially strong, althoughit does not prove it. A balance sheet may show signs of weakness – and weignore these at our peril. Accountants are often criticized when a companygets into financial difficulty because they did not warn in big red letters,‘This company is dodgy. Avoid it like the plague’. But, in most cases, thesigns of financial difficulty are there for all to see, long before a much pub-licized collapse, if only they take the trouble to try to understand thebalance sheet.

Companies collapse in one way or another when they cannot pay whatthey are required to pay: when they are unable to meet their financial lia-bilities. Many factors may contribute to this situation: poor management,poor marketing, poor planning, trying to do too much with too littlemoney, bad luck, dodgy customers, changes in the world economy and soon. There is usually someone, or something to blame. But, in the end,either a company can pay its bills, or it can’t. The balance sheet gives apretty good guide to what bills are due to be paid – and the resources avail-able for paying them.

Although there may be question marks about the reliability of somefigures in published accounts, the liabilities �3 figures are among the mostreliable. A company needs to have sufficient funds readily available tomeet its liabilities when they fall due. A company’s ‘current liabilities’, or‘Creditors: amounts falling due within one year’ should be clear from thebalance sheet. The important question is: does the company have enoughshort-term assets to be able to pay its short-term liabilities as they falldue?


3 There are occasions when crooked accountants and directors omit liabilities com-pletely, or seek to hide them as some form of ‘off balance sheet finance’. This issue isexamined later in relation to ‘Creative Accounting’.

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A company’s current assets include money in the bank, debtors�4 that aredue to become money in the bank within a few months, and stocks ofgoods which the company plans to sell and convert into money in the bankwithin a matter of months. If a company has a lot more current assets thancurrent liabilities, it should be able to pay its current liabilities when theyfall due. If their current assets are two or three times as much as theircurrent liabilities, then they appear to be fairly strong; or in the termi-nology of accounting, they have a high current ratio.

In Illustrations 1.1 to 1.3 above, current assets are £5,000, and short-termliabilities are £3,000. The current ratio is 1.67 : 1.�5 This is not particularlyhigh, but it looks as if there is enough cash and near cash available in theshort term to be able to pay the short-term liabilities as they fall due.

It should be possible for all current assets to become cash within a matterof months, but this is more difficult with some items than others. Not allstocks of goods are easily and quickly turned into cash. A half-baked loafwill probably be finished and sold for cash within a matter of hours. A half-built house, in an area where no-one wants to live, could remain unsold fora long time. If most of a company’s ‘current assets’ are actually stocks ofgoods, their ability to pay creditors quickly may be less than their currentratio suggests. A useful approach to assessing a company’s ability to pay itsshort-term liabilities would be to exclude stocks from current assets, andassess the company’s ‘liquidity’, by comparing their ‘liquid assets’ withtheir short-term creditors. This is known as the liquidity ratio, or acid test,or quick assets ratio.

Long-term debts are also important – a company or individual can gobankrupt because of the weight of long-term liabilities. It is difficult to sayhow much debt is too much – some people, and some companies, seem tomanage with huge debts, whereas others (like Marconi, and a number ofairlines recently) collapse. An individual who has lots of money can affordto borrow lots of money. Similarly, a company with a large amount ofequity, or shareholders’ funds (the company’s ‘own’ money) can afford toborrow more money than a company with very little equity. In Illustrations1.1 to 1.3 above the amount of equity is £100,000, so it would seem reason-able to borrow another £100,000. If a business is financed half by bor-rowing, and half from its own shareholders’ funds, then the borrowing ishigh, but probably not excessive. But in the above illustrations the bor-rowing is much more than the equity. If we add together all of the long-term funds (shareholders’ funds, plus long-term creditors # £322,000),

1.4 BALANCE SHEETS: FINANCIAL STRENGTH AND WEAKNESS 9

4 Debtors are customers who have not yet paid for the goods or services with whichthey have been supplied.

5 £5,000 2 £3,000 # 1.67.

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then we can see that the assets of the business are mainly�6 financed byborrowing. In accounting terminology such a company is ‘high geared’,which usually means high risk.

But high gearing, or high amounts of long-term debt, does not particu-larly matter if the individual or company has a substantial amount ofincome with which to pay the interest, and to repay the creditors (orborrow more!) when repayment is due. Individuals who have to pay mort-gage interest of £20,000 a year should have no problems if their annualincome is £100,000 a year or more. Someone who has to pay £20,000 a yearmortgage interest from an annual income of £25,000 is likely to have realproblems! It is worth comparing the amount of interest that has to be paideach year, with the income available to pay that interest. If the interest iscovered, say, 5 times by the income, then it is probably all right. But if theinterest is covered only 1.25 times by the available income, then there arelikely to be problems.

In assessing the financial strength of a company, or how likely it is to gobankrupt, it is worth calculating the current ratio, the liquidity ratio, thecapital gearing ratio, and the interest times cover.

1.5 Depreciation and Balance Sheet

‘Values’

Before looking at the published balance sheet of a real company it is usefulto know that all assets are not simply shown at cost. Some fixed assets, par-ticularly land and buildings, are revalued from time to time; and most fixedassets are depreciated each year.

If you buy a car for £10,000, you might decide that you will keep it for4 years, and expect that at the end of the 4 years you will be able to sell it for£2,000. This is a plan, or an accounting policy. After one year you can showthe car as being £8,000; after 2 years it would be £6,000 and so on. This doesnot mean that the car is ‘worth’ £8,000 after one year. What we need to dois to show three things:

(a) the car cost £10,000;

(b) after one year the cumulative depreciation is £2,000 (after 2 years itwould be £4,000; after 3 years it would be £6,000);

(c) after one year the net book�7 value of the car would be £8,000 (after 2years it would be £6,000; after 3 years it would be £4,000).


6 £222,000 of £322,000 is almost 69 per cent.

7 The amount shown for it in the ‘books’ of the company, or its balance sheet value.

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It is important that all three of these can be found on the balance sheet, orin notes to the balance sheet: the cost of an asset, the cumulative deprecia-tion, and the net book value. As the above example shows, the net bookvalue is not an attempt to show what the asset is really worth now. Wedecided to write off the initial cost of the car, down to an estimated trade invalue when we have finished with it, and to charge the same amount ofdepreciation each year�8 for 4 years.

In Illustrations 1.1 to 1.3 above depreciation has been ignored to simplifyit. The car is shown at £10,000. If we decided that a depreciation charge, orexpense, of £2,000 is appropriate, there would be two effects on the balancesheet: the car would be reduced by £2,000; and the equity, or net worthwould be reduced by £2,000. We saw that the basic balance sheet equation is

Assets 0 Liabilities # Equity�9

Depreciation is an expense and we can now say that assets minus expensesminus liabilities equals equity: a new equity figure emerges after expenseshave been deducted. Ilustration 1.4 shows how the balance sheet changes asa result of charging expenses, earning income, and making a profit.

1.6 Balance Sheets and ProfitA successful individual or business is likely to show an increase in capital orequity or net worth each year.

Expenses, such as depreciation, decrease assets and decrease equity. Mostexpenses reduce the asset of cash when they are paid.�10 If they have not yetbeen paid, then there is an increase in liabilities – shown as creditors (whichhas the same effect as a reduction in assets). Whether they are paid out incash or not, the effect of all expenses is to reduce equity.

Revenues, mainly from sales, increase assets and increase equity. If theycome in the form of cash, then the asset of cash is increased. If thecustomers have not yet paid, then the increase in assets shows up as anincrease in debtors. Whether they are received in the form of cash or not,the effect of all revenues is to increase equity.

In a successful business revenues should be greater than expenses, and sothe net effect is to increase equity.

1.6 BALANCE SHEETS AND PROFIT 11

8 Depreciation does not have to be on a ‘straight line’ or ‘equal annual instalments’basis. Businesses can choose to charge more depreciation in the early years by usinga ‘diminishing balance’ basis.

9 The next step would be that assets minus expenses plus income minus liabilitiesequals equity; a new equity figure emerges showing an increase as profit. The profitis income less expenses.

10 Depreciation is an expense which reduces the fixed asset; it does not reduce the cash– it is not paid.

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If we take the balance sheet at the end of one year, and compare it withthe balance sheet at the end of the next year, we can get a fairly good idea ofthe amount of profit that was made in the period between the two dates. Allwe do is compare the figure for equity, or net assets, or shareholders’ fundson the most recent balance sheet with the equivalent figure a year ago. Thisis shown in Illustration 1.4. The amount of equity or shareholders’ fundshas increased by £25,000 during Year 2: it looks as if the company has made£25,000 profit. The profit has shown up in additional stocks, debtors andcash: they have increased by £29,000. But fixed assets have gone down by£2,800 (depreciation), and there are additional liabilities of £1,200; theincrease in net assets is £25,000.

Without more evidence we cannot always be sure that the increase in netassets is the profit for the year, for three main reasons:

1 It could be that the amount of equity has increased because shareholdershave put more money into the business; there has been a new issue ofshares. Any extra coming in from the issue of shares does not count asprofit, and so should be deducted from the increase in equity shown onthe balance sheet to arrive at the profit figure for the year.

2 All of the profits that have been made do not necessarily stay within thebusiness. Most companies pay out dividends. They can make a substan-tial profit, and pay most of it out as dividends. Dividends do not reduceprofits. But they do mean that any increase in equity is not the whole ofthe profit. Dividends must be added to the increase in equity in calcu-lating the profit for the year.

3 Sometimes companies revalue their assets. This does not seem to havehappened in Illustration 1.4. If the freehold land and buildings were reallyworth £350,000, the company could add £50,000 to the figure shown onthe balance sheet for freehold land and buildings; and they would have toadd £50,000 to equity; it would probably be separately labelled as a‘Capital reserve’. The company would then appear to be £50,000 betteroff, but we would probably not think of this as being profit.

A balance sheet is not the most convenient way of calculating profit, butit can be done! Profit for the year is the increase in equity during the year,minus any additional shares that have been issued, plus any dividends thathave been provided.

The third of these is more problematic. Are we going to use the term‘profit’�11 for the whole of the increase in equity (after making the two


11 Profit is very British. The more international term is ‘income’. Or you can use theterm ‘earnings’ when you want to keep changing the terminology in order toimpress, and confuse the enemy. Be careful, though; they might know more aboutaccounting than you do.

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adjustments above)? Revenues clearly contribute to equity and profit.Expenses clearly reduce equity and profit. But equity will also increase ifwe revalue land and buildings – provided the revaluation results in anincrease. What would you think of a company that boasted of making£90,000 profit, if it had lost £10,000 on normal operations, but ‘made’ asurplus of £100,000 by revaluing its premises? The traditional accountantwould not be impressed, and would want to see a loss of £10,000 beingrecorded. But much is changing in accounting, and we need to keep acareful eye on the strange ideas of the Accounting Standards Board.

1.6 BALANCE SHEETS AND PROFIT 13

Illustration 1.4

Balance Sheet of A. Reader Company Limited as at 31 December

Year 1 Year 2Fixed assets £00, £,00 £,00 £00

Tangible assetsFreehold land and buildings (at cost) 300,000 300,000Furniture (at cost less depreciation) 4,000 3,200Vehicles (at cost less depreciation) w w1w0v,w0w0w0 w w w8v,w0w0w0

314,000 311,200Investments w w w6v,w0w0w0 320,000 w w w6v,w0w0w0 317,200

Current assetsStocks 200 9,000Debtors �–� 20,000Cash and Bank w w w4v,w8w0w0 w w w5v,w0w0w0

5,000 34,000Current liabilities

Creditorsw w w3v,w0w0w0 w w w4v,w2w0w0

Net current assets w w w2v,w0w0w0 w w2w9v,w8w0w0Total assets less current liabilities 322,000 347,000

Creditors: amounts falling due after more than one year

Mortgage w2w2w2v,w0w0w0 w2w2w2v,w0w0w0w1w0w0v,w0w0w0 w1w2w5v,w0w0w0

Capital and reserves w1w0w0v,w0w0w0 w1w0w0v,w0w0w0w1w0w0v,w0w0w0 w1w2w5v,w0w0w0

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1.7 A Company’s Published Balance Sheet

A recent published balance sheet of Ted Baker plc for the year ended 25January 2003 is shown in Illustration 1.5. The company’s current liabilities(‘Creditors: amounts falling due within one year’) are as follows:

2003 2002£000 £000

Current liabilities 16,456 14,333

Does the company have plenty of current assets to be able to pay the currentliabilities as they fall due? The amount of current assets is as follows:

Current assets 23,690 21,904

We can express the proportion of current assets to current liabilities as follows:

Current Ratio 1.44 : 1 1.53 : 1

There are plenty of current assets, which should become cash within amatter of months, to pay the current liabilities as they fall due. The ratio islower than the 2 : 1 which some textbooks recommend, but it is in line withmost retailers where current ratios tend to be lower than average.

With some current assets such as stocks it may take some months beforethey are turned into cash. Liquidity can be assessed by taking only ‘quickassets’ and comparing them with current liabilities. This is the ‘acid test’. Ifstocks are excluded from current assets, the liquidity ratio is calculated asfollows:

Current assets excluding stocks 9,753 9,586Current liabilities 16,456 14,333Liquidity ratio 0.59 : 1 0.67 : 1

The company’s current ratio and liquidity ratio are both rather low, andhave weakened since 2002. However, relatively low current ratios andliquidity ratios are fairly normal with retailers.�12

The company’s long-term debt is fairly low. The total net assets (or totalcapital and reserves) amount to nearly £19 million; but there is only £4 millionof long-term creditors. This may be calculated as a gearing ratio as follows:

(‘D’) Creditors: amounts falling due aftermore than one year 4,000 4,000

(‘E’) Total capital and reserves 18,835 15,723Creditors: amounts falling due after w w4v,w0w0w0 w w4v,w0w0w0

more than one year(‘D ! E’) Total long-term funds 22, 835 19,723

Gearing 17.5% 20.3%D

D + E


12 Because they have more stocks than debtors, since they sell mainly for cash, not oncredit.

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1.7 A COMPANY’S PUBLISHED BALANCE SHEET 15

Illustration 1.5

25 January 26 January

2003 2002

CONSOLIDATED BALANCE SHEET

At 25 January 2003 Notes £’000 £’000

Fixed assetsTangible assets 11 15,375 12,167Investments 12 349 446

15,724 12,613

Current assetsStocks 13 13,937 12,318Debtors 14 6,975 5,711Cash at bank and in hand 2,778 3,875

23,690 21,904

Creditors: amounts falling due within one year 15 (16,456) (14,333)

Net current assets 7,234 7,571

Total assets less current liabilities 22,958 20,184Creditors: amount falling due

after more than one year 16 (4,000) (4,000)Provisions for liabilities and charges 17 (123) (461)

Net assets 18,835 15,723

Capital and reservesCalled-up share capital 18 2,072 2,064Share premium 19 1,412 978Profit and loss account 19 15,411 12,638

Equity shareholders’ funds 20 18,895 15,680Minority interests – equity 19 (60) 43

Total capital and reserves 18,835 15,723

The accompanying notes are an integral part of this consolidatedbalance sheet. The financial statements on pages 27 to 46 were approvedby the board of directors on 24 March 2003 and signed on its behalf by:

L.D. Page Director

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The gearing is relatively low, which means that the company is not heavilydependent on long-term borrowings. The gearing has also fallen, whichmeans that their already low risk in 2002 was even lower in 2003.

The total of capital and reserves increased by about £3 million during theyear which suggests that the company’s retained profit for the year wasabout £3 million. The profit and loss account (Illustration 2.3 in Chapter 2)shows that they made about £6.6 million profit; £3.6 million was paid outas dividends; this left about £3 million as retained profit.

The total for net assets (or total capital and reserves) is shown as beingnearly £19 million. This is sometimes referred to as the ‘balance sheet value’of the company. But the market value of a successful company should bemuch higher than its balance sheet value. The ‘market capitalization’ of theshares of a company is shown in the Financial Times on a Monday.In September 2003 the market capitalization of Ted Baker plc was about£145 million.

Published accounts show a lot more detail than the simplified balancesheets included in this chapter. A great deal of additional information isshown in notes to the accounts.

1.8 Role and Limitations of Balance Sheets

Balance sheets can be useful in a number of ways.

1 We saw that the balance sheet, or a statement of assets and liabilities, canbe useful in showing what a person or business is worth. But there areproblems in establishing agreed rules as to exactly which assets (andperhaps even which liabilities) should be included, and in determiningthe basis upon which they should be valued. There is also the problemthat the value of a business as a whole is likely to be different from thevalue of all of its assets (less liabilities) added together. The real value ofa business (or an individual) might depend more on the income that itcan generate (as a whole entity) in the future than upon whateveramounts might be shown for individual assets and liabilities.

2 We also saw that, in listing the various liabilities that have to be paid,short term and long term, we can get an idea of the financial strength ofa business. If its liabilities are too high, and it cannot pay them, it is likelyto get into serious financial difficulties, and perhaps go out of business.Balance sheets can give a good indication of whether liabilities are toohigh, or whether the business is reasonably strong. The balance sheet isthe basis for assessing the financial position of a company.

3 We can also measure profit using the balance sheet. There are easier waysof measuring profit, but it is useful to calculate it in two different ways so


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that one checks the other. The balance sheet approach to measuringprofit is one of the two main approaches, and one that may becomemuch more important.

4 Balance sheets play an important role in ‘stewardship’. Shareholders puttheir money into a company; directors and managers are the ‘stewards’of that money; and shareholders want to know what has happened totheir money. The balance sheet shows what money has been put in bythe shareholders, and what retained profits have been added to it; thisamount is shown as equity (or shareholders’ funds). Examination of thefirst part of the balance sheet, the assets and liabilities, shows what thatmoney is now financing; or, if you like, what has happened to it.

5 In order to produce a balance sheet it is necessary to produce a listing ofall of the company’s assets and liabilities. This can be useful in keepingtrack of various assets, and ensuring that all are being put to good useand are earning their keep. When a company gets into financial dif-ficulties it sometimes seems as if they manage to find assets that they hadpreviously forgotten about, or done nothing with. There may be in-vestments that are not much use; sports and social facilities that arehardly used; debtors who have been neglected and have got away withnot paying for too long (perhaps because of a half forgotten dispute);a workshop developing a new product that made little progress;machinery, or components and raw materials that were specially boughtfor a new product that was quietly abandoned; too many premises orbranches; an expensive head office in the centre of London; a trainingcentre, kitchens, computer workshops, and maintenance facilities thatshould have been sold or redeployed when these activities were out-sourced.

Many companies do not even know what assets they own, or howmany laptop computers have ‘walked’ out of the door, and they do noteven have an up-to-date fixed assets register. The process of producinglistings of assets in order to compile a balance sheet can be a usefulhousekeeping exercise.

6 In addition to providing a basis for assessing the financial position of acompany, the balance sheet also provides a basis for assessing the finan-cial performance of a company. The shareholders of a company are likelyto be concerned about performance in terms of profitability. They arenot concerned merely with the amount of profit the company makes;they are concerned with how much profit the company makes in re-lation to the amount of capital employed. A profit of £1 million maylook good for a company with capital employed of £5 million; it wouldlook pathetic in relation to capital employed of £100 million. It is the

1.8 ROLE AND LIMITATIONS OF BALANCE SHEETS 17

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balance sheet which shows the amount of capital employed. The ratio ofprofit to capital employed is a key ratio in assessing and improving acompany’s financial performance.

7 Financial accounting is a whole system, and the balance sheet is an essen-tial part of the system in checking, balancing and controlling other partsof the system. If a company’s balance sheet does not balance, there isdefinitely something wrong! Accountants are only (or nearly!) human,and inevitably some mistakes are made with figures. The financialaccounting system is designed to show up errors, and to find where theyoccurred. An accounting system can also show up fraud and theft. Whena balance sheet does balance, we cannot be sure that there is no fraud orerror. If it does not balance we can be sure that something is wrong; andif we do make a mistake, it will probably show up during the accountingprocesses before producing a balance sheet.�13

But we should not expect too much from balance sheets. They were neverproperly designed to achieve anything very useful. When double entrybookkeeping first became widely used, the balance sheet was just a matterof bookkeeping convenience. It was not even necessary to produce oneevery year. Until the eighteenth century a balance sheet was often not pro-duced until the ledger was full; then a balance sheet was a summary of theassets and liabilities that were transferred to the new ledger. Any remainingold balances, mostly revenues and expenses, were written off. The balancesshown on the balance sheet are items that are continuing, but they tend tobe shown at the cost price when they are first entered in the business’sbooks.

By the end of the eighteenth century the production of balance sheets onan annual basis became normal. During the nineteenth century it became arequirement for companies to publish annual balance sheets; and duringthe twentieth century legislation became increasingly specific about whatshould be shown on a balance sheet. Towards the end of the twentiethcentury accounting standards laid down more detailed requirements, andby 2005 the European Union will require the application of InternationalAccounting Standards in the same way as many other countries.

The main limitations of balance sheets have already been referred to:

1 What items are we going to include?

2 How do we establish the value of particular items?

3 The value of a company as a whole is likely to be very different from thetotal net value of the individual assets and liabilities.


13 Mistakes usually show up in the trial balance.

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Sometimes it is very difficult to decide whether or not an item shouldappear on the balance sheet. If a company running a number of hotels buysan additional hotel, that is clearly an extra fixed asset that would be shownon the balance sheet, and the amount shown would be the amount paid forit. If such a company pays for routine cleaning of a hotel, there is no ad-ditional asset, and the amount paid should not appear on the balance sheetas an additional asset. A payment for cleaning will reduce assets (cash) andalso reduce equity. Routine redecoration, like cleaning, is an expense thatdoes not appear on the balance sheet. Improvements, such as installingdouble glazing, an extension, or additional bathrooms, are ‘capital expen-diture’: the amounts are added to fixed assets on the balance sheet.Sometimes the boundary between ‘capital expenditure’ (which appears onthe balance sheet, and does not reduce equity) and ‘revenue expenditure’(which does not appear on the balance sheet, and does reduce equity) is notclear and there may be scope for creative accounting.

Where there is a lack of clear principles to determine what should beincluded on a balance sheet, and the basis or valuation which is to be usedfor the various items, the value of balance sheets is restricted. A variety ofofficial ‘Financial Reporting Standards’ has been produced to deal with thisproblem, and the development of financial accounting has steadily encour-aged users to expect more from balance sheets. It is unrealistic to expectthem to meet all of the different expectations that interested parties mighthave. But we cannot even begin to assess a company’s financial positionand performance without a good understanding of balance sheets.

Summary

A balance sheet shows the liabilities of a company, and solvency ratios cangive an indication of whether a company is likely to become insolvent.Assets are not usually shown at their current value, and care is needed inusing balance sheets as an indication of the value of a company. A businessas a whole, as a going concern, is usually worth much more than the totalof its net assets.

SUMMARY 19

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◆ A balance sheet shows what a company owns (assets) and what itowes (liabilities)

◆ By deducting liabilities from assets we arrive at the figure for‘equity’, or ‘capital’, or ‘net assets’

◆ Assets and liabilities are classified as being long term or short term,and in the UK are usually listed in the order fixed assets, currentassets, current liabilities, long-term liabilities

◆ A successful business is usually worth more than the balance sheetfigure for its net assets

◆ Balance sheets can indicate if a company has excessive liabilities

◆ Comparing this year’s balance sheet with last year’s can provide abasis for calculating profit

Review of Key Points

1 Which of the following are shown on a balance sheet?Assets; Expenses; Liabilities; Sales; Share Capital; Profit for the year

2 What is the difference between a fixed asset and a current asset?

3 Give examples of fixed assets. In what circumstances would some of the items you have listedbe current assets?

4 Arrange the three main balance sheet items (Assets, Liabilities, Equity) as an equation.

5 A balance sheet appears to show what a business is worth. What are the main problems withthis statement?

6 You are given the following simplified balance sheet of the Sandin Castle Company:

£00 £00Fixed assets 50,000Current assets

Stocks (at cost) 24,000Debtors 12,000Cash w w9v,w0w0w0

45,000Creditors w2w2v,w0w0w0 w2w3v,w0w0w0

w7w3v,w0w0w0

Share capital 50,000Retained profits w2w3v,w0w0w0

w7w3v,w0w0w0

Self-testing Questions

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SELF-TESTING QUESTIONS 21

(a) Calculate the current ratio.(b) Calculate the liquidity ratio.(c) The company sells stocks which had cost £4,000 for £8,000, which it immediately receives

in cash. Show how the balance sheet would appear after this transaction.(d) How does the above transaction affect the current ratio and the liquidity ratio?

7 You are given the following simplified balance sheets of the Windysand Company as at 31December:

Simplified Balance Sheet of Windysand Company as at 31 December

Year 1 Year 2

£00 £0,0 £00 £0,0

Fixed assets 320,000 350,000

Current assets 5,000) 45,000)Deduct: Creditors: amounts fallingdue within one year v(w3v,w0w0w0v) v(w1w0v,w0w0w0v) w w3w5v,w0w0w0

w w w2v,w0w0w0322,000 385,000

Deduct: Creditors: amounts fallingdue after more than one year w2w2w2v,w0w0w0 w2w0w2v,w0w0w0

w1w0w0v,w0w0w0 w1w8w3v,w0w0w0w0w0w0v,w0w0w0 w0w0w0v,w0w0w0

Shareholders’ funds w1w0w0v,w0w0w0 w1w8w3v,w0w0w0

(a) How much profit does it at first seem that the company made during Year 2?(b) How would your answer to (a) be affected if you found out that the company had paid

£10,000 in dividends; that additional shares with a value of £20,000 had been issued; andthat fixed assets had been revalued upwards by £30,000?

8 You are given the following simplified balance sheets of the Domer Castle Company and theWarmer Castle Company as at 31 December Year 1:

Domer Castle Warmer Castle

Fixed assets £,00 £,00 £,00 £,00

Tangible assetsFreehold land and buildings (at cost) 300,000 100,000Furniture (at cost less depreciation) 4,000 80,000Vehicles (at cost less depreciation) w w1w0v,w0w0w0 w w9w0v,w0w0w0

314,000 270,000Investments �–� 314,000 w w4w4v,w0w0w0 314,000

Self-testing Questions (continued)

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Current assetsStocks 8,000 19,000Debtors 12,000 10,000Cash and Bank w w1w4v,w0w0w0 w w w5v,w0w0w0

34,000 34,000Current liabilities

Creditorsw w1w7v,w0w0w0 w1w7v,w0w0w0

Net current assets w w1w7v,w0w0w0 w w1w7v,w0w0w0Total assets less current liabilities 331,000 331,000

Creditors: amounts falling due after more thanone year

10% Debentures w1w0w0v,w0w0w0 w2w0w0v,w0w0w0w2w3w1v,w0w0w0 w1w3w1v,w0w0w0

Capital and reservesShare capital 100,000 100,000Retained profits w1w3w1v,w0w0w0 w w3w1v,w0w0w0

w2w3w1v,w0w0w0 w1w3w1v,w0w0w0

During Year 1 the operating profit (earnings before interest and taxation�14) of the DomerCastle Company amounted to £31,000. The operating profit of the Warmer Castle Companyamounted to £32,000.

Which of the two companies appears to be financially weakest, and why? You should calcu-late the current ratio, the liquidity ratio, the capital gearing ratio, and the interest times cover.

9 You are given the following simplified balance sheet of the Stonefolk Company as at 31 MarchYear 4:

£00, £00,

Fixed assets 158,000Current assets

Stocks (at cost) 110,000Debtors 120,000Cash w w2w0v,w0w0w0

250,000Creditors w1w2w0v,w0w0w0 w1w3w0v,w0w0w0

w2w8w8v,w0w0w0

Share capital 250,000Retained profits w w3w8v,w0w0w0

w2w8w8v,w0w0w0


14 ‘EBIT’ is a widely used measure. It is not always the same as operating profit.

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ASSESSMENT QUESTIONS 23

(a) The following transactions took place in April Year 4. Show how each would affect thebalance sheet. (Each transaction must affect two or more figures, and the balance sheetmust continue to balance.)

(i) A building which had cost £80,000 was sold for £100,000 which was immediatelyreceived in cash.

(ii) Stocks which had cost £30,000 were sold to Mr Spliff for £80,000. Mr Spliff agreedto pay for the goods by the end of May Year 4.

(iii) The company paid £40,000 of the amount that it owed to creditors.

(b) Show how the balance sheet would appear after these transactions have been recorded.


1 What are the main functions of a balance sheet?

2 You are given the following simplified balance sheet of the Hackin Company as at 30 June Year 9:

£00 £00


Stocks (at cost) 60,000Debtors 40,000Cash w1w2w0v,w0w0w0

220,000Creditors w1w0w0v,w0w0w0 w1w2w0v,w0w0w0

w3w7w0v,w0w0w0

Share capital 250,000Retained profits w1w2w0v,w0w0w0

w3w7w0v,w0w0w0

(a) Calculate the company’s current ratio and liquidity ratio.(b) The following transactions take place during July Year 9:

(i) New fixed assets are bought for £80,000, and payment is made in cash.(ii) Additional stocks of goods are bought for £15,000; it is agreed that they will be paid

for in August.

Prepare a revised balance sheet after these transactions have been recorded.

(c) How do these transactions affect the current ratio and the liquidity ratio?

Assessment Questions

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3 You are given the following simplified balance sheets of the Fourpine Company as at31 December:

Simplified Balance Sheet of Fourpine Company as at 31 December

Year 1 Year 2

£00, £00, £00, £00,

Fixed assets 520,000 450,000

Current assets 45,000) 55,000)Deduct: Creditors: amounts fallingdue within one year v(w3w0v,w0w0w0v) v(w3w5v,w0w0w0v)

w w1w5v,w0w0w0 w2w2w0v,w0w0w0535,000 470,000

Deduct: Creditors: amounts fallingdue after more than one year w2w0w0v,w0w0w0 w1w0w0v,w0w0w0


Shareholders’ fundsShare capital 300,000 310,000

w w3w5v,w0w0w0 w w6w0v,w0w0w0w3w3w5v,w0w0w0 w3w7w0v,w0w0w0

(a) How much profit does it at first seem that the company made during Year 2?(b) How would your answer to (a) be affected if you found out that the company had paid

£25,000 in dividends?

4 You are given the following simplified balance sheets of the Port Andrew Company and thePort Edward Company as at 31 December Year 1:

Port Andrew Port Edward

Fixed assets £00 £00 £00 £00

Tangible assetsFreehold land and buildings (at cost) 100,000 200,000Machinery (at cost less depreciation) 200,000 100,000Vehicles (at cost less depreciation) w1w0w0v,w0w0w0 w1w0w0v,w0w0w0

400,000 400,000Investments w2w0w0v,w0w0w0 600,000 w w3w0v,w0w0w0 430,000

Current assetsStocks 70,000 40,000Debtors 50,000 90,000Cash and Bank w w1w0v,w0w0w0 w w6w0v,w0w0w0

130,000 190,000

Assessment Questions (continued)

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ASSESSMENT QUESTIONS 25

Current liabilitiesCreditors w w7w0v,w0w0w0 w w8w0v,w0w0w0

Net current assets w w6w0v,w0w0w0 w1w1w0v,w0w0w0Total assets less current liabilities 660,000 540,000

Creditors: amounts falling due after more than one year

10% Debentures w3w0w0v,w0w0w0 w1w0w0v,w0w0w0w3w6w0v,w0w0w0 w4w4w0v,w0w0w0

Capital and reservesShare capital 300,000 300,000Retained profits w w6w0v,w0w0w0 w1w4w0v,w0w0w0


During Year 1 the operating profit of the Port Andrew Company amounted to £61,000. Theoperating profit of the Port Edward Company amounted to £40,000.

Which of the two companies appears to be financially weakest, and why? You should calcu-late the current ratio, the liquidity ratio, the capital gearing ratio, and the interest times cover.

5 You are given the following simplified balance sheet of the Whiting Company as at 31 AugustYear 6:

£0,0 £00,


Stocks (at cost) 90,000Debtors 80,000Cash w w3w0v,w0w0w0

200,000Creditors w1w3w0v,w0w0w0 w w7w0v,w0w0w0

w4w2w0v,w0w0w0

Share capital 380,000Retained profits w w4w0v,w0w0w0

w4w2w0v,w0w0w0

(a) The following transactions took place in September Year 6. Show how each would affectthe balance sheet. (Each transaction must affect two figures, and the balance sheet mustcontinue to balance.)

(i) A new machine costing £10,000 was purchased and paid for in cash.(ii) Stocks which had cost £50,000 were sold to Mrs Fish for £90,000 and paid for

immediately in cash.(iii) £30,000 was received from debtors.

(b) Show how the balance sheet would appear after these transactions have been recorded.

Assessment Questions (continued)

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References and Further Reading

Glynn, J., M. Murphy, J. Perrin and A. Abraham (2003) Accounting forManagers, 3rd edn, Thomson Learning.

Pendlebury, M. and R. Groves (2003) Company Accounting: Analysis,Interpretation and Understanding, 6th edn, Thomson Learning.

Wood, F. and A. Sangster (2002) Business Accounting Volume 1, 9th edn,Pearson Education.

www.tedbaker.co.uk (select: £, share info, investor relations)

1 Each individual in the group should attempt to answer the question ‘How much am I worth?’There is no need to disclose actual figures or personal information. The objective is to deter-mine – and for members of the group to agree – the way in which the question would beanswered. What principles or rules would you use?

2 Each member of the group should choose two listed companies, and obtain their publishedbalance sheet (from the companies’ websites; or by using the Financial Times Annual ReportsService). Try to assess how financially strong each company is (or is it likely to collapse?). Thegroup should rank each of the companies that members have examined from the strongestfinancially, to the weakest. The group should discuss, and try to agree, criteria to form the basisfor this assessment.

3 Is it possible to calculate the value of a company? If not, why not? If so, how?

4 Which of the following should be included as assets on a company’s balance sheet: moneywhich is owed to the company; the cost of an advertising campaign; machinery which is over20 years old but which is still used occasionally; key employees who have a high market value;money paid as ‘commission’ to a government minister in Wayawayaland which has helped tosecure a lucrative contract; brand names; profits that will be earned next year on a contractwhich was signed yesterday; machinery which the company does not own, but for which theyhave signed a 5-year lease.

Group Activities and Discussion Questions

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