Accounting for Dummies: Part 3
In a previous blog post I introduced the two key accounting documents that you use to manage your business. This post concentrates on the second one of these, the Balance Sheet.
The balance sheet is a snapshot of all your assets and liabilities at a point in time, this can be the year end, month end, quarter end depending on your bookkeeping habits.
The balance sheet has a direct relationship with the P&L as follows. The profit or loss retained for the period will equal the net increase or decrease in your balance sheet totals or net assets. The format of the balance sheet is a listing of your assets and liabilities according to type and the figure at the bottom is known as net assets. This figure will always balance with the capital of the business which represents the cash that you the owner has tied up in the business. This figure of net assets (also called shareholders funds) is in theory similar to the ‘value’ of the company but in reality they can differ substantially. Valuation of companies is an art rather than a science (perhaps another post) but differs from net assets in the following key ways.
- Net assets values a business at the break-up value of its assets and liabilities and takes no account of the goodwill or intrinsic value of the business as a going concern
- Balance sheets do not place a value on brands or other intangible assets such as the skills and experience of staff
- Net assets value is usually the floor of a range of valuations depending on valuation methods used.
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…are always the first item in the Balance sheet. These are as the name suggests semi-permanent assets which are necessarily used by the business in its trading activity. These usually include Land and buildings, Plant and equipment, Fixtures and fittings and Motor Vehicles. Depreciation will be charged on these (written off to P&L) over the useful lives of the assets.
…are the short term assets used in the business and are usually made up of cash, debtors and stocks.
…are the opposite i.e. short term liabilities of running the business and are made up of overdrafts, creditors and accruals. The difference between Current assets and liabilities is known as Working Capital and a 2 to 1 ratio was always seen as healthy when I went to school.
Ratio analysis on your working capital figures is one of the best ways of measuring and monitoring the financial health of your business. Debtor days, stock days, creditor days define your business and careful cash-flow management is essential for business survival
The larger a business gets, other measures become more important like Return on Investment (ROI), Gearing ratios, Earnings per share (EPS) and Price Earnings ratio (P/E). These all measure the attractiveness of a business as it looks to investors rather than management.