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Reading a balance sheet.

[check] This checklist is designed to help you read and understand a balance sheet. It is intended as a guide, not as a replacement for full accounting support and interpretation.

Definition

A balance sheet is a snapshot of a company's financial position at a given date. It differs from a profit and loss account which summarises a company's trading performance during a given period. The date of the balance sheet is always disclosed in the heading and the figures are (or should be) correct as at that date.

Every balance sheet includes the balance of every account in the accounting system. Accounts are not usually shown individually, but those of a similar nature are grouped to show just one net figure for each category. For example, there may be many accounts relating to fixed assets and accumulated depreciation, but just one net figure will be shown in the balance sheet. All the accounts of a profit and loss nature are aggregated to show a net profit or net loss. This is shown in the balance sheet as part of capital and reserves.

A balance sheet summarises the balances in a double-entry bookkeeping system and as a consequence it must balance. This means that the total of all the debit balances (assets) must equal the total of all the credit balances (liabilities). These totals always appear twice. The method of presentation usually shows some liabilities being deducted from the assets, but there are always two identical totals.

A company may produce a balance sheet for internal purposes; this may be done in any way chosen by the management and as at any date. However, a balance sheet must be prepared as at the last day of the company's financial year, which is the final date of the profit and loss period. This balance sheet is published and it must be drawn up in accordance with recognised statutory and accounting rules.

Advantages of understanding a balance sheet

* It should help provide a thorough and detailed understanding of a company's financial position. This is especially true when it is studied in conjunction with the notes and the other financial statements.

* It may be compared with earlier balance sheets to see how a company is progressing.

* It should indicate the solvency and liquidity of a company and it may predict impending financial difficulties.</p> <pre> ACME LTD Balance Sheet at 30th June 2001 30th June 2001 [pounds [pounds

sterling] sterling] Fixed assets Tangible assets 2,398,834 Current assets Stocks

5,545,805 Debtors 4,614,264 Investments 28,250 Cash at bank and

3,423 in hand Creditors: amounts falling due within one year

(5,500,243) Net current assets 4,691,499

(5,500,243) Total assets less

7,090,333 current liabilities Creditors: amounts falling due after (747,665) more than one year Provision for (20,885) liabilities and charges Net assets 6,321,813 Capital and reserves

Called up share capital 1,779,992 Revaluation reserve

620,240 Profit and loss account

3,921,581 Shareholders' funds 6,321,813

30th June 2000

[pounds [pounds sterling]

sterling] Fixed assets Tangible assets

2,450,804 Current assets Stocks 5,068,240 Debtors 5,948,817 Investments

94,930 Cash at bank and 3,467 in hand

11,115,454 Creditors: amounts falling due

(6,642,622) within one year Net current assets

4,472,832 Total assets less 6,923,636 current liabilities Creditors: amounts falling due after

(918,458) more than one year Provision for

(37,100) liabilities and charges Net assets

5,968,078 Capital and reserves Called up share capital 1,779,992 Revaluation reserve

634,200 Profit and loss account 3,553,886 Shareholders' funds 5,968,078 The financial statements were approved by the Board on Director The notes on pages ... to ... form part of these financial statements. </pre> <p>Points to remember about balance sheets

* A balance sheet is always out of date. It shows figures obtained at some specified date in the past.

* Some of the figures may reflect subjective judgments. Examples are the bad debt reserve and the valuation of stocks.

* Some of the book values may differ from the 'real-life' realisable values. An example is the figure for fixed assets after accumulated depreciation.

Published balance sheets

The balance sheet on the last page must be in a form suitable for publication.

The Companies Act 1985 as amended requires that published balance sheets are shown in one of two Specified formats--the horizontal format or the vertical format. Virtually all balance sheets are in the vertical format, and the example is shown in this way.

The Companies Act specifies a long list of headings that must be used. However, if there is a nil balance for a heading, it may be omitted.

A balance sheet should always accompanied by explanatory notes. Comparative figures for the previous published balance sheet must be given.

A balance sheet must be formally approved by the directors and signed by one of them. It must be sent to Companies House within 10 months (if it is a private company) or 7 months (if it is a public company). The directors may take an extra 3 months if there are exports or overseas interests. Anyone can get a copy of the balance sheet of any company by telephoning Companies House on 0870 333 3636.

If the annual turnover exceeds 1,000,000 [pounds sterling] (90,000 [pounds sterling] for a charitable company) a balance sheet must be audited. An audit is also required for some companies that have a lower turnover. These figures are currently under review and may be increased.

Action checklist

1. Look at shareholders' funds

The balance sheet is set out showing the liabilities deducted from the assets. The amount left over, provided that the company is solvent, is the value that the owners have invested in it. In the example this figure is 6,321,813. [pounds sterling] Shareholders' funds will be split into share capital accounts, reserve accounts and profit and loss account. Notes will give further details. If, in the example, there are 1,000,000 shares in issue, each has a net asset backing of 6.32 [pounds sterling].

2. Look at net current assets

Current assets are likely to be owned for less than a year or realisable in less than a year, and further details are usually given in the notes. They may include:

* short-term investments

* stocks

* money owed to the company (debtors)

* prepayments (payments, such as rent, made in advance)

* bank accounts in credit

* cash.

3. Look at current liabilities

Current liabilities are short-term debts due to be settled within the next year and further details are usuallyg given in the notes. They may include:

* bank overdrafts and short-term loans

* money owed by the company (creditors)

* accruals (debts incurred where invoices have not yet been received).

4. Consider the figure for net current assets

This is current assets less current liabilities. It is a very important figure. The greater the figure the greater the margin of safety, with less chance of a funding crisis in the near future. There is nearly always a figure for net current assets, and a deficit is termed net current liabilities. This would be cause for serious concern or, at the very least, indicate a need to ask some searching questions. In the example the figure is 4,691,499 [pounds sterling]. This seems satisfactory.

5. Examine the fixed assets

Assets are items owned by the company, expressed in financial terms. 'Fixed assets' are those items of long-term value to a business and appear at the top of the balance sheet. They may be divided into three categories: tangible--land, buildings, plant, equipment, machinery, fixtures and fittings, motor vehicles intangible--licences, intellectual property, patents, goodwill investments--in other companies, government stocks.

Fixed assets are likely to be long-term assets and are most likely to be items in which the company does not trade.

6. Consider the accounting policies

The key accounting policies will be disclosed in the notes. The most important questions are likely to include:

* How are the stocks valued?

* What are the policies concerning depreciation of fixed assets?

* What are the policies concerning the bad debt reserve and other reserves?

Different accounting policies will produce different profit or loss figures and a different balance sheet. Any change in accounting policies may be particularly important and must be disclosed in the notes.

Dos and don'ts for understanding a balance sheet

Do

* Remember that it is essential to read the notes and study the accounting policies.

* Remember that it is useful to study carefully selected ratios and that it is useful to compare balance sheets as at different dates.

* Remember to study the balance sheet in conjunction with the other financial statements and reports. It is important to see the complete picture.

Don't

* Forget that the assets are 'book values' and not necessarily what would actually be obtained in the event of a sale.

* Forget that a balance sheet is a snapshot on one particular one day, and that it is out of date by the time it appears.

Useful reading

The meaning of company accounts, 8th ed, Walter Reid and D R Myddleton

Aldershot: Gower, 2005

Reading between the lines of company accounts, Stephen Bloomfield

Tadworth: Elliot Right Way Books, 2001

How to read a financial report: wringing vital signs out of the numbers 5th ed,

John A Tracey

New York NY: John Wiley, 1999
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Title Annotation:Checklist 130
Publication:Chartered Management Institute: Checklists: Small Business
Geographic Code:4EUUK
Date:Oct 1, 2005
Words:1578
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