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A balance sheet is one of the most critical financial statements for any business or individual.
Providing a snapshot of financial health at any specific point in time, it shows what you own (assets), what you owe (liabilities), and your net worth (equity).
Properly understanding and analysing a balance sheet allows you to make informed decisions regarding growth, investment, risk, and financial strategy.
In this article, Emma Clifton, Business Advisory Partner, breaks down the most important components of a balance sheet and how to better understand yours.
What is a Balance Sheet?
Also known as the statement of financial position, a balance sheet is divided into three main sections:
- Assets: Everything the business owns, such as cash, debtors, stock, and property.
- Liabilities: All obligations or debts, including loans, suppliers, HMRC and other obligations.
- Equity: The funds attributable to the business owners after all debts have been received and all creditors have been paid.
It uses one fundamental equation:
Assets = Liabilities + Equity
Whilst many have tried to defy the laws of double entry over the years, it remains that for every debit there must be a credit, and therefore the balance sheet must always balance!
Understanding Net Assets
Net assets, sometimes referred to as “net worth”, represent the difference between total assets and total liabilities. This is essentially what remains for the owners or shareholders after all liabilities have been settled.
Net Assets = Total Assets − Total Liabilities
Net assets are a key indicator of financial health. A positive net asset figure means that the company owns more than it owes, whilst a negative net asset value is the opposite, which can suggest financial distress.
When evaluating net assets though, it’s essential to look at the quality of both the assets and the liabilities. For example, long-term investments or property can signify stable, valuable assets, whilst high levels of short-term debt might raise concerns about the business’s financial stability.
Gearing: A Measure of Financial Leverage
Gearing refers to the proportion of a company’s debt in relation to its equity, and is a key measure of financial leverage. It shows how much of the company’s operations are financed by debt versus equity. High gearing indicates a high level of debt in relation to equity, whilst low gearing means the company relies more on equity.
The formula for gearing can be expressed as:
Gearing Ratio = Total Debt / Equity
A high gearing ratio suggests that the company is more reliant on borrowing to finance its operations, which can be risky, especially during times of financial instability or interest rate increases. However, some industries often have to operate with higher gearing ratios due to the capital-intensive nature of their business.
There are some key points to consider with this:
- High gearing can lead to higher returns on equity during the good times but can also lead to increased risk during the bad times.
- A lower gearing ratio typically signifies a more conservative financial structure, which often replicates the owners’ attitude to risk.
Liquidity: The Ability to Meet Short-Term Obligations
Liquidity refers to how easily and quickly a company can convert its assets into cash to pay off short-term liabilities. It’s a critical concept in balance sheet analysis because businesses need to have enough liquid assets to cover their current obligations.
Two key ratios help in assessing liquidity:
- Current Ratio: The ratio of current assets to current liabilities. This measures whether the company has enough assets that can be quickly converted into cash to cover its liabilities due within one year.
Current Ratio = Current Assets / Current Liabilities
- Quick Ratio: A stricter version of the current ratio. This excludes stock and work in progress from current assets, and focuses on assets that can be more immediately liquidated, like cash and trade debtors.
Quick Ratio = Current Assets – Stock & WIP / Current Liabilities
A company with low liquidity might struggle to meet its financial obligations, that can eventually lead to insolvency. Conversely, a high liquidity position provides flexibility and security and opportunities for growth and investment.
Why do I need a Balance Sheet?
A balance sheet can be a vital tool for assessing the financial health of a company and its operational success. By calculating and examining the ratios above, it can provide important information to stakeholders and potential investors about a company.
A balance sheet is also an important tool for strategic planning as it reflects the results of past decisions and trading to provide a platform for the future success of the business. It can also be used to set financial targets, plan for investment and growth, and offer insights into what’s working well and what isn’t.
Ultimately, under the Companies Act 2006 all companies must prepare and file annual accounts each year, which includes a balance sheet. Therefore, as a Director of the Company, you must file a balance sheet to comply with your legal duties.
In summary
A balance sheet offers an invaluable insight into the financial health of your business. By understanding key concepts such as net assets, gearing, and liquidity, you’ll gain a clearer picture of your company’s financial position and its ability to navigate both opportunities and challenges.
And with regular analysis of these factors you’ll be able to make well-informed financial decisions and maintain a healthy balance between debt, equity, and assets – ultimately guiding you toward sustainable financial success.
If you’d like Emma or a member of the team to help you get your business finances in order so that you understand your current financial position, please call 0330 058 6559 or email hello@scruttonbland.co.uk
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