Introduction to Financial Statements (part two)
The Balance Sheet
Last week we looked at the profit and loss statement and we move on this week to look at the balance sheet.
A balance sheet is a statement of balances at a point in time in regard to what the company owns (its assets), what it owes (its liabilities) and who owns the company (its equity). The accounting equation which must always hold true is therefore:
Assets less Liabilities equals Equity, or put simply what the company is worth take off what is owed to creditors results in what is owned by the owners/shareholders.
The bare bones of a balance sheet looks like this:
Fixed assets £X
Intangible Assets £X
Current Assets £X
Total Assets £X
Current Liabilities £X
Non-Current Liabilities £X
Total Liabilities £X
Net Assets £X
Equity/Owner's Interest £X
The difference between the definition of current or non-current is if the business expects to have possession of the asset/liability in 12 month's time. So Inventory would be a current asset, whereas land would be non-current; trade payables would be a current liability, whereas a secured loan would be a non-current liability. Also in terms of convention assets are usually listed in terms of their least liquid (how easily converted to cash) to its most liquid. Therefore cash would be the final entry on the current assets.
Net Assets are the total assets minus the total liabilities, and following on from the accounting equation above this must equal the equity.
In reality there are many sub-divisions that the above skeleton of a balance sheet is usually broken down into. It is on this richer detail that the management accountant goes to work to derive values from ratios to add value the reader of the statements and aid decision-making.
In last week's post we mentioned the ratio asset turnover. This is the total revenue divided by the total assets. This tells you how you are "sweating the assets", what multiple of your invested capital is being translated into sales. Have you invested heavily in assets in recent years and is this being translated into a better sales performance? Is this ratio declining, and do you have a good understanding of why? Where do you rank in terms of your peers in the industry you operate?
Another key metric is ROI or return on investment, this measures the profit you make divided by the 'total assets less current liabilities'. This assumes you are a going concern and can service long-term debt and demonstrates what return you are making on your business and is easily comparable across industries. Looking at growth in ROI is also useful to understanding performance.
Finally I would like to talk about the cash collection cycle. This is calculated by working out the number of days it takes to pay suppliers (payables days), how quickly the company can then convert this inventory into sales (inventory days) and then how long it takes to get paid from a sale (receivable days). Cash collection cycle = receivables days less inventory days less payables days. For some firms this will be a bigger number than for others, for highly cash-generative companies such as supermarkets for example this could be a negative number!
This introduces next week's blog and the final topic in this series; cash, namely the cash flow statement. Profit is one thing but of course "Cash is King" and decision-makers need to keep this in mind when it comes to the importance of accurate cash forecasting.