12.04 – Balancing The Books
Knowing where you are financially is essential before making any plans for the future. A business summarizes its current position in a balance sheet, the primary reporting document. The balance sheet contains the cumulative evidence of financial events, showing where money has come from and what’s been done with it. Logically, the two sums must balance.
In practical terms, balancing your books takes quite a bit of work. The hardest part isn’t necessarily balancing, but figuring out the numbers. Your cash-in-hand figure is probably accurate, but can you say the same for the value of your assets? Accountants have their own rules on how to arrive at these figures, but they are approximations. Every measuring device has inherent inaccuracies, and financial controls are no exception.
To help balance the books, the balance sheet sets out a business’s assets and liabilities in a way that makes it easier to understand crucial relationships. The following sections explore the balance sheet and the essential technical terms you need to grasp to get the full picture of how a business is faring.
Balancing A Balance Sheet
In formal accounts, figures are set out vertically rather than horizontally, as shown in Figure 13-9. Long-term borrowings, such as the mortgage and hire purchase charges, are named Creditors, amounts falling due in over 1 year, and deducted from the total assets to show the Net total assets being employed.
The bottom of the balance sheet shows how the owners have supported these assets, typically through their own funds or reinvested profits. For example, an owner’s house converted into business premises owned by the company would appear here, with wider implications but none relevant to the arithmetic or the balance sheet.
Balance Sheet Example
Categorising Assets
Accountants describe assets as valuable resources owned by a business, acquired at a measurable monetary cost.
An exception is goodwill, which is the value placed on the business’s reputation and other intangible assets, like a brand name. Goodwill usually appears in accounts when a business is sold for more than the value assigned to the tangible assets. An owner may feel they have created goodwill, but it will not appear as an entry until the business is sold or bought for more than the tangible assets.
A useful convention is to list assets in the balance sheet in order of permanence, starting with the most difficult to turn into cash and working down to cash itself. This structure is practical when comparing balance sheets or recognizing information gaps quickly.
Accounting for Liabilities
Liabilities are claims against the business. These claims include tax, accruals (expenses for items used but not yet billed for, such as telephone and utilities), deferred income, overdrafts, loans, hire purchase, and money owed to suppliers. Liabilities can also be harder to identify and quantify, such as bad debts.
Understanding Reserves
Reserves are the accumulated profits a business makes over its working life, which the owner has reinvested into the business rather than taking them out.
For example, Jane Smith’s balance sheet shows her capital as the sole support for the liabilities of the business. This implies she put this whole sum in at once. In practice, this sum is likely to have been paid over time and in various ways.
She might have started with £25,000 and, over time, made a net profit after tax of £50,000, reinvesting this amount to finance growth. Additionally, the premises bought a few years ago for £111,615 have been re-valued at £150,000, a paper gain of £38,385.
Reserves Example
The profit of £50,000 reinvested in the business is called a revenue reserve, meaning the money exists and can be used to buy stock or more assets. The increase in value of the business premises is a paper increase. Jane can’t use the £38,385 increase in capital reserves to buy anything until the premises are sold. However, she can use that paper reserve to secure a loan from the bank, turning a paper profit into a cash resource. Both reserves and the capital introduced represent all the money that the shareholder has invested in this venture.
Understanding and managing these elements ensures that you can make informed decisions and maintain a clear picture of your company’s financial health.
