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INTERPRETATION
OF ACCOUNTS FOR BEGINNERS
This document is designed to
provide an introduction (or refresher) for non-accounting professionals who are
involved (maybe as part of a team) in advising businesses that are in financial
difficulties.
Contents –
Interpreting the Balance
Sheet
INTRODUCTION
As with any form of decision making having accurate information on which
to base the decisions is vital. However, when a business is in financial
difficulties those who are brought in to advise on the
options for recovery or whether recovery is likely to be possible are often
confronted with information that is out of date. Even where book keeping has
been good it is important to remember that some financial events can overwhelm
a business very quickly. The most obvious event that impacts dramatically on
the financial viability of a business is that a larger debtor of that business
defaults.
Nevertheless the accounts of any business provide one of the most
reliable bases for assessing the performance of a business. However, it is
important to remember that accounts are normally produced for a particular
purpose, usually the Inland Revenue, particularly so in the case of a small or
medium sized business. If they are to provide a fuller insight as to the health
of the business they will need interpretation.
The two main financial statements are the Balance Sheet and the
Trading and Profit and Loss Account, but there may also be a Source and Application of Funds
Statement.
THE BALANCE SHEET
The Balance Sheet shows what funds are employed in the business. It
shows how they are employed (these are the ASSETS) and how they were provided (these
are the LIABILITIES). The balance sheet shows this state of affairs at a
particular moment, usually the last day of the trading year but it can be
prepared for any other time that it is required.
Assets
Assets
can take many forms from buildings or land to machinery or cash and even to money
that is owed to the business in the form of debts. Assets are normally grouped
into two categories.
The
first group is those assets
which form the means of production and which are not normally traded
these are the Fixed Assets.
The
second category is those assets which are intended to be sold in the normal
course of business these are the Current Assets.
Land or Machinery would be regarded as Fixed Assets because although
they can be sold and in the case of say a car they will eventually be sold
the buying and selling is incidental to the main reason for having them which
is as a means of production. Raw materials are current assets because they are
purchased as an ingredient of production and the finished product is also a
Current Asset because it will be sold.
Within the broad groupings of fixed assets and current assets it is
possible to see a range of "Fixedness" from land and buildings at one end of the scale to cash at the other
end so that it is normal to list the assets in order starting with the most
fixed and descending to the most liquid.
The assets in a typical farm balance sheet would be grouped as follows:-
ASSETS
Land )
Buildings
and Improvements )
Fixed Assets- the means
Machinery )
of production
)
Raw Materials )
Work in Progress )
Current Assets-
Finished
Products )
production in progress
Debtors )
Cash
in the Bank )
Liabilities
The second part of the balance sheet shows how the assets employed in
the business were provided.
The term "liability" has an slightly
ominous meaning in everyday parlance but in the balance sheet this is not
necessarily so. Much of the money employed in the business will usually have
been provided by the owners, both in the form of the initial capital they
invested in the business and profits earned by the business over the years that
have been retained , these are “good” but they will still be shown as a
liability. So interpreting the liabilities it must be considered to whom there
is a liability.
Apart from the owners of the business and retained profits funds will
have been supplied by banks or other lending institutions who
have made funds available on a formal basis. Another source of funds will be
suppliers of goods and services to the business on credit. These do not regard
themselves as investors in or lenders to the business and expect to be paid
within a short period.
So just as the level of "fixedness "
varied with different assets so the long term availability of funds to the
business may vary. Long term liabilities represent those investors or owners of
the business who do not expect to have their money repaid whilst the business
continues. Medium term liabilities are fund provided for an agreed period, such
as is the case with a mortgage or bank loan. Current Liabilities are those
funds provided without any commitment to the business and due to be paid quite
soon, theoretically instantly.
The
liabilities of a typical balance sheet for a Small or Medium Sized Business
might
look like :-
LIABILITIES
Owners
Capital )Long Term Liability
plus retained profit. )
Mortgage )
Bank
Loan )Medium Term Liability
Hire
Purchase Agreement )
Bank
Overdraft )Current Liabilities
Trade
Creditors )
Balance Sheet Layout
Traditional Layout
Traditionally Balance Sheets were arranged with the Assets shown in a
vertical column on the right hand side of the page and the Liabilities in a
column on the left. The assets and liabilities were normally arranged with the
long term assets and liabilities at the top and the current at the bottom.
LIABILITIES ASSETS
Mortgage Buildings
&
Loan
capital Improvements
Bank
Overdraft Machinery
Trade
Creditors
Finished
Products
Raw
Materials
Debtors
Cash
in Bank
___________________ ___________________
Total
Capital Employed Total
Capital
Employed
Modern Layout
Modern
accounting practice is to arrange Balance Sheets horizontally
:-
FIXED ASSETS
Land
Buildings
Machinery
Breeding
Livestock -----------
Total Fixed Assets
CURRENT ASSETS
Growing
Crops & Livestock
Harvested
Crops
Stores
Debtors
Cash
in Bank
--------------
Total
Current Assets
---------------
Total
Assets
CURRENT LIABILITIES
Bank
Overdraft
Trade
Creditors
-------------
Total Current Liabilities
-------------
Net Assets
FINANCED
BY
Mortgage
Loan -------------
Net Worth -----------
Total Capital Employed
INTERPRETING THE BALANCE SHEET
Owner's Equity
The owner's stake in the business is shown as a liability, but this
liability is the least likely to have to be repaid so represents little threat
to the business, It follows then that the higher the proportion that the
owner's stake (called the owner's equity) is of the total assets employed in the
business, the less vulnerable is the business to demands for repayment of loans
or more normally the payment of the interest charges on them or the payment of
creditors. Clearly any organisation being asked to provide funds for a business
would prefer that in the event of misfortune there will be sufficient assets in
the business to repay them, so a business with a high owner's equity would be
considered a safer lending proposition than one with a low owner's equity.
The
Ratio of Owner’s Equity can be expressed by the formula :-
Owner's
Capital (Net Worth) X 100 = Owner's
Equity
Total Assets
Liquidity
Apart from how much money is employed in the business the balance sheet
shows how the funds are employed and how they are provided. It provides further
insight by showing relative demand and availability of money in terms of time.
The liquidity of a business is the measure of the ability of the business to
meet its current liabilities out of its liquid assets. A business that had
£50,000 in cash in the bank would easily be able to pay current liabilities of
£25,000 without interfering with the smooth running of the business and would
be said to have a high level of liquidity. If the business had £25,000 in the
bank and current liabilities of £50,000 it would have difficulty in paying its
bills as they become due and would be said to be a very low level of liquidity.
This could put the business at risk if all the creditors demanded to be paid.
The liquidity of a business may vary through the year. Some business have a
seasonal pattern of production so an arable farm is typically in a liquid state
once the crops are sold, say in winter or early spring but less liquid by
harvest time. A small house builder usually becomes less liquid a house nears
completion and a large amount of money is tied up in its construction but
liquidity improves when the house is sold.
The
Liquidity of a Business can be expressed by the formula :-
Liquid
Assets X 100 = Liquidity
Current
Liabilities
Current Asset Ratio
Whilst liquidity demonstrates the ability of a business to meet short
term liabilities out of cash without the need for forced sales of current or
even fixed assets, it
is often more reasonable to compare the ratio of current assets to current
liabilities on the grounds that in an ongoing business it is unlikely that it
would become necessary to pay all the bills at one time without the opportunity
to collect debts or sell any product.
Ideally current assets should be twice current liabilities, the lower
this ratio becomes the greater the chance that cash will have to be raised
under duress such as by the premature sale of produce or unfinished animals.
The Current Asset Ratio can be expressed by the formula
:-
Current Assets X 100 = Current Asset
Ratio
Current Liabilities
Fixed Asset Ratio
In the case of some types of business so much of the assets are in the
form of very fixed assets, such as property that it can be difficult to raise
cash to meet demands from creditors in the short term. Farm businesses are
often a good example of this category as, particularly in the case of owner
occupiers, most of the assets are in fixed assets of land, building, machinery
and breeding stock. This may lead to the situation where a business with a high
ratio of owner’s equity may still experience difficulties because the ratio of
fixed assets to current assets is too high. This situation can occur when
improvements or land purchase is financed out of working capital.
The Fixed Asset Ratio can be expressed by the formula
:-
Fixed
Assets X 100 = Fixed Asset Ratio
Total
Assets
Gearing
This is a measure of the amount of loan capital employed in the business
in relation to the owner's equity. If the amount of loan capital is high
relative to the owner's equity the business is said to be highly geared. In a
profitable business high gearing is attractive to the owner as it greatly
increases the return on their capital. For example if the business is making a
return on capital employed of 20% and the loan capital costs only 10% then
every extra pound borrowed and invested in the business increases the return to
the owner by 10 pence. The effects of
gearing at different levels can be seen in the following table:-
|
Ratio of Borrowed Capital to Owner's
capital |
Return on Capital |
Interest Rate on Loan Capital |
Return on Owner's Capital |
|
2:1 |
20% |
10% |
40%
|
|
1:1 |
20% |
10% |
30% |
|
1:2 |
20% |
10% |
25% |
BUT if income declines :-
|
Ratio of Borrowed Capital to Owner's
capital |
Return on Capital |
Interest Rate on Loan Capital |
Return on Owner's Capital |
|
2:1 |
10% |
10% |
10% |
|
1:1 |
10% |
10% |
10% |
|
1:2 |
10% |
10% |
10% |
BUT if income declines and interest
rates rise at the same time:-
|
Ratio of Borrowed Capital to Owner's
capital |
Return on Capital |
Interest Rate on Loan Capital |
Return on Owner's Capital |
|
2:1 |
10% |
12% |
9% |
|
1:1 |
10% |
12% |
8% |
|
1:2 |
10% |
12% |
6% |
It
can be seen that
a highly geared business is vulnerable if interest rates rise at the same time
as income declines.-
Gearing can be expressed by the formula :-
Long
Term Loans X 100 = Gearing
Net
Worth (Owner's Capital)
TOTAL DEBT
Whilst gearing deals with the ratio of formal loans (
on which interest is being paid) to the owner's capital in the business,
it is important not to overlook the total indebtedness of a business. Total
indebtedness includes all creditors not just formal
loans.
The
total debt ration can be expressed by the formula :-
External
Liabilities X 100 = Total Debt Ratio
Net
Worth (Owner's Capital)
OVERTRADING
This
is the situation that is often incurred by a successful and rapidly growing
business. As the business expands the need for capital exceeds that which is
available. More raw materials have to be purchased, more wages paid before the
extra revenue from the higher volume of sales is received.
HIDDEN ASSETS AND
LIABILITIES
Accounts are prepared following certain conventions as to how assets and
liabilities are to be valued. This may mean that assets are shown as having a
value greater or less than could be obtained if they were sold.
Some liabilities will not appear on the balance sheet at all as they
will not crystallise until such time as the business
ceases to trade e.g. redundancy payments, dilapidations. These uncrystallised liabilities could be a major consideration
for some businesses which are in difficulties.
Hidden Assets