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Balance sheet

What is a balance sheet?

A balance sheet is a snapshot of what a company owns (assets), and what it owes (liabilities), at a certain point in time.

It’s used together with the income and cash flow statements to assess the financial health of a business.

What is a balance sheet used for?

The balance sheet shows how stable a company’s financial position is. One way it can do that is by giving us the tools to work out a company’s net debt position.

Net debt is calculated by subtracting cash and its equivalents away from total debt.

If a company has more debt than cash, then it will have a net debt position. If there’s more cash than debt, then the net debt position will be negative, and the business is “net cash”. A net debt position isn’t necessarily a bad thing, so long as the company can afford to keep up with the repayments.

How does a balance sheet work?

Balance sheets hold a clue in their name – a company’s assets, liabilities and shareholders’ equity must balance. This idea is highlighted in what’s known as the ‘accounting equation’, which is shown below.

Assets = Liabilities + Shareholders’ Equity

Assets are the things a company owns. Typical assets are cash, property, equipment or vehicles. They can also be non-physical, like intellectual property, or brands.

Liabilities simply represent an amount owed. This could include unpaid bills, mortgages or bonds.

Shareholders’ equity represents the portion of the business over which shareholders have a claim. It’s best thought of as the assets that are left over after paying back lenders. It includes money raised from share sales (share capital) and retained earnings, which is profits left over from previous years. It can be used to pay dividends or reinvested back into the company. Remember all dividends are variable and not a guarantee of future income.

The easiest way to think about how the accounting equation works is through an example. Imagine a company wanted to build a new factory: it could do this by borrowing £10m, which would mean its assets, specifically cash, would go up by this amount. At the same time its debts, or liabilities, would also increase by £10m.

Alternatively, if the company decided to raise the money by selling new shares, then assets would rise, but so would shareholder’s equity.

Balance sheet example and how to read it

Non-current assets
Property, plant and equipment 50 45
Intangible assets 20 18
Deferred tax 6 4
Total non-current assets 76 67
Current assets
Cash and cash equivalents 12 10
Inventories 18 15
Trade and other receivables 10 11
Total current assets 40 36
Total assets 116 103
Non-current liabilities
Loans -5 -4
Defferred tax -3 -5
-8 -9
Current liabilities
Loans and overdrafts -4 -4
Trade and other payables -7 -3
Tax payable -6 -8
-17 -15
Total liabilities -25 -24
Net assets 91 79
Shareholder's Equity
Share capital 50 45
Retained earnings 41 34
Total equity 91 79

The other odd wording on a balance sheet is when you see “current” and “non-current” attached to assets or liabilities. All this tells you is the timescale in which an asset could be converted to cash, or when a debt is due. Anything current can usually be turned into cash in under a year, and non-current is anything longer than that.

Most companies will also show a deferred tax number. This can show up as an asset, where a company has overpaid tax, which will see an amount returned to the company. Deferred tax can also be a liability, when tax is due in the future. Both of these discrepancies usually occur because financial years don’t always match tax years.

Investors shouldn’t necessarily worry too much about this number – companies can’t often do much to control the tax they pay after all.

The bottom line

The balance sheet is a very important tool used for assessing a business’s financial strength. But remember it’s a historical snapshot, not a summary of a longer period. That can make balance sheets prone to manipulation. For example, a company could call in debts for the balance sheet date, temporarily improving the net cash position.

Even if there’s no intentional manipulation at work, all companies will see their balance sheets vary over time. There’s no reason that the balance sheet date should be representative of the longer-term norm.

Investors should always look at a balance sheet with other financial statements, including the summary of cash flows which we’ll be looking at next week. Remember to look back beyond the current year to see how a company and its position has changed and its wider future prospects. Figures shouldn’t be looked at in isolation.

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