Understanding Balance Sheets and Profit and Loss Accounts Part 2
This second article follows on directly from the first article (which should be read first) and starts by showing how the more easier to understand ‘side by side’ (Assets on one side and liabilities on the other) style of balance sheet has over time been replaced by the now commonly used ‘vertical’ style, so as to make the document more useful and highlight certain useful things (see later).
Therefore the old style balance sheet shown below…
Please note, in the first instance, that all the same category headings and related blocks of figures are used. The next thing to note is that it can still be described as a ‘Balance Sheet’. It’s just that by changing the layout and ‘doing sums within sums’, we are looking at two different balancing figures. In fact the figures immediately tell us, at first glance what the business is worth, on paper, on the balance sheet date: i.e. in this case £12,500.
This is because the difference between the Total of the Assets less the total of the Current and Long Term Liabilities is what is left as the owners share. Put another way, if all the assets were sold at their book value and all the liabilities were paid (£56,000-£43,500,000) the amount left, or ‘paper value’ of the business, is £12,500. This is sometimes referred to as the ‘Surplus Resources’ of the business.
The next most useful thing to consider is the amount of ‘Working Capital’. This is the difference between the Current Assets and the Current Liabilities i.e. in the short term, is it likely that the business will have enough cash or be able to generate enough cash (by collecting in debtors or selling more stock) in order to pay its short term liabilities. Normally, the bigger the amount of working capital the safer the business is. However if the make-up is a small amount of cash, old or doubtful debtors and say outdated or slow moving stock, then obviously this won’t help much!
Something else that is of interest to lenders, investors and other trading companies who are checking your franchise business out (this may be suppliers or existing or potential customers) is the Gearing Ratio shown by your balance sheet. This is the relationship between the ‘Surplus Resources’ mentioned above and any borrowed money (e.g. bank loans, overdrafts, leasing, HP, factoring etc.).
Gearing is normally expressed as a percentage e.g. where the surplus resources are £50,000 and the borrowing is £50,000 i.e. a ratio of 1:1 this is 100%. This means that the lenders do not have more than you invested in the business and is a good bench mark because most lenders start to become concerned when the ratio starts to get much bigger than this, particularly if they do not have any security.
Balance Sheet Summary
Now you understand what a balance sheet is and are beginning to see what it tells you about your franchise business, you can see it is a very useful document. It becomes even more useful when you look at trends over say three consecutive balance sheets (and this aspect will be referred to further in a separate forthcoming Article next month). Also, you can use your increasing knowledge to investigate the financial strength of your customers, potential customers or even your suppliers to help you make safer decisions on who you should be doing business with.
However, the third and final Article in this series will cover the Profit and Loss Account which is the second and equally important part of a set of accounts. This will be published next week.
The author, Chris Roberts, runs a series of one to one and group courses and Franchise Finance also prepare full business plans and financial projections for their clients.