Understanding Balance Sheets and Profit and Loss Accounts
Chris Roberts - Director, Franchise Finance Ltd
This is the first part of a series of three articles written on the above subject by Chris Roberts of Franchise Finance and provides an introduction to the balance sheet.
“A Balance Sheet, in simple terms, is a list (or a snap-shot in time) of the Assets and Liabilities of your business. Right at the outset it will help if you accept and understand three fundamental things.
1. It is called a Balance Sheet, because the value of the Assets will always equal the value of the Liabilities (assuming you have correctly completed your accounts!).
You can think of it as a set of scales or a seesaw – see below.
2. YOU are not the business (even if you are a sole trader). Look at it as a separate thing. It is, for arguments sake, sitting in a box on the other side of the room. If you invest £1,000 into your new business on day one, that investment in the accounts of the business is a Liability, because ultimately the business (sitting on the other side of the room) owes it back to you. The corresponding entry, i.e. to make the balance sheet balance, is that the business now has an Asset of £1,000 sitting in its bank account.
3. There is a concept in book-keeping called ‘Double Entry’. This means that every time you undertake a business transaction there will be two entries to be made in your accounts. The above example shows this.
If the next day the owner of the business takes a loan of £500 in the name of the business and buys some equipment worth the same amount, the balance sheet will be updated with two more entries (in this case, once again, one on each side). It will look like this:
However, if the business owner had used the money in the business bank account, rather than a new loan, it would have looked like this, with two entries being made on the same side (plus 500 and minus 500) ensuring that the Balance Sheet still balances.
So, to sum up the 3rd fundamental point, every business transaction will have 2 entries on the Balance Sheet; one on each side or a plus and a minus on the Asset side or a plus and a minus on the Liability side. The end result is that both sides will continue to balance.
Most assets and liabilities that you will come across will fall into one of the following categories. You need to understand which and why so that you can then use your balance sheets, in due course, to help you run your business more efficiently (see forthcoming Articles). The headings are shown below:
Current Liabilities are Liabilities that need to be paid within the short term (strictly speaking 12 months from the balance sheet date). Therefore they would normally include Trade Creditors, Bank overdrafts, VAT and most other taxes. Long Term Liabilities are therefore anything due for payment after 12 months, e.g. a long term mortgage or bank loan.
Capital is the amount of money permanently invested in the business by the owner (or owners) and Reserves include things like past profits that have not been drawn out and a revaluation upwards of say a property owned by the business.
If you are asking yourself ‘How can PROFIT be a liability?’ the answer is that any profit made by the business is owed back to the owner of the business (in the same way as the capital invested is also owed back to the owner/investor. It is therefore a liability of the business.
Current Assets are money (cash or positive bank balances) or things that are ‘nearly money’, i.e. that can be turned into money in the short term e.g. debtors (people who owe the business money) or stock (when it is sold). Current Assets will come and go, i.e. regularly change around as for example when cash is used to buy stock which is sold on credit thereby creating a debtor, which when paid is turned back into cash (this is called the ‘Working Capital Cycle’ and is covered in more detail in a forthcoming article).
Fixed Assets, by contrast and as the name suggests, stay in the business because they are needed to run the business on an ongoing basis. They therefore include things like property, vehicles, equipment and fixtures and fittings.
The concept of a Balance Sheet is a lot easier to understand, in the first instance, when it is viewed on this ‘seesaw’ side by side basis, and indeed, many years ago this is how balance sheets were actually prepared. However today the figures are arranged in a slightly different format and this will be explained in Article No. 2 next week, along with some examples of how to interprate and use the information contained in a balance sheet to help run your business.
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.
Tags: accounting, chris roberts, franchise accounts, Franchise Finance
