Understanding a balance sheet
If you are having trouble understanding a balance sheet, then this post is designed to help you understand this better.
If you are in business or looking to set one up or perhaps even looking to buy a company, then if you are able to understand a balance sheet, this will certainly help you in business.
Making or creating a balance sheet from scratch, if you don’t know what you are doing is a bit daunting, however, if you have reasonably sophisticated accounting software in your business, this should produce a balance sheet for you. So instead of worrying about how to make your own balance sheet, all you need do is to understand how to read one that can be produced from your accounting software.
Whereas your profit and loss account represents a period of time, a balance sheet is designed to show the businesses health at a single point in time, either at a month end or at your year end.
Your balance sheet is essentially a summary of your assets (things you own, like cars, machinery, property etc..) and liabilities (amounts you owe to others, like to suppliers, loans, hire purchase, taxes etc.). The net of these two totals represents the net balance sheet value, which is represented by owner’s equity or your capital account (can be in the form of shares, if a company, or capital account if not, together with your profit or loss to the date of the balance sheet).
What are assets?
An asset is anything of value your business owns or controls and these assets are normally split between two types of asset – fixed assets and current assets.
Fixed assets include physical assets that you can see and touch and would include property, cars, equipment, like computers, furniture and so on. These assets are usually categorised, so all your vehicles will be put together as a total in a heading of say motor vehicles. On the face of the balance sheet you will usually be shown the ‘Net Book Value’ of your fixed assets and all this means is the cost of the asset to the business less depreciation. Another concept to understand, depreciation, which is designed to charge the profit and loss account with the use of the asset and also to reduce the ‘value’ of the asset as it reduces over time.
Current assets are usually assets that are non-physical assets that you cannot touch and include what’s in your bank, amounts owed by your customers (accounts receivable) and stock and work in progress (although stock is physical and can be touched).
What are liabilities?
Liabilities are amounts the business owes at the balance sheet date and includes what you owe to your suppliers, loans from you or your bank, hire purchase amounts, taxes owed and so on. Liabilities are also usually split between what is owed within 12 months (short-term liabilities) and what is owed in more than 12 months (long-term liabilities). For example, if you borrowed money from a bank over say 5 years and after the first 12 months you prepare a balance sheet, assuming you’ve paid off 12 months to that date, there will be 4 years left outstanding. This amount will be split 12 months under short-term and 3 years under long term.
What is owner’s equity?
Owner’s equity represents the net of the assets and liabilities, both short and long-term, which effectively you own free and clear. So, if you were to liquidated all of your assets (i.e. sell them) and pay off all of your liabilities, the amount left over would be your owner’s equity. However, it’s important to understand that owner’s equity is not necessarily how much the business is worth in a sale, unless the business is a property based business.
The value of a business is not usually the owner’s equity, as most businesses usually sell based on a multiple of their earnings (net adjusted profit) and in most cases the value of a business will usually (but not always) be greater than the owner’s equity value.
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