Paying Attention to the Balance Sheet in Bookkeeping
When bookkeepers prepare a set of accounts, they usually concentrate on whether or not the company has made a profit. They like to see the Profit and Loss Statement as one of the key performance reports. The Balance Sheet (which is also a critical report that managers should look at) is often left at the bottom of the pile because many people simply don’t understand how to read it.
The Balance Sheet is simply a snapshot of a company’s health at a single point in time (usually a month- or year-end). It lists the company’s assets and liabilities and shows how it’s been financed. The Balance Sheet is an incredibly useful document for future investors or those responsible for issuing loans, for example, because they can see at a glance the company’s financial position.
The liquidity of a company can be assessed simply by viewing the value of its current assets versus the value of its current liabilities. For a healthy company, you’d expect current assets to be higher in value than current liabilities, which means it’s capable of paying off current liabilities easily (by converting its current assets into liquid form, that is, cash) and thus reducing its debt. Check out the following example.
You can see by looking at the Balance Sheet for ABC Decorating that the company’s in very good shape. Current assets total £19,000 and current liabilities only £6,600. There are 2.9 times as many assets for every liability (£19,000/£6,600), which is a good ratio.
You can also see that the assets mainly comprise £12,000 of debt; presuming the debtors can be chased up, these debts can easily be converted into cash to pay off the liabilities. The ratio you’ve just calculated is known as the current ratio. You can also see that the company doesn’t have too much money tied up in stock (only £2,000) and has a reasonable sum in the bank (£5,000).
You can also look at the gearing of the company to identify the proportion of debt compared to equity. First, you need to calculate the company’s total debt by adding together current liabilities and long-term liabilities. In this case, you add £6,600 and £30,000 for a total of £36,600.
You then take the total debt and divide it by the total capital in the business. Here, the capital is £157,400, so you divide £36,600 by £157,400 for a result of 0.23. This means that the company has 23 per cent debt in proportion to the total capital of the business, which is quite a healthy position to be in.
You can now see how useful it is to be able to pick out the key elements of a Balance Sheet to identify how well a company is performing.