I’ve updated this post on 3 March 2020
The purpose of a balance sheet in business actually differs according to the person reading it and a business’ legal structure.
If you’re a small business owner or entrepreneur understanding your balance sheet is a fantastic way to you unlock valuable information about the financial state of your business. As well as helping with your business decision making.
In this post, I’ll explain the purpose of a UK balance sheet, show you how to read one and share tips on how to strengthen up your balance sheet.
What is the Purpose of a Balance Sheet
So now you know what it looks like, apart from the legal requirement for Limited Companies, what is its purpose?
Well, the specific purpose will actually depend on who is reading it. Let’s look at who the main readers might be and what they are looking for:
Although investors are more drawn to the profit and loss account as an indicator of performance and returns on their investment.
They will also review the balance sheet for the purpose of understanding the financial health of a business.
The balance sheet will tell an investor how the business is being run. Does it have debt? How much cash is in the bank? And what assets does it own?
When a lender is reviewing the books of a business to assess its status for a loan they will take particular interest in the Business Balance Sheet.
The purpose of looking at the balance sheet is to assess:
- Whether the business has sufficient cash available, or easily convertible short term assets such as trade debtors, to meet the monthly repayment plan of the suggested loan;
- If the business has other loans and facilities in place that may jeopardise its ability to repay a new loan.
A new supplier may look at the business balance sheet when deciding how much credit to offer.
The purpose of looking at the balance sheet is to check whether the business owes a large amount to its trade creditors.
That may suggest that the business is not paying their suppliers on time or they have cash flow problems.
How to Read a Business Balance Sheet
Here are my top tips when it comes to reading a balance sheet quickly and extracting key information.
They will help you to make sense of your own one if you have an accountant who has produced one for your business or if you have one on your bookkeeping system if you manage your own books.
Let’s look at an example balance sheet:
Sample UK Balance Sheet
Not only can you see the key lines noted above, but there is also a declaration required to be signed by the Director of the Company to confirm everything is true and correct.
Fixed assets have value and depending on the business, they can be quite high.
In the example, fixed assets are £7,000 which suggests if something happened the business could sell them for this amount.
In other business fixed assets may include things like property, so you’d expect to see a higher figure here.
Depending on the reader seeing a higher number here can add comfort because it is something the business can always “fall back on” in hard times.
Current Assets and Current Liabilities
This line shows cash and anything else that is owed to the business that can be easily converted into cash like stock and trade debtors.
The key with current assets is to compare them to creditors on the line below. As long as assets exceed liabilities then it indicates that the business is liquid.
Capital and Reserves
The next key line I recommend you look at is the Profit and Loss line. This is an accumulation of all the profit and losses made by the Company since it started trading.
If I see a positive figure then that indicates that the business has been profitable and well run over time.
A negative number here could show a loss-making business which cannot afford to pay its bills.
How to Strengthen Your Balance Sheet
Your company balance sheet is an indication of financial strength. It gives an idea of how much you owe, cash in the business and profit you have built up over time.
Demonstrating you have a strong balance sheet will help if you are trying to get business credit, bank loans and funding.
It also extends to your personal life. If you own a Limited Company and you are trying to get a mortgage since some lenders will take into account your shareholder funds when working out how much you can borrow.
If you are planning on taking out a mortgage then I put together some advice to help you apply successfully for a self-employed mortgage.
Here are 4 simple ways you can strengthen your balance sheet:
1. Defer costs
If you have new costs coming in which you can defer then try and order them in at the start of your new financial year.
You’ll disclose a higher profit and therefore shareholder funds on your balance sheet.
Watch out, this will result in increased corporation tax so this approach may not be right for you.
2. Collect Your Debts
Cash is king.
So chasing your customers who owe you money and getting this cash in your bank account while not altering your net asset position.
You’ll show a healthy cash balance adding confidence to those reading your balance sheet.
3. Pay Off Loans
If you have a loan in your books and are fortunate enough to have enough cash to pay it off then consider doing so.
A balance sheet with little or no debt is stronger than one which has financial responsibilities and creditors.
4. Capitalise Assets
The fixed assets section discloses what you own and their value, after depreciation.
Check that all the assets you have bought during the financial year are correctly included within assets and not in your profit and loss account.
This not only increases your fixed assets but if misallocated will increase your profit for the year by transferred a cost to your balance sheet.
A balance sheet is a snapshot of all your businesses assets and liabilities on a particular day of the year.
Now I have explained balance sheets you can see useful it is because it will give you useful insights about your own business and your potential customers.
Do You Need a Balance Sheet if You Are Self-Employed?
No. You are not legally required to prepare a balance sheet for self-assessment
If you use an accountant then they may prepare one for you as part of working out your taxes.
Or if you use a bookkeeping system like Quickbooks then it will automatically generate one for you.
Don’t ignore it either, it can be useful to know how much money you are owed and how much you owe your suppliers.
What is another Name for a Balance Sheet?
Balance sheets are more commonly known as a Statement of Financial Position in the UK.
The lines and the ways things are classified have not changed.
How Does a Balance Sheet Balance?
When preparing a balance sheet assets and liabilities must always equal. This is because accounting is based on the balance sheet equation.
If you have £10,000 in your business bank account and a trade debtors pays you £5,000, you’ll have £15,000 in the bank and your total trade debtors will go down by £5,000.
Everything is still equal. Just the numbers have moved around.
What Happens if a Balance Sheet Doesn’t Balance?
If you’re an accountant, this can be really frustrating!
Sometimes the difference can be really small, £1 or £2. Often this is simply down to rounding so accountants will commonly rectify this by amending the bank balance or through general expenses.
This approach is fine if the difference is very small and doesn’t materially affect the numbers involved.
If you have a large difference then start by going through each line and check that everything has been included in the accounts.
You should also check that you have used your debits and credit correctly. For example, trade debtors should be a debit but shareholders funds and share capital are a credit.
Is a Loss an Asset or a Liability?
This question used to baffle me when I was an accounting student.
In double-entry bookkeeping, a loss is a debit in the accounts. That can be confusing because a debit in usually an asset like cash or trade debtors.
Profit in a business is a credit (liability) because it is owed to the shareholders for distribution. Therefore the opposite has to be true and a loss is a debit (asset).
What is the Difference Between a P&L and Balance Sheet?
A P&L (or profit and loss) is made up of income and expenses for a period of time.
A balance is a snapshot on a particular day (not a period of time) and captures the assets and liabilities of a business on said day.