The second key financial statement is the balance sheet. There are two reasons why it is called a balance sheet. The first is that this is a snapshot at the end of a period of trading of the business’s: It is therefore a statement of the balances on these accounts at the end of a period. As it is a statement of the business’s assets and liabilities, the balance sheet is sometimes seen as a statement of the business’s worth. This is, however, a dangerous assumption as in accounting terms it is simply a list of balances. For example, the balance sheet values of assets (at historical cost, as discussed in the last chapter) are unlikely to provide you with an accurate reflection of their current market value. It also takes no account of business assets such as goodwill or brand awareness, which have a value, but generally do not appear on the balance sheet.

Widget Co Ltd’s balance sheet as shown in Chapter 2 consists of the following. The second reason why it is called a balance sheet is that it should balance. That is to say that the value of the net assets (which should normally be a positive number) will then in the case of a limited liability company match the value of the shareholders’ funds which consist of: For a partnership the net assets will be matched by the total of the partners’ capital and current accounts.If the balance sheet does not balance in this way it shows that there is a fundamental problem in the business’s bookkeeping system.

What Does The Balance Sheet Tell You?

Financial Stability

• liquidity, which can show how much risk the business has of running out of cash in the short term; and
• gearing, which shows how reliant on, and exposed to, borrowed money the business is.

Financial Efficiency

• stock turn and debtor and creditor days, which brings us back to the working capital cycle;
• return on capital employed; and
• return on investment.

Understanding Financial Stability

Liquidity

Sometimes a business’s balance sheet will show a very positive position, but it still has financial problems in meeting its bills. This can be because it has its cash tied up in illiquid assets. For example, a business had a balance sheet that showed net assets of well over £10m. However, looking more closely at the make up of the assets, £12m of this asset base was farming land which could not be used as such to meet day-to-day payments required by the business and so the business had a liquidity problem.

Liquidity is an indication of the business’s likely ability to pay its current liabilities. Quite simply it measures: does it have enough cash to hand?

The basic measure is the liquidity or the current ratio which divides:

• the current assets, the cash and the assets that should turn into cash over the next 12 months such as the debtors and the stock; by
• the current liabilities, the sums that need to be paid over the next 12 months:

Simplistically, one would expect that a ratio of more than one would indicate financial stability, and significantly less than one would indicate problems. Whilst this is generally a safe working hypothesis, you must compare the ratio calculated against that of other businesses in the same industry as in some sectors an apparent low liquidity is normal. As for all ratios discussed in this book, what you need to know for any figures calculated is:

• whether for your industry the ratio is relatively good or bad, so why not obtain a copy of your competitors’ accounts from Companies House and benchmark your ratios against theirs; and
• what the trend is over time (in this case, increasing or decreasing liquidity).

In the case of Widget Co Ltd the answer is 0.94 which would suggest that the company has reasonable liquidity:

In order to generate cash at a known value, however, stock must first be sold. Stock is therefore less liquid than debtors and cash, and is therefore less reliable for meeting existing liabilities than these assets.

For example, an importer of summer goods had a poor season, and was left at the end of September with stock at a value equal to almost half the normal annual turnover and little or no prospects of sales until the following spring. While the current ratio still showed a reasonable position, the trading position worsened over October and November, as the debtors paid and the cash was used to meet overheads and pay some creditors. Despite having stock (a current asset) the business obviously had a liquidity problem.

The acid test (N ratio) measure of liquidity therefore excludes stock to see how readily the business can pay its current liabilities from the cash and near cash assets on hand:

Again the trend over time (improving or worsening) and relative performance to the norm for your industry is as important, if not more so, than the actual number.

In the case of Widget Co Ltd the answer is 0.65 which might start to give some cause for concern:

By contrast a shop which is buying on credit and selling for cash will typically have no debtors, but will still have a large value of creditors. You would therefore expect most shops to show a very low acid test measure; however, you would also expect most shops to be able to turn stock into cash fairly quickly, so in this sector a low ratio is not necessarily a cause for concern.