The 30 Day MBA (7 page)

Balance sheet structure

The layout of the balance sheet using UK accounting rules is something of a jumble, with assets and liabilities intermingled. In the United States the balance sheet is traditionally set out horizontally, with the assets on one side and the liabilities and owner's equity, the two sources of funds, on the other (see
Table 1.9
).

TABLE 1.9
  
High Note balance sheet – US style

Working capital

You will also have noticed in this example that the assets and liabilities have been jumbled together in the middle to net off the current assets and current liabilities and so end up with a figure for the working capital. ‘Current' in accounting means within the trading cycle, usually taken to be one year. Stock will be used up and debtors will pay up within the year, and overdraft being repayable on demand also appears as a short-term liability.

There are a number of other items not shown in the working capital section of the example balance sheet that should appear, such as liability for tax and VAT that have not yet been paid, and these should appear as current liabilities.

Intangible fixed assets

There are a number of seemingly invisible items that nevertheless have been acquired for a measurable money cost and so have to be accounted for:

• Goodwill: This is where the price paid for an asset is above its fair market price. This is fairly common in the case of acquisitions where competition for a company can push prices higher.
  
• Intellectual property such as patents, copyright, designs and logos.
  

These items too are amortized over their working life. So, for example, if a patent is considered to have a 10-year life and cost £1 million to acquire, it would be written down in the accounts by $/£/€100,000 a year.

Accounting for stock

Deciding on the stock figure to put into a balance sheet is a tricky calculation. Theoretically it is simple; after all, you know what you paid for it. The rule that stock should be entered in the balance sheet at cost or market-price, whichever is the lower, is also not too difficult to follow. But
in the real world a business keeps on buying in stock so it has product to sell, and the cost can vary every time a purchase is made.

Take the example of a business selling a breakfast cereal. Four pallets of cereal are bought in from various suppliers at prices of $/£/€1,000, $/£/€1,020, $/£/€1,040 and $/£/€1,060 respectively, a total of $/£/€4,120. At the end of the period three pallets have been sold, so logically the cost of goods sold in the profit and loss account will show a figure of $/£/€3,060 ($/£/€1,000 + $/£/€1,020 + $/£/€1,040). The last pallet costing $/£/€1,060 will be the figure to put into the balance sheet, thus ensuring that all $/£/€4,120 of total costs are accounted for.

This method of dealing with stock is known as FIFO (first in first out), for obvious reasons. There are two other popular costing methods that have their own merits. LIFO (last in first out) is based on the argument that if you are staying in business you will have to keep on replacing stock at the latest (higher) price, so you might just as well get used to that sooner by accounting for it in your profit and loss account. In this case the cost of goods sold would be $/£/€3,120 ($/£/€1,060 + $/£/€1,040 + $/£/€1,020), rather than the $/£/€3,060 that FIFO produces.

The third popular costing method is the average cost method, which does what it says on the box. In the above example this would produce a cost midway between those obtained by the other two methods; in this example $/£/€3,090.

All these methods have their merits, but FIFO usually wins the argument as it accommodates the realities that prices rise steadily and goods move
in and out of a business in the order in which they are bought. It would be a very badly run grocer's shop that sold its last delivery of cereal before clearing out its existing stocks.

Methods of depreciation

The depreciation is how we show the asset being ‘consumed' over its working life. It is simply a bookkeeping record to allow us to allocate some of the cost of an asset to the appropriate time period. The time period will be determined by such factors as how long the working life of the asset is. The principal methods of depreciation used in business are:

• The straight-line method: This assumes that the asset will be ‘consumed' evenly throughout its life. If, for example, an asset is being bought for £1,200 and sold at the end of five years for £200, the amount of cost we have to write off is £1,000. Using 20 per cent, so that the whole 100 per cent of cost is allocated, we can work out the ‘book value' for each year.
  
• The declining-balance method: This works in a similar way, but instead of an even depreciation each year we assume the drop will be less. Some assets, motor vehicles for example, will reduce sharply in their first year and less so later on. So at the end of year 1, both these methods of depreciation will result in a £200 fall, but in year 2 the picture starts to change. The straight-line method takes a further fall of £200, while the declining-balance method reduces by 20 per cent (our agreed depreciation rate) of £800 (the balance of £1,000 minus the £200 depreciation so far), which is £160.
  
• The sum of the digits method: This is more common in the United States than in the UK. While the declining-balance method applies a constant percentage to a declining figure, this method applies a progressively smaller percentage to the initial cost. It involves adding up the individual numbers in the expected life span of the asset to arrive at the denominator of a fraction. The numerator is year number concerned, but in reverse order.
  

  For example, if our computer asset bought for £1,200 had an expected useful life of five years (unlikely), then the denominator in our sum would be 1+2+3+4+5 which equals 15. In year 1 we would depreciate by 5/15 times the initial purchase price of £1,200, which equals £400. In year 2 we would depreciate by 4/15ths and so on.
  

These are just three of the most common of many ways of depreciating fixed assets. In choosing which method of depreciation to use, and in practice you may have to use different methods with different types of asset, it is useful to remember what you are trying to do. You are aiming to allocate the cost of buying the asset as it should apply to each year of its working life.

Balance sheet and other online tools

SCORE (
www.score.org/resources/projected-balance-sheet-template.xls
) is an Excel-based spreadsheet you can use for constructing your own balance sheet. You can find guidance on depreciation, on handling stock and on the layout of the balance sheet and profit and loss account as required by the Companies Act from the Accounting Standards Board (
www.frc.org.uk
> Accounting and Reporting Policy > FRSSE). Accounting Glossary (
www.accountingglossary.net
) and Accounting for Everyone (
www.accountingforeveryone.com
> Accounting Glossary) have definitions of all the accounting terms you are ever likely to come across in the accounting world.

Package of accounts

The cash-flow statement, the profit and loss account and the balance sheet between them constitute a set of accounts, but conventionally two balance sheets, the opening and closing one, are provided to make a ‘package'. By including these balance sheets we can see the full picture of what has happened to the owner's investment in the business.

Table 1.10
shows a simplified package of accounts. We can see from these, that over the year the business has made £600 of profit after tax, and has invested that profit in £200 of additional fixed assets and £400 of working capital such as stock and debtors, balancing that off with the £600 put into reserves from the year's profits.

TABLE 1.10
  
A package of accounts

Filing accounts

A company's financial affairs are in the public domain. As well as keeping the government tax authorities such as The Internal Revenue Service (IRS) and HM Revenue and Customs (HMRC) informed, companies have to file their accounts with Companies House (
www.companieshouse.gov.uk
). Accounts should be filed within 10 months of the company's financial year-end. Small businesses in the UK (turnover below £5.6 ($8.8/€6.3) million) can file abbreviated accounts that include only very limited balance sheet and profit and loss account information and these do not need to be audited. Businesses can be fined up to £1,000 ($1,570/€1,127) for filing accounts late.

US company accounts can be obtained from The Securities Exchange Commission (
www.sec.gov
). The Investor Relations Society (
www.irs.org.uk
> IR Resources > Best Practice Guidelines) makes an award each year to the company producing the best set of report and accounts.

Financial ratios

Earlier in this chapter the two important financial statements of profit and loss account and balance sheet were examined. To recap – the trading performance of a company for a period of time is measured in the profit and loss account by deducting running costs from sales income. A balance sheet sets out the financial position of the company at a particular point in time, usually the end of the accounting period. It lists the assets owned by the company at that date matched by an equal list of the sources of finance.

Reading company accounts, with practice, you can get some insight into a company's affairs. Comparing the current year's figure with the previous year's figure can identify changes in some of the key items, but conclusions drawn from this approach can be misleading. Consider the situation shown in
Table 1.11
.

TABLE 1.11
  
Factors that affect profit performance

You can see that the table is nothing more than a simplified profit and loss account on the left and the assets section of the balance sheet on the right. Any change that increases net profit (more sales, lower expenses, less tax etc), but does not increase the amount of assets employed (lower stocks, fewer debtors etc), will increase the return on assets. Conversely, any change that increases capital employed without increasing profits in proportion will reduce the return on assets.

Now let us suppose that events occur to increase sales by $/£/€25,000 and profits by $/£/€1,000 to $/£/€8,910. Superficially that would look like an improved position. But if we then discover that in order to achieve that extra profit new equipment costing $/£/€5,000 had to be bought and a further $/£/€2,500 had to be tied up in working capital (stock and debtors), the picture might not look so attractive. The return being made on assets employed has dropped from 31 per cent (8,910 / 28,910 × 100) to 27 per cent (9,910 / [28,910 + 5,000 + 2,500] × 100).

Analysing accounts

The main analytical approach is to examine the relationship of pairs of figures extracted from the accounts. A pair may be taken from the same statement, or one figure from each of the profit and loss account and balance sheet statements. When brought together, the two figures are called ratios. Miles per gallon, for example, is a useful ratio for drivers checking one aspect of a vehicle's performance. Some financial ratios are meaningful in themselves, but their value mainly lies in their comparison with the equivalent ratio last year, a target ratio, or a competitor's ratio.