Your balance sheet is a financial statement at a given point in time. It provides a snapshot summary of what your business owns or is owed - assets - and what it owes - liabilities - at a particular date.
The balance sheet therefore shows how your business is being funded and how you are using these funds. See contents of the balance sheet.
There are three ways you may use your balance sheet:
- for reporting purposes as part of a limited company's annual accounts
- to help you and other interested parties such as investors, creditors or shareholders to assess the worth of your business at a given moment
- as a tool to help you analyse and improve the management of your business
This guide explains who needs to produce balance sheets and when, the different elements within them and how to use the information from a balance sheet to assess and manage business performance.
Balance sheet reporting - who, when and where?
Limited companies and limited liability partnerships must produce a balance sheet as part of their annual accounts for submission to:
- Companies House
- HM Revenue & Customs (HMRC)
- shareholders - unless agreed otherwise
As well as the balance sheet, annual accounts include the:
- profit and loss account
- auditor's reports - unless exemptions apply
- directors' report
- notes to the accounts - these should provide any information you think may be relevant, eg supplementary financial information or additional detail
Other parties who may wish to see the accounts - and therefore the balance sheet - are:
- potential lenders or investors
- potential purchasers of the business
- government departments carrying out inspections
- trade unions
There are strict deadlines for submitting annual accounts and returns to Companies House and HMRC - you may have to pay a fine if you send them in late.
Reporting requirements for other business structures
Self-employed people, partners and partnerships are not required to submit formal accounts and balance sheets on their tax return. However, the returns do require the relevant financial details to be entered in a set format, so you may find it beneficial to prepare the figures in a balance sheet format.
Other key benefits of producing a balance sheet include:
- if you want to raise finance, most lenders or investors will want to see three years' accounts
- if you want to bid for large contracts, including government contracts, the client will probably want to see audited accounts
- producing formal accounts - including a balance sheet - will help you monitor the performance of your business
Contents of the balance sheet
Contents of a balance sheet includes:
- fixed assets - long-term possessions
- current assets - short-term possessions
- current liabilities - what the business owes and must repay in the short term
- long-term liabilities - including owner's or shareholders' capital
The balance sheet is so-called because there is a debit entry and a credit entry for everything (but one entry may be to the profit and loss account), so the total value of the assets is always the same value as the total of the liabilities.
1. Fixed assets include:
- tangible assets - eg buildings, land, machinery, computers, fixtures and fittings - shown at their depreciated or resale value where appropriate
- intangible assets - eg goodwill, intellectual property rights (such as patents, trade marks and website domain names) and long-term investments
2. Current assets are short-term assets whose value can fluctuate from day to day and can include:
- work in progress
- money owed by customers
- cash in hand or at the bank
- short-term investments
- pre-payments - eg advance rents
Find out more about the different types of business assets.
3. Current liabilities are amounts owing and due within one year. These include:
- money owed to suppliers
- short-term loans, overdrafts or other finance
- taxes due within the year - VAT, PAYE (Pay As You Earn) and National Insurance
4. Long-term liabilities include:
- creditors due after one year - the amounts due to be repaid in loans or financing after one year, eg bank or directors' loans, finance agreements
- capital and reserves - share capital and retained profits, after dividends (if your business is a limited company), or proprietors capital invested in business (if you are an unincorporated business)
Read more about the difference between assets and liabilities.
Interpreting balance sheet figures
A balance sheet shows:
- how solvent the business is
- how liquid its assets are - how much is in the form of cash or can be easily converted into cash, ie stocks and shares
- how the business is financed
- how much capital is being used
A balance sheet is only a snapshot of a business' financial position on one particular day. The individual figures can change dramatically in a short space of time but the total net assets (assets less liabilities) would only change dramatically if the business was making large profits or losses. For example:
- If you hold large inventories of finished products, a change in market conditions might mean their value is reduced. You may even need to sell at a loss.
- Customers sometimes have payment problems. If they are unable to pay, you may need to revalue your assets by making allowances for bad debts.
Current liabilities - money you owe
This section might include money owed for goods or services received but not yet paid for.
Debtors - money owed to you
This figure assumes that debtors will pay up on time. Where there are doubts about being paid, a provision can be made to reduce the value of the debts in the business' accounts.
The value of goodwill, patents and intellectual property can fluctuate with market trends, so the balance sheet value should be updated annually.
These are shown at their depreciated rates. There are two main approaches to calculating depreciation of an asset:
- Write off the same charge over the calculated life of the asset. For example, you may decide that a computer bought for £2,000 has a useful life of five years and that you will write off 20 per cent of its value each year.
- Apply a steeper depreciation rate in the first few years of an asset's value. For example, you may decide to offset 30 per cent of the value of the same computer in the first two years, 20 per cent in the third year and 10 per cent in the final two years.
Read more about the difference between assets and liabilities.
The relationship between balance sheets and profit and loss accounts
The profit and loss (P&L) account summarises a business' trading transactions - income, sales and expenditure - and the resulting profit or loss for a given period.
The balance sheet, by comparison, provides a financial snapshot at a given moment. It doesn't show day-to-day transactions or the current profitability of the business. However, many of its figures relate to - or are affected by - the state of play with profit and loss transactions on a given date.
Any profits not paid out as dividends are shown in the retained profit column on the balance sheet.
The amount shown as cash or at the bank under current assets on the balance sheet will be determined in part by the income and expenses recorded in the P&L. For example, if sales income exceeds spending in the period preceding publication of the accounts, all other things being equal, current assets will be higher than if expenses had outstripped income over the same period.
If the business takes out a short-term loan, this will be shown in the balance sheet under current liabilities, but the loan itself won't appear in the P&L. However, the P&L will include interest payments on that loan in its expenditure column - and these figures will affect the net profitability figure or 'bottom line'.
For further information on profit and loss accounts and balance sheets, see:
Compare balance sheets to assess business performance
There are some simple balance sheet comparisons you can make to assess the strength or performance of your business against earlier periods, or against direct competitors. The figures you study will vary according to the nature of the business. Some comparisons draw on figures from the profit and loss (P&L) account.
If inventory (stock) levels are rising from one period to the next, but sales in your P&L are not, some of your stock might be out of date. You may also have a cashflow problem developing - see cashflow management.
If the amount trade debtors owe you is growing faster than sales, it could indicate poor internal credit controls. Find out whether any of your customers are having problems with cashflow, which could pose a threat to your business.
A positive relationship with your trade creditors is essential. Key to this is managing your cashflow effectively, so that payments can be made on time. For example, trade creditors are more likely to be flexible about extending terms of credit if you have built up a good payment record.
Making early payments may qualify you for a discount. However, early payment for the sake of it will have a negative impact on your cashflow. Good payment controls will help prevent imbalances in what you owe suppliers and in levels of stock and inventory.
Borrowing as a percentage of overall financing (gearing) is important - the lower the figure, the stronger your business is financially. It's common for start-up businesses to have high borrowing requirements, but if the gearing figure reaches 50 per cent you may have difficulty getting further loans.
You can also compare the above balance sheet figures with those of direct or successful competitors to see how you measure up. See use accounting ratios to assess business performance.
Use accounting ratios to assess business performance
Ratio analysis is a good way to evaluate the financial results of your business in order to gauge its performance. Uses of accounting ratios include allowing you to compare your business against different standards using the figures on your balance sheet.
There are four main methods of ratio analysis:
1. Liquidity ratios
There are three types of liquidity ratio:
- Current ratio - current assets divided by current liabilities. This assesses whether you have sufficient assets to cover your liabilities. A ratio of two shows you have twice as many current assets as current liabilities.
- Quick or acid-test ratio - current assets (excluding stock) divided by current liabilities. A ratio of one shows liquidity levels are high - an indication of solid financial health.
- Defensive interval - liquid assets divided by daily operating expenses. This measures how long your business could survive without cash coming in. This should be between 30 and 90 days.
2. Solvency ratios
Gearing is a sign of solvency. It is found by dividing loans and bank overdrafts by equity, long-term loans and bank overdrafts.
The higher the gearing, the more vulnerable the company is to increasing interest rates. Most lenders will refuse further finance where gearing exceeds 50 per cent.
3. Efficiency ratios
There are three types of efficiency ratio:
- Debtors' turnover - average of credit sales divided by the average level of debtors. This shows how long it takes to collect payments.
- Creditors' turnover - average cost of sales divided by the average amount of credit that is taken from suppliers. This shows how long your business takes to pay suppliers.
- Stock turnover - average cost of sales divided by the average value of stock. This ratio indicates how long you hold stock before selling.
4. Profitability ratios
Divide net profit before tax by the total value of capital employed to see how good your return on the capital used in your business is.
You could also use the net profit ratio to evaluate your profitability. Divide the net profit before tax by the total value of net sales (sales less returns) to see how good your net profit is.
Business accounting periods
A balance sheet normally reflects a company's position on its accounting reference date (ARD), which is the last day of its accounting reference period. The accounting reference period, also known as the financial year, is usually 12 months. However, it can be longer or shorter in the first year of trading, or if the ARD is subsequently changed for some reason.
Companies House automatically sets the first ARD. The end of the first financial year is the first anniversary of the last day of the month in which the company was formed. If you decide to change this, you will need to notify Companies House.
You should also notify HM Revenue & Customs (HMRC) if you change your ARD. Self-employed people and partnerships can choose their first accounting period. Subsequent accounts are usually prepared a year after the first balance sheet date.
Your business may decide to draw up accounts to help you monitor business performance as frequently as monthly. In this case the figures - often known as management accounts - are for internal use only. You do not need to file them with Companies House or HMRC.