UNIT 9- BALANCE SHEET AND WORKING CAPITAL
INTRODUCTION
A balance sheet is one of the primary financial statements you can adapt to your personal finances
to gauge your financial health. In this lesson, we'll discuss what a balance sheet can tell you and how
to prepare your own.
1. DEFINING BALANCE SHEET
In business, balance sheets are one of the two most important financial statements for anyone
interested in the financial health of the company. These parties may include managers,
shareholders, and anyone else interested in how the company is doing.
A balance sheet is a financial statement that takes a point-in-time picture of the financial state of
the company, by listing all assets owned and all liabilities owed. The other important financial
statement is an income statement, but in this lesson, we'll focus on what a balance sheet can tell
you about your financial situation and how to make one.
2. THE BALANCE SHEET
A balance sheet typically isn't a difficult document to prepare. In summary, all you do is list all of
your assets - anything you own that has financial value - and all your liabilities - any debt or financial
obligations you have the responsibility to pay. Here you can see an example of a simple balance
sheet:
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After you list your assets and liabilities, you list the values of the assets and the balance of the
liabilities, and then total up both categories. These numbers will rarely be the same; you don't want
them to be.
A. ASSETS
Assets are anything that a company owns, in other words, assets are simply goods that carry
monetary value. You can easily identify assets you own or assets that are owned by a business.
There are two types of assets:
1) Fixed assets: serve the company in long term. E.g.
• Buildings
• Office Equipment
• Car pool
• Computer equipment
2) Current assets: serve the company in the short term; E.g.
• Goods for sale
• Accounts receivable (money that is owed to a company by its customers)
• Cash at the bank
• Cash in hand
As a rule of thumb, we can say that: assets that remain in the company for a period of above one
year are shown in the fixed assets. All others belong to current assets. However, take note that what
are fixed assets for one company may be current assets for another (cars, for instance, are fixed
assets for most businesses, a hotel for example. In the case of a car retailer, however, cars belong
to current assets).
3) Cumulative Amortisation
Fixed tangible assets lose their value as time passes and their start losing their value. For example,
if you by today a machine which costs 100.000 € and you know that each year, this tool is going to
lose a 10% of its value, then you know that at the end of the year, the machine’s real value will be
90.000 €. For gathering this in the balance sheet, we use the concept of “cumulative amortization”,
which is the accountable prove of the loss of value of assets.
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In the balance sheet, we will have the initial value of the fixed tangible assets followed by the
“cumulative amortization”, but with negative sign (in brackets), which means that we need to
subtract the amortization value to the total assets value.
Therefore, after two years, the machine’s cumulative amortization will be 20.000, so we will be able
to know that its real vale is 80.000 even if we still gather its original price in the balance sheet
(100.000 €).
B. LIABILITIES
They are the balances of the debt you have and obligations to other people. This is an important
part of listing your liabilities - do not list the payment on the debt, list the balance of the debt. If
your car payment is 200 € per month on a 10,000 € loan, your liability would be 10,000 €, not 200
€.
The most common examples of debt are:
• Mortgages (home loans)
• Auto loans
• Student loans
• Credit cards
• Lines of credit (i.e. the 90 days same-as-cash loan for your new fridge)
So therefore, liabilities are financial obligations a business owes to other persons, businesses, and
governments.
We may find two types of liabilities:
1º) Short-term liabilities are financial obligations that become due within a year
• Short-term notes payable (loans that come due in less than one year)
• Accounts payable (money owned for goods and services provided to the business)
• Dividends payable (dividends that have been announced but not yet paid to shareholders)
• Sales taxes
• State income taxes
• Wages and salaries
• Payroll taxes
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• Retirement benefits
2º) Long-term liabilities are due in a year or longer.
A company's total liabilities is the sum of its short-term and long-term liabilities. Liabilities are
reported on a company's balance sheet along with its assets and owners' equity.
• Credit line (a revolving credit account that allows you to draw upon the line for money as
needed up to a set limit for a set period of time)
• Long-term note payable (loans that are due in a year or longer)
• Bonds (negotiable debt securities that are issued to investors to raise money)
C. OWNER'S EQUITY OR NET WORTH
It is the difference between your assets and liabilities. Basically, it is how much cash you would have
if you sold all of your assets and paid off all your debts.
When you have a negative or low equity, you'll probably want to spend more of your discretionary
income on paying down debt. With a higher equity, you are able to be more flexible with your extra
income - spending it or investing it in your future.
Your equity is also an important consideration when lenders decide what interest rate to charge on
your loans. The higher your net worth, the more comfortable a lender will be, which means lower
interest rates.
This owner's equity is formed by:
a) Capital Stock: It is the amount of money that a company owner has personally invested in the
company. Initial start-up cost of a company that comes from the owner's own pocket (that's a good
example of owner's equity).
b) Retained earnings: accounting reserves obtained by benefits obtained and not distributed.
c) Fiscal Year result: If the results have turn to be benefits, the quantity will be positive, whilst if
they have been losses, the quantity set in this section will be negative.
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This is, as a summary, the balance sheet structure:
ASSETS OWNER’S EQUITY&LIABILITIES
FIXED ASSETS OWNER’S EQUITY
INTANGIBLE
TANGIBLE LONG-TERM LIAB
CURRENT ASSETS
STOCK SHORT-TERM LIAB
DEBTORS
AVAILABLE/CASH
3. BASIC ACCOUNTING EQUATION
The accounting equation, written as Assets = Liabilities + owner's equity, shows the relationship
between the three major types of accounts found in the accounting world. When used correctly, it
is a reliable tool in maintaining balance in company accounts.
4. PROFIT AND LOSS ACCOUNT (P&L ACCOUNT)
By making a balance sheet comparison you compare a company's financial position at two different
points in time — at the beginning and end of a business year (= fiscal year).
However, this comparison does not tell us what happened during the year. But for an entrepreneur
it is not only important to know whether the company became richer or poorer, but also why the
company made a profit or loss. This question is answered by the profit and loss account (P&L
account for short).
The profit and loss account (also called income statement) comprises and consolidates all of a
company's business transactions that occurred during a business year and contributed to making
the company "richer” or "poorer”.
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• Transactions making a company richer are called income
• Transactions making a company poorer are called expenses.
Note: Only transactions that actually augment or diminish a company's wealth, i.e. make the
company either richer or poorer, are booked in the P&L account.
The P&L account in report is concentrated on the following subtotals:
P&L ACCOUNT
1. Operating Income
2. (Operating Expenses)
A. OPERATING RESULT (1+2)
3. Financial Income
4. (Financial Expenses)
B. FINANCIAL RESULT (3+4)
C. RESULT BEFORE TAXES (A+B)
5. (Profit taxes)
D. NET PROFIT (C+5)
1. Operating result: Indicates income and expenses arising exclusively from the main activity
of the company.
Operating Result=Operating Income + Operating Expenses
2. Financial result: These results indicates de income and expenses coming from financial
activities. Expenses could be interest paid on loans or credits granted. On the other hand,
financial incomes are, for example, interest or dividends obtained.
Financial result =Financial Income + Financial Expenses
3. Result before taxes: Includes also the extraordinary result, which may give rise to significant
distortions (in a positive or negative sense). It’s the figure that serves as the basis for
calculating the taxes on income that must be paid to the tax office.
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Result before taxes = Operating result + Financial result
4. Net Profit/Loss for the year:
If we subtract from the net profit the taxes that must be paid in accordance to the profit
obtained, we will obtain the fiscal year net profit.
Net Profit = Result before taxes + Profit Taxes
5. THE WORKING CAPITAL
Working capital is the amount of cash and liquid assets a company owns. In the normal course of
operations, a business must have cash to pay expenses and liabilities that are due. This may include
payroll, monthly rent and utility expenses, and other operating costs. Working capital is the money
that is available to cover these expenses and is readily accessible.
One of the greatest challenges small businesses face is having enough working capital available. This
can be even more difficult if the company offers terms to its customers and must wait for other
companies or customers to pay their bills.
As an example, you run a small auto parts company providing parts to local mechanics with 30-day
terms, meaning the mechanics have 30 days after the parts are delivered to pay their bill. Offering
terms helps you sell more parts to the mechanics, which is helpful when they pay their bill. In the
meantime, though, you may find you run short on cash until the bills are paid.
In the 30-days before the mechanics pay for their parts your company may need to purchase
additional parts and inventory, pay your employees, and cover other normal operating expenses. If
you have been able to save money and keep extra cash available in your company bank account,
you have working capital that can be used to cover expenses until you receive payments from the
mechanics.
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The higher the working capital a company has, the more options are available for that business. If
working capital is insufficient, the company can experience significant financial problems and may
not be able to continue operating. When a company has no working capital, because it will not be
able to cover the expenses and debts that are due. Unfortunately, this is one of the most significant
factors in small business failures.
As with a personal budget, a company must have access to funds to cover unexpected expenses.
Having working capital available ensures a business will be able to cover incidental charges that
become due. Many companies keep a petty cash account which would qualify as part of working
capital. However, working capital is usually a much higher amount than the small balance most
companies keep in petty cash.
How Is Working Capital Calculated?
Working capital is determined by subtracting current liabilities from current assets. Working capital
in a formula looks like this:
Working Capital = Current Assets - Current Liabilities
Assets and liabilities are considered current if they are expected to be used or paid within one year.
Working capital is the difference between the amount of current assets the company has access to
and the current liabilities.
As you already know, current assets include cash, accounts receivable, and inventory. They are items
that can easily be converted to cash. As accounts receivable amounts are paid, the company receives
cash from its customer. Likewise, inventory can be sold and cash received for the sale.
On the other hand, current liabilities include bank loan payments, salaries, taxes, accounts payable,
and any other expenses that must be paid in the immediate future.
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6. BALANCED AND IMBALANCED EQUITY SITUATIONS
Balance or imbalance equity situations appear when we compare assets with liabilities & owner’s
equity.
From the calculation of the working capital, we are going to analyse the different financial situations
in which a company can be:
A) Total balance
The perfect balance is the one which is produced when the net
worth finances completely the fixed and current assets.
This situation is not normally given in the companies. It is usually
present at the beginning, when the company is founded but when
the company starts working in the trade, the situation changes,
as assets will stop being equal to the net worth.
To this respect, the company will have solvency in a short and
long term since it has no difficulty to deal with debts because it doesn’t have any (liabilities = 0).
WC=CA
B) Normal balance
A company is in a balanced / stable financial situation when the
fixed assets are completely funded by the net worth and the long-
term liabilities. At the same time, these two also finance part of
the current assets and working capital.
The rest of the current assets and working capital will be funded
by the current liabilities.
In this situation, some of the current assets are funded by current
liabilities and some, by the long-term liabilities and net worth, so:
WC > 0 (will be positive) but less than the current assets.
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C) Short-term imbalance (payments’ suspension)
A company is in this imbalanced situation when the current
liabilities fund the current assets completely and part of the
working capital. The rest of this capital and the fixed assets are
funded by the net worth and long-term liabilities.
This situation is reached, because the current liabilities have
grown a lot and they begin funding part of the fixed assets. This
is because current liabilities are facing those things which take
longer than a year for becoming money.
Take into account that this is a short-term situation, as in a long-
term there are enough liabilities to end up paying all the debts
and obligations, even though in the short-term (in that moment) it hasn’t been possible to get all
the money needed.
According to the abovementioned, this case would be represented as:
WC < 0 (will be negative, as there are more liabilities than assets).
D) Long-term Imbalance (bankruptcy)
A company faces bankrupt situation when there is no net worth
left or at least, it has been reduced more than a 50%.
In other words, debts have increase so much that creditors won’t
be able to receive their payments, as the current assets aren’t
enough for funding all the pending liabilities.
Obviously, in this case WC < 0 and the company will surely have
to end up closing.
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Bibliography
• David Broadbent, Chris Lindle, Kristie McHale, Sarah Oxley & Andy Park (2015). A-level
Economics, CGP, England.
• Michael Mandel (2012). Economics, the basics (second edition), McGraw- Hill, New York
• European Business Competence Licence (2011). Easy Business Training, Budapest.
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