Balance Sheets (AQA A-Level Business): Revision Notes
Balance Sheets
What is a balance sheet?
A balance sheet is a financial document that provides a snapshot of a business's finances at a specific point in time. Think of it as taking a photograph of what the business owns and owes on a particular date. Unlike other financial statements that show information over a period, a balance sheet captures a single moment.
The balance sheet serves several important purposes for businesses:
- It shows the value of all the business's assets (the things that belong to the business, such as cash, equipment and stock)
- It records all the business's liabilities (the money the business owes to others)
- It displays the capital invested in the business (money put in by owners and retained profits)
- It reveals where money has come from (sources of finance) and what's being done with it (how it's being used)
A crucial feature of balance sheets is that they always balance. The net assets value (total assets minus total liabilities) is always the same as the total equity value (all the money invested in the business). This is why they're called balance sheets — the two sides must equal each other.
Understanding assets
Assets are items of value that the business owns. Businesses use capital (money) to purchase assets because these assets will generate more revenue in the future — this is called investment. Assets provide a financial benefit to the business, which is why they're given a monetary value on the balance sheet.
Types of assets
Assets are classified into two main categories based on how long the business expects to keep them:
Non-current assets (also called fixed assets) are assets the business is likely to keep for more than a year. These are long-term investments that help the business operate and generate sales over time.
Examples include:
- Property and land — buildings where the business operates
- Production equipment — machinery used to manufacture products
- Desks and computers — office equipment
- Vehicles — company cars and delivery vans
The value shown on the balance sheet for non-current assets is the combined value of all these items. However, it's important to remember that non-current assets typically lose value over time through wear and tear — this is called depreciation. Businesses should factor in depreciation to give a realistic, up-to-date value of their assets.
Current assets are assets that the business is likely to exchange for cash within the accounting year (before the next balance sheet is prepared). All current assets are added together to give the total current assets value. Current assets include:
- Receivables (or debtors) — money owed to the business by other companies and individuals who have bought goods on credit
- Inventories (or stock) — products or materials that will be used to make products, which will then be sold to customers
- Cash in the bank — liquid funds immediately available for spending
Current assets are particularly important because they can be quickly converted into cash to pay bills and debts. The total of current and non-current assets, minus liabilities, gives the figure for net assets on the balance sheet.
Understanding liabilities
Liabilities are debts that the business owes to others. These represent money that must be paid back at some point. Like assets, liabilities are divided into two categories based on when they need to be repaid.
Current liabilities
Current liabilities are debts that need to be paid off within a year. These short-term obligations are crucial to monitor because the business must have enough cash or current assets to cover them. Current liabilities include:
- Overdrafts — money borrowed from the bank when the account goes negative
- Taxes due to be paid — corporation tax and VAT owed to the government
- Payables (or creditors) — money owed to suppliers for goods or services purchased on credit
- Dividends — profits due to be paid to shareholders
The total current liabilities figure is deducted from total assets to calculate the value of 'assets employed' — essentially, what's left over after paying immediate debts. This calculation gives you net current assets, which is the same as working capital.
Non-current liabilities
Non-current liabilities are debts the business will pay off over several years. These are long-term financial obligations. Common examples include:
- Mortgages — long-term loans secured against property
- Long-term bank loans — borrowed money to be repaid over multiple years
Long-term liabilities are typically used to finance major investments in non-current assets like buildings or expensive equipment.
Working capital
Working capital represents the finance available for day-to-day spending. It's the amount of cash and assets that can be easily turned into cash that the business has available to pay its immediate debts. Having adequate working capital is essential — the more working capital a business has, the more liquid (able to pay its short-term debts) it is.
Calculating working capital
Working capital is calculated using a simple formula:
This formula shows what's left over when you subtract current liabilities (like overdrafts, payables and tax due) from current assets (like cash, receivables and stock). On the balance sheet, this figure appears as net current assets.
Why working capital matters
Businesses cannot survive without enough working capital. Beyond generating sales, the business must ensure it collects money quickly to get cash to pay its liabilities. The challenge is that businesses need to avoid tying up too much of their working capital in inventories or receivables — they can't use these to pay current liabilities until they're turned into cash.
However, having too much cash sitting idle isn't ideal either. While businesses need just enough cash to pay short-term debts, holding excessive cash means missing out on opportunities to earn money for the business through investment.
Factors affecting working capital needs
Different situations affect how much working capital a business requires:
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Businesses with a long cash-flow cycle need more cash because they have to wait for money to come in. For example, manufacturers must pay for materials and production before receiving payment from customers.
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Inflation increases the costs of wages and buying or holding stock, so firms need more cash when prices are rising.
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When a business expands, it needs more cash to avoid overtrading. Overtrading occurs when the business produces so much that it can't afford to pay its suppliers until it receives payment from its customers.
Capital expenditure
Fixed capital (or capital expenditure) refers to money used to buy non-current assets (fixed assets). These are long-term investments in items used repeatedly to produce goods or services for sale — such as factories and equipment.
Purpose of capital expenditure
Businesses need capital expenditure for several key reasons:
- To start up — new businesses must invest in premises and equipment
- To grow — expanding businesses need additional facilities and machinery
- To replace worn-out equipment — assets deteriorate over time and must be updated
Companies must set aside enough money to prevent non-current assets from wearing out. They then decide how much money to invest in growth initiatives. This strategic planning is called allocated capital expenditure.
Capital expenditure appears on the balance sheet as non-current assets. This investment represents a significant commitment of funds that will benefit the business over many years.
Managing debtors and stock
Controlling debtors (receivables)
A business needs to carefully control its debtors — people and companies who owe money to the firm. It's crucial that businesses ensure their debtors pay them on time. Without this control, serious problems emerge.
A company might sell millions of pounds worth of goods, but if it doesn't make sure that payment has been received, there'll be no money coming in. This means the business has no cash flow in terms of actual money, even though it has made sales on paper. The business still has to pay wages, loan repayments and other expenses, regardless of whether debtors have paid up. Therefore, businesses must control debtors carefully to survive.
Controlling stock (inventories)
Stock control is equally important for business success. A business needs to hold appropriate volumes of stock (raw materials and unsold products) to allow it to satisfy market demand.
However, balance is essential:
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A business holding too little stock will lose sales because it won't be able to supply enough goods to the market to meet customer demand. Customers will go elsewhere.
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A business with too much stock has money tied up in stock instead of working for the company. This is inefficient — it would be better to use the money to pay debts, wages or invest it in new projects.
To achieve the right balance, businesses predict what the demand for their products will be. This helps them maintain a suitable level of stock — enough to meet customer needs without having excess sitting in warehouses.
Stock valuation
Accounting conventions require that stock values on the balance sheet must be realisable — meaning they reflect what the business could actually get for the stock. The net realisable value is the amount the company could get by selling the stock right now in its current state, rather than after it's been used to make a finished product.
The lower of cost or net realisable value rule
When valuing stock, businesses must follow an important rule: record stock at whichever value is lower — the original cost or the net realisable value.
Sometimes the realisable value might be lower than the cost value (the amount the business paid for the stock). In other cases, the net realisable value might be higher than the original cost price. This can happen if demand for the materials has increased since the business bought them. For example, in jewellery manufacturing, precious metal and gemstone prices fluctuate and might rise after purchase.
The company must record the stock value in its accounts as the lower value out of cost or net realisable value. This conservative approach ensures the balance sheet doesn't overstate the business's assets.
Example of stock valuation
Worked Example: Stock Valuation in Practice
Consider a computer business that buys 300 microprocessors at $100 each for laptop production, giving a total cost of $30,000. Later, the business updates its laptop specifications and can't use these microprocessors in the new models, so it must sell them. Meanwhile, technology has advanced and more sophisticated microprocessors are now available on the market. There's little demand for the old microprocessors, and the business can only sell the old stock for $40 each ($12,000 altogether).
Following accounting rules, the business must record the stock value as $12,000 in its accounts, rather than the $30,000 it originally paid.
Understanding depreciation
Depreciation is the drop in value of a business asset over time. Most assets lose value as time passes — the longer the business has owned them, the less they're worth.
Why assets depreciate
Assets lose their value for several main reasons:
- They suffer wear and tear through regular use — machinery and vehicles deteriorate from constant operation
- They may break down — equipment fails and becomes unusable
- They become old fashioned — new models or inventions enter the market, making older versions less desirable
For example, if a business has been using a piece of machinery for six months, it won't be worth as much as when it was new, even if it's still in good condition. Technology products especially depreciate rapidly as newer, faster versions constantly appear.
It's worth noting that although most assets depreciate, sometimes the opposite occurs. Property can increase in value over time because property prices tend to rise. This makes property a valuable long-term asset.
Accounting for depreciation
Businesses calculate depreciation each year to ensure that an asset's value on the balance sheet provides a true reflection of what the business would get if it selling the asset.
Why businesses spread depreciation costs
Building depreciation into each year's accounts avoids the fall in value hitting all at once when the business eventually sells the asset. Spreading out the cost of depreciation over several years gives a truer reflection of the financial situation and allows the business to make comparisons between financial years more easily.
Worked Example: Depreciating Machinery Over Time
Imagine depreciating a piece of machinery over 10 years. The business can account for a tenth of the fall in value each year (the difference between what the asset cost to buy and what managers think they'll be able to sell it for).
Without depreciating the asset annually, the business would be understating its costs (and therefore overstating its profits) for each year until it disposed of the asset. When it finally sold the machinery, this would show up as a huge cost on the accounts for that year.
How depreciation appears in accounts
The amount lost through depreciation is recorded on the income statement as an expense. This is unusual because it isn't a cash expense in the traditional sense — rather, it's a recognition of the money that's been invested in the asset that the business can't ever get back. The business has paid for the asset upfront, but its value gradually disappears through use and time.
Depreciation must be reflected in the net assets calculation. If depreciation wasn't included in the balance sheet, the figures wouldn't balance correctly. The depreciation expense reduces the value shown for non-current assets on the balance sheet.
Bad debts
Bad debts are debts that debtors won't ever pay. Ideally, every debt owed by debtors to the business would be paid eventually. Unfortunately, the real world doesn't work like that. Most debts get paid eventually, but some debtors default on their payments — they don't pay up.
Accounting treatment of bad debts
Debts which don't get paid are called "bad debts". These bad debts can't be included on the balance sheet as an asset — because the business isn't going to receive money for them. Including unpaid debts as assets would make the business appear more valuable than it actually is.
The business writes off these bad debts, recording them as an expense on the profit and loss account. This accounting entry shows that the business has lost money — it provided goods or services but never received payment.
Being realistic about bad debts
It's important for businesses to be realistic when assessing bad debts. They shouldn't be over-optimistic and report debts as assets when they're unlikely to ever be paid. However, they also shouldn't be too cautious and write debts off as bad debts prematurely when they could still persuade the debtors to pay up. Finding this balance requires careful judgment about which customers are likely to pay and which genuinely cannot or will not settle their accounts.
Using balance sheets to assess financial performance
Balance sheets are valuable tools for analyzing a business's financial situation and making informed decisions.
Short-term financial status
The balance sheet reveals how much the business is worth at a specific point in time. Working capital (net current assets) shows the amount of money the business has available in the short term, calculated by subtracting current liabilities from current assets.
Suppliers are particularly interested in working capital and liquidity (how easily assets can be turned into cash to spend). They examine the balance sheet to see how liquid the firm's assets are and how much working capital the firm has. The more liquid the assets, the better the firm will be at paying bills. This information helps suppliers decide whether to offer the business supplies on credit, and how much credit to offer.
The balance sheet also shows sources of capital. Ideally, long-term loans or mortgages are used to finance the purchase of fixed assets. A well-managed business wouldn't borrow too much through short-term overdrafts, because overdrafts are an expensive way of borrowing.
Identifying strengths and weaknesses
Short-term information from the balance sheet helps businesses assess their internal strengths and weaknesses. For example, if a business has a large amount of working capital, management could invest this money in new equipment or use it to pay off some loans, improving the business's financial position.
Comparing balance sheets to identify long-term trends
Comparing this year's balance sheet to previous years' accounts allows businesses to identify trends in company finances and evaluate the financial performance over time. Looking at the "bottom line" figures over several years shows how the business is changing.
A quick increase in non-current assets indicates the company has invested in property or machinery. This suggests the company is investing in a growth strategy, which may increase its profit over the medium term. This is useful information for shareholders and potential shareholders who want to see increased returns on their investment.
Increases in reserves also suggest an increase in profits — good news for shareholders as it indicates the business is generating more value.
Analyzing capital structure trends
Examining several balance sheets together reveals trends in how the business has raised its capital. It's risky to suddenly start borrowing a lot of money, especially in case interest rates rise. A company with a high value of loan capital and relatively low value of share capital or reserves would be in trouble if the Bank of England increased interest rates. This would dramatically increase their loan repayment costs.
Businesses can use long-term trends to identify their strengths and weaknesses. If non-current liabilities (long-term debts) have increased significantly, the business might want to try to reduce its borrowing in the future. This analysis helps management make strategic decisions about financing and investment.
Remember!
Key Points to Remember:
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Balance sheets are financial snapshots — they show assets and liabilities at a specific point in time, not over a period
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Net assets always equals total equity — this is why balance sheets balance
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Working capital = current assets - current liabilities — this shows the finance available for day-to-day operations
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Assets depreciate over time — businesses must calculate depreciation annually to show realistic asset values on the balance sheet
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Balance sheets help assess financial health — they reveal working capital, liquidity, capital structure and long-term trends essential for decision-making