Preparing A Balance Sheet
When someone, whether a creditor or investor, asks you how your company is doing, you'll want to have the answer ready and documented. The way to show off the success of your company is a balance sheet. A balance sheet is a documented report of your company's assets and obligations, as well as the residual ownership claims against your equity at any given point in time. It is a cumulative record that reflects the result of all recorded accounting transactions since your enterprise was formed. You need a balance sheet to specifically know what your company's net worth is on any given date. With a properly prepared balance sheet, you can look at a balance sheet at the end of each accounting period and know if your business has more or less value, if your debts are higher or lower, and if your working capital is higher or lower. By analyzing your balance sheet, investors, creditors and others can assess your ability to meet short-term obligations and solvency, as well as your ability to pay all current and long-term debts as they come due. The balance sheet also shows the composition of assets and liabilities, the relative proportions of debt and equity financing and the amount of earnings that you have had to retain. Collectively, this information will be used by external parties to help assess your company's financial status, which is required by both lending institutions and investors before they will allot any money toward your business.
I. Who Wants to See Your Balance Sheet
Many people and organizations are interested in the financial affairs of your company, whether you want them to be or not. You of course want to know about the progress of your enterprise and what's happening to your livelihood. However, your creditors also want assurance that you will be able to pay them when they ask. Prospective investors are looking for a solid company to bet their money on, and they want financial information to help them make a sound decision. Your management group also requires detailed financial data and the labor unions (if applicable) will want to know your employees are getting a fair share of your business earnings.
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II. Common Classifications
On the balance sheet you list your assets and equities under classifications according to their general characteristics. It is a relatively simple matter to make a comparison of one classification with another or to make comparisons within a classification because similar assets or similar equities are listed together. Some of the most commonly used classifications are:
Current assets include cash and other assets that in the normal course of events are converted into cash within the operating cycle. For example, a manufacturing enterprise will use cash to acquire inventories of materials. These inventories of materials are converted into finished products and then sold to customers. Cash is collected from the customers. This circle from cash back to cash is called an operating cycle. In a merchandising business one part of the cycle is eliminated. Materials are not purchased for conversion into finished products. Instead, the finished products are purchased and are sold directly to the customers. Several operating cycles may be completed in a year, or it may take more than a year to complete one operating cycle. The time required to complete an operating cycle depends upon the nature of the business. It is conceivable that almost all of the assets that are used to conduct your business, such as buildings, machinery, and equipment, can be converted into cash within the time required to complete an operating cycle. However, your current assets are only those that will be converted into cash within the normal course of your business. The other assets are only held because they provide useful services and are excluded from the current asset classification. If you happen to hold these assets in the regular course of business, you can include them in the inventory under the classification of current assets. Current assets are usually listed in the order of their liquidity and frequently consist of cash, temporary investments, accounts receivable, inventories and prepaid expenses.
Cash is simply the money on hand and/or on deposit that is available for general business purposes. It is always listed first on a balance sheet. Cash held for some designated purpose, such as the cash held in a fund for eventual retirement of a bond issue, is excluded from current assets.
These investments are temporary and are made from excess funds that you do not immediately need to conduct operations. Until you need these funds, they are invested to earn a return. You should make these investments in securities that can be converted into cash easily; usually short-term government obligations.
Simply stated, accounts receivables are the amounts owed to you and are evidenced on your balance sheet by promissory notes. Accounts receivable are the amounts billed to your customers and owed to you on the balance sheet's date. You should label all other accounts receivable appropriately and show them apart from the accounts receivable arising in the course of trade. If these other amounts are currently collectible, they may be classified as current assets.
Your inventories are your goods that are available for sale, products that you have in a partial stage of completion, and the materials that you will use to create your products. The costs of purchasing merchandise and materials and the costs of manufacturing your various product lines are accumulated in the accounting records and are identified with either the cost of the goods sold during the fiscal period or as the cost of the inventories remaining at the end of the period.
These expenses are payments made for services that will be received in the near future. Strictly speaking, your prepaid expenses will not be converted to current assets in order to avoid penalizing companies that choose to pay current operating costs in advance rather than to hold cash. Often your insurance premiums or rentals are paid in advance.
Investments are cash funds or securities that you hold for a designated purpose for an indefinite period of time. Investments include stocks or the bonds you may hold for another company, real estate or mortgages that you are holding for income-producing purposes. Your investments also include money that you may be holding for a pension fund.
Often classified as fixed assets, or as plant and equipment, your plant assets include land, buildings, machinery, and equipment that are to be used in business operations over a relatively long period of time. It is not expected that you will sell these assets and convert them into cash. Plant assets simply produce income indirectly through their use in operations.
Your other fixed assets that lack physical substance are referred to as intangible assets and consist of valuable rights, privileges or advantages. Although your intangibles lack physical substance, they still hold value for your company. Sometimes the rights, privileges and advantages of your business are worth more than all other assets combined. These valuable assets include items such as patents, franchises, organization expenses and goodwill expenses. For example, in order to become incorporated you must incur legal costs. You can designate these legal costs as organizing expenses.
During the course of preparing your balance sheet you will notice other assets that cannot be classified as current assets, investments, plant assets, or intangible assets. These assets are listed on your balance sheet as other assets. Frequently, your other assets consist of advances made to company officers, the cash surrender value of life insurance on officers, the cost of buildings in the process of construction, and the miscellaneous funds held for special purposes.
On the equity side of the balance sheet, as on the asset side, you need to make a distinction between current and long-term items. Your current liabilities are obligations that you will discharge within the normal operating cycle of your business. In most circumstances your current liabilities will be paid within the next year by using the assets you classified as current. The amount you owe under current liabilities often arises as a result of acquiring current assets such as inventory or services that will be used in current operations. You show the amounts owed to trade creditors that arise from the purchase of materials or merchandise as accounts payable. If you are obligated under promissory notes that support bank loans or other amounts owed, your liability is shown as notes payable. Other current liabilities may include the estimated amount payable for income taxes and the various amounts owed for wages and salaries of employees, utility bills, payroll taxes, local property taxes and other services.
Your debts that are not due until more than a year from the balance sheet date are generally classified as long-term liabilities. Notes, bonds and mortgages are often listed under this heading. If a portion of your long-term debt is due within the next year, it should be removed from the long-term debt classification and shown under current liabilities.
Your customers may make advance payments for merchandise or services. The obligation to the customer will, as a general rule, be settled by delivery of the products or services and not by cash payment. Advance collections received from customers are classified as deferred revenues, pending delivery of the products or services.
Your owner's equity must be subdivided on your balance sheet: One portion represents the amount invested directly by you, plus any portion of retained earnings converted into paid-in capital. The other portion represents your net earnings that are retained. This rigid distinction is necessary because of the nature of any corporation. Ordinarily, stockholders, or owners, are not personally liable for the debts contracted by a company. A stockholder may lose his investment, but creditors usually cannot look to his personal assets for satisfaction of their claims. Under normal circumstances, the stockholders may withdraw as cash dividends an amount measured by the corporate earnings. The distinction in this rule gives the creditors some assurance that a certain portion of the assets equivalent to the owner's investment cannot be arbitrarily withdrawn. Of course, this portion could be depleted from your balance sheet because of operating losses. The owner's equity in an unincorporated business is shown more simply. The interest of each owner is given in total, usually with no distinction being made between the portion invested and the accumulated net earnings. The creditors are not concerned about the amount invested. If necessary, creditors can attach the personal assets of the owners.
Cost is conventionally used as the basis for accountability. Assets, when acquired under normal circumstances, are recorded at the price negotiated between two independent parties dealing at arm's length. Simply stated, the cost of an asset to the purchaser is the price that he or she must pay now or later in order to obtain it. The fair value of the asset is not relevant in recording the transaction on your balance sheet. A purchaser may acquire an asset at a cost that is greater or less than the fair value determined in the marketplace. If the asset is acquired, the purchaser accounts for the assets at his cost, value notwithstanding. A simple formula to remember in determining cost is: Assets = Liability + Equity or Equity = Assets - Liability
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III. Preparing Your Balance Sheet
Title and Heading
In practice, the most widely used title is Balance Sheet; however Statement of Financial Position is also acceptable. Naturally, when the presentation includes more than one time period the title "Balance Sheets" should be used.
In addition to the statement title, the heading of your balance sheet should include the legal name of your company and the date or dates that your statement is presented. For example, a comparative presentation might be headed:
December 31, 2000 and 2001
There are two basic ways that balance sheets can be arranged. In Account Form, your assets are listed on the left-hand side and totaled to equal the sum of liabilities and stockholders' equity on the right-hand side. Another format is Report Form, a running format in which your assets are listed at the top of the page and followed by liabilities and stockholders' equity. Sometimes total liabilities are deducted from total assets to equal stockholders' equity.
Captions are headings within your statement that designate major groups of accounts to be totaled or subtotaled. Your balance sheet should include three primary captions: Assets, Liabilities and Stockholders' Equity. In the report form of presentation, the placement of your primary captions would be as follows:
2000 2001 ASSETS
LIABILITIES AND STOCKHOLDERS' EQUITY
Except in certain specialized industries your balance sheet should include the following secondary captions:
Your remaining assets and liabilities are generally combined into two or three other secondary captions, based on their materiality.
Order of Presentation of Captions
First, start with items held primarily for conversion into cash and rank them in the order of their expected conversion. Then, follow with items held primarily for use in operations but that could be converted into cash, and rank them in the order of liquidity. Finally, finish with items whose costs you will defer to future periods or that you cannot convert into cash. Following these guidelines, your major assets should normally be presented in the following order:
Liabilities are ordinarily presented in the order of maturity as follows:
Components of stockholders' equity are usually presented the following order:
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IV. Sample Trial Balance Sheet
|Accum. Depr Equip||8000|
|Accum. Depr Computers||6000|
|Payroll Taxes Withheld||2500|
|Loans Payable - Short Term||10000|
|Loans Payable - Long Term||30000|
|Paid In Capital||5000|
(You can use the interactive table provided to create an income statement for your company. Netscape users must scroll back down to the form after clicking 'submit' for your results.)
Now that the balance sheet is complete, here are some simple ratios you can calculate using the information provided on the balance sheet.
Computation: Total current assets divided by total current liabilities.
Total Current Assets / Total Current Liabilities
The current ratio is a rough indication of a firm's ability to service its current obligations. Generally, the higher the current ratio, the greater the cushion between current obligations and a firm's ability to pay them. The stronger ratio reflects a numerical superiority of current assets over current liabilities. However, the composition and quality of current assets is a critical factor in the analysis of an individual firm's liquidity.
Computation: Cash and equivalents plus trade receivables divided by total current liabilities.
Cash & Equivalents + Trade Receivables / (net) Total Current Liabilities
Also known as the "acid test" ratio, this is a refinement of the current ratio and is a more conservative measure of liquidity. The quick ratio expresses the degree to which a company's current liabilities are covered by the most liquid current assets. Generally, any value of less than 1 to 1 implies a reciprocal dependency on inventory or other current assets to liquidate short-term debt.
Computation: Fixed assets (net of accumulated depreciation) divided by tangible net worth.
Net Fixed Assets / Tangible Net Worth
This ratio measures the extent to which owner's equity (capital) has been invested in plant and equipment (fixed assets). A lower ratio indicates a proportionately smaller investment in fixed assets in relation to net worth and a better cushion for creditors in case of liquidation. Similarly, a higher ratio would indicate the opposite situation. The presence of substantial leased fixed assets (not shown on the balance sheet) may deceptively lower this ratio.
Computation: Total liabilities divided by tangible net worth.
Total Liabilities / Tangible Net Worth
This ratio expresses the relationship between capital contributed by creditors and that contributed by owners. It expresses the degree of protection provided by the owners for the creditors. The higher the ratio, the greater the risk being assumed by creditors. The lower the ratio, the greater the long-term financial safety. A firm with a low debt/worth ratio usually has greater flexibility to borrow in the future. A more highly leveraged company has a more limited debt capacity.
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John Clay and Stephen Holton, "Guide to Preparing Financial Statements" (Practitioners Publishing, 1997)
Peter Atrill and Eddie McLaney, "Accounting and Finance for Non-Specialists" (Prentice Hall, 1997)
Leopold Bernstein and John Wild, "Analysis of Financial Statements" (McGraw-Hill, 2000)
Daniel L. Jensen, "Advanced Accounting" (McGraw-Hill College Publishing, 1997)
Martin Mellman et. al., "Accounting for Effective Decision Making" (Irwin Professional Press, 1994)
Eric Press, "Analyzing Financial Statements" (Lebahar-Friedman, 1999)
Gerald I. White, "The Analysis and Use of Financial Statements" (John Wiley & Sons, 1997)
Journal of Accountancy
The Practical Accountant
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