2. The Balance Sheet: What do I have and to whom does it belong?
3. The structure of the Balance Sheet
4. The equivalence of the Balance Sheet
5. The Balance Sheet as "parking lot" of the financial manager
6. The goal of the Balance Sheet
7. Time to structure of the Balance Sheet
8. Some important terms from the Balance Sheet
9. The reconciliation of the Balance Sheet with the Profit and Loss Statement and the Cash Flow Statement
The Balance Sheet is one of the three financial statements.
Together with the Profit and Loss Statement and the Cash Flow Statement the Balance Sheet forms the basis of Financial Management. The Balance Sheet is a special overview because it is a snapshot of a moment in time and consists of two parts. The first left side, which we call the assets, consists of a list of everything the company has, with the corresponding value. The right side is called the equities and liabilities, this is an overview with all those parties who have a claim to the company and to what extent. Or in layman terms: What do I have and to whom does it belong?
1. The Three Overviews of Financial Management
All companies report their financial situation annually in the form of financial statements. Small companies do this mainly for the tax authorities, the large companies also do this to inform their owners and other interested parties. This "informing" is done by making an annual report that consists of information from the Board of Directors, the Supervisory Board, a statement from the auditor and the Financial Statements. The latter is the numerical part and is again composed out of THE three overviews. The structure of Financial Management is the same throughout the world and consist of the Profit and Loss Statement, the Cash Flow Statement and the Balance Sheet.
1.1 The Profit and Loss Statement: The overview of realized minus consumed
The Profit and Loss Statement is the most discussed financial overview and provides insight into the profitability of the activities of companies: What, and for which value, has been realized on delivered products and services. The costs are deducted from this revenue. Costs are the value of the items and time consumed to realize the activities. Read my article about the Profit and Loss Statement in which I explain this into more detail.
1.2 The Cash Flow Statement: How much money flows into and out of the company
The Cash Flow Statement provides insight into the money flows in and out of the company in a specific period. In addition, the overview distinguishes between where the money comes from and where it goes. We make an operational cash flow that arises from the company's "normal" activities. Secondly, the money flow that is spent on investments or comes from the sale of investment goods and finally the flow to and from the owners and the debtors of the firm. Read here the article about the Cash Flow Statement.
The special characteristic from the Balance Sheet is that it is a moment in time. This in contrast to the Profit and Loss and the Cash Flow statement, both of which focus on events and describe a specific time period. The Balance Sheet represents a snapshot of all the assets, equity and debts that the company has at a given moment in time. We therefore see in the annual reports of the companies that both a Balance Sheet at the beginning of the period and a second version at the end of the period is published. If you want to assess the performance from a company based on the Balance Sheet you will have to assess the differences between the two.
The left side of the Balance Sheet is called the assets with all the items described that are in the possession of the firm, with the value as stated in the books. This value can be represented in two way’s. Either by the original value with the depreciation to deduct or by only the current value which is the sum of the previous two.
- Tangible assets: We differentiate between the Assets in various ways, for example between Assets that we can "grasp", tangible assets, such as land, buildings, machines and inventory and possessions that we cannot "grasp", Intangible assets such as patents or rights.
- Fixed Assets: We also make a difference between assets that we "use multiple times", fixed assets, such as a building that I can use for multiple periods and current assets that we "consume", such as raw materials, finished goods or cash.
- Financial Assets: Companies are often linked to each other, whereby the parent company has the shares of the subsidiary as a holding (financial asset) on its balance sheet.
The Equity and Liabilities:
Did we describe the assets as "what I have" so the equivalence describes the liabilities or in layman’s terms "to whom does it belong" or more specifically who has claims to what extent. We divide the liabilities into two major groups.
- Equity: The part that belongs to the owners of the company. Within this group we can further distinguish between what is invested by the owners, the share capital and the profits and reserves realized by the company itself in the past.
- Liabilities: The second group consists out of the lenders, the debt providers. You can think of the Bank or private providers, but also the suppliers (whom we still have to pay) form a large part of the debt.
The reason for the equivalence of the balance sheet is not technical. After all, on the assets side I describe "what I have" and on the liabilities side I describe "to whom does it belong". If, for example, circumstances show that the building suddenly loses value, the equity providers will notice this in the value that belongs to them. After all, the mortgage does not change due to this event.
- An example of a private Balance Sheet: Imagine starting a business and depositing the money 1000 on the new bank account. After this event the Balance Sheet looks as shown on the first Balance. If you decide to purchase a building from 2000 with this money and to finance the difference with a mortgage, the balance will look like the second after this transaction. Now, for whatever reason, it appears that the building has increased in value to 2300. As a result, the mortgage does not change and the shareholders are happy as you can see in the third balance sheet. If the reverse happens and the value of the building drops to 1700, the shareholders are sad. In short: the Balance Sheet is in balance because what I have belongs to someone.
The Profit and Loss Statement shows the realizations and consumption of the company. What has been delivered and what has been used or consumed. The Cash Flow Statement shows the cash flows of the company. How much money has come into and has left the company. If activities take place within the company that do not lead to realization or consumption and also do not have to go in or out in the form of cash, they must be parked somewhere. The parking lot of the financial person is the Balance Sheet. An example to make it clearer helps with this.
- A trade organization: Suppose a trade organization is going to buy € 100 chairs. At the time of receiving the chairs, we store them in the warehouse. This creates both a asset in the inventory and a debt towards the supplier. Since there is no realization by means of the sale and no payment is made to the supplier, this activity will not result in an entry on the Profit and Loss Statement and also no mention on the Cash Flow Statement, since we have not yet paid the supplier. When we deliver the chairs for € 120 to the customer, we realize an activity that we include in the Profit and Loss Statement. As a result, however, the chairs are no longer owned by the company and are therefore no longer part of the inventory. However, I have a claim towards my customer. After all, he still has to pay me the chairs in the near future. The moment that he pays is a cash inflow that is included in the Cash Flow Statement. At that same moment my claim on the customer obviously expires, but I have money in cash instead. If I then pay my supplier the bill for the chairs, I generate a cash outflow (on the Cash Flow Statement) and my cash is lower on the balance sheet but the debt is also gone.
As with all financial statements, the objective of the balance sheet is to be "in control". In other words, knowing what is going on within the organization and responding to situations with actions to realize improvements. At the Profit and Loss Statement everyone understands that the goal is to have the profit as high as possible. But what is the goal of the balance and why? The purpose of the Balance Sheet is to work with as little capital / assets as possible (the value of the buildings, machines, stock). Why? Because capital providers demand a return for their investment.
Capital minimization: Every capital provider that gives money to the firm wants something in return. It does not matter whether we speak about the bank that provides a loan and wants to receive interest for it or a shareholder who invests for the dividend that he expects. In short: everyone who invests capital, demands a return. Also view my video about the pie and shareholder value for more insight. The objective of the Balance Sheet is therefore to 'use' minimal capital with the highest possible return.
As discussed above, the Balance Sheet consists of two parts that have exactly the same total. The assets that indicate “what do I have” and the Equity and Liabilities that indicate “to whom does it belong”. All Balance Sheets in the world have this structure.
The Assets of the Balance Sheet are structured together by the length of time they are used. Traditionally the longest used assets are the land, buildings and tools, followed by patents, rights or IT-systems. The shortest used items are those that are consumed like inventory and cash. English firms will start with the shortest assets, continental firms with the longest.
- Types of Assets: We distinguish between several types of assets
- Tangible Fixed Assets like land and buildings
- Intangible Fixed Assets like IT-systems and patents
- Financial Assets like interests in other companies
- Current Assets like inventory, debtors and cash
As the name already gives away there is a major distinction between the providers of capital.
- The owners of the firm are represented by the equity capital that remains the longest in the company, such as shares, profits from the past and reserves.
- The second group is the debt capital. Also here we distinguish in time. Where a mortgage can easily run for 30 years and suppliers credit is usually the shortest. Also here English firms will start with the shortest liability, continental firms with the longest.
A debtor is a customer of the company that still has to pay for a product or service received. It is someone who has a debt to the company. The aim of the company is to work with as little as possible capital. Money tied up in customers cannot be used for other activities. Therefore the goal is to have as few debtors as possible. Everyone is asked to pay the money as soon as possible for the goods and services they have received.
A creditor is a supplier of the company who has delivered a product or service and has sent an invoice to the company that still has to be paid. It is someone who has a claim on the company. Since the credit from the supplier is considered “capital for free” the aim of the company is to have as many creditors as possible. Everyone is asked to pay as late as possible for the goods and services they have supplied.
Debtors and creditors
The objective of the company can be described in two aspects:
- Make as much profit as possible
- Use as little capital as possible
How can you use little capital within your company? Let your customers pay quickly and pay your supplier late. Think about the supermarket ...... You pay yourself before you leave the building, while the farmer who delivered the tomatoes will only get paid weeks later.
Goodwill is a term that is registered on the assets side of the balance sheet it is something a company owns. This means that it is a property of the company. But what is Goodwill? In short, this is the difference between the price paid by the buying party for the acquired company and the value of that company in the accounts. Now you will think but how is that possible? I buy something and then it is worth less? Then I would not buy it!
The development of Goodwill arises from the accounting principles. When making financial statements we have agreed that we are prudent in determining the value. In other words, things that we cannot certainly convert into value are not included in our list of assets (= the Balance Sheet).
Why are companies bought? Of course because of the assets they have like land or buildings. However, companies are also often purchased because of the knowledge they have, because of the sales channel they are active in or the brand name. The latter group are typical assets that we do not include on the balance sheet due to the prudence principle. After all: "What are they worth?" and "Is it possible to cash this with certainty in the future?"
Conclusion: Goodwill is the difference in value between the price paid during the acquisition and the conservative value of the company if I make an estimate based on the accounting principles. But mustn’t the buying party also be careful? Of course and therefore it will decrease the goodwill in the following years, via depreciation and in the occurrence of a special event extra (=impairment).
9. The reconciliation of the Balance Sheet with the Profit and Loss Statement and the Cash Flow Statement
The three overviews from the Financial Statements are to be reviewed together. All three reflect in their own way the activities and assets of the company. The period starts with the opening Balance Sheet. This shows all the assets and ownership of the company at the start. During the period (year, quarter, month) there are a number of activities within the company that are represented in the Profit and Loss Statement and the Cash Flow Statement. The period ends with a closing Balance Sheet.
The difference in 'result from the past' of the opening and closing Balance Sheet is equal to the result of the Profit and Loss Statement. The difference in cash between the start and the closing Balance Sheet is explained by the Cash Flow Statement.
In practice, there are a number of factors that make the connection of the profits more complicated. Consider, for example, a company that is active in various countries and possesses assets that are valued in different currencies and that generate exchange rate results. These also needs to be represented and intervenes the link for the Profit.
In this article I have described what is registered on the Balance Sheet and what the overall goal is. To remember: First of all, the Balance Sheet is in balance because it describes on the one hand “what do I have” and on the other side “to whom does it belong”. Second, the Balance Sheet is a snapshot, to form an opinion it is important to compare different Balance Sheets and to compare the development of the items in time. The goal of every company is to use as little capital as possible because everyone who puts money in the firm also wants something in return.
It's just like a party: How do I get a big piece of cake? By baking a large cake (making a lot of profit) or by inviting a less people (using little capital). And most importantly: Why do you look at a Balance Sheet? To judge how well have I performed? What happened? Where should I adjust? Which actions could I or should take?
Would you like to receive my free book Financial Management unravelled?
Fill in the form below and mention the description "Book Financial Management Unravelled". You will receive the book and my article: "The eight most common financial mistakes by managers".