The second key financial statement is the balance sheet. There are two reasons why it is called a balance sheet. The first is that this is a snapshot at the end of a period of trading of the business’s:

• assets, things that are owned by the business which have a value; and
• liabilities, the business’s obligations to pay money to others.

It is therefore a statement of the balances on these accounts at the end of a period.

As it is a statement of the business’s assets and liabilities, the balance sheet is sometimes seen as a statement of the business’s worth. This is, however, a dangerous assumption as in accounting terms it is simply a list of balances.

For example, the balance sheet values of assets (at historical cost, as discussed in the last chapter) are unlikely to provide you with an accurate reflection of their current market value. It also takes no account of business assets such as goodwill or brand awareness, which have a value, but generally do not appear on the balance sheet.

Widget Co Ltd’s balance sheet as shown in Chapter 2 consists of the following.

• Fixed assets such as property, plant and machinery, motor vehicles, or even some intangible assets which the company owns and will use over a number of years. These are shown at the cost of acquisition, less the depreciation accumulated over the years to show a net book value, which is essentially the remaining cost of the asset to be written off to the profit and loss as the asset is used.
• Any investments in subsidiary companies would be shown separately.
• Current assets, which are those assets such as debtors (or to use the American term receivables), stock and cash in hand and at the bank which should be used in trading the business over the next 12 months.
• Current liabilities are all the creditors (or payables in American parlance) which are due and payable within the next 12 months. This will include normal trade creditors, balances due to the Crown in respect of VAT or PAYE/NI (tax deducted from employees’ wages under Pay As You Earn and employees’ and employers’ contributions to National Insurance), the proportion of the capital of long-term loans, hire purchase and leases that are due to be paid during this period, and the total of any bank overdraft (as these are always repayable on demand).
• Net current assets (or in this case, liabilities) is the total of the current assets less the current liabilities, and broadly represents the working capital of the business.
• Long-term liabilities are all creditor balances due after periods longer than a year.
• Net assets is the sum of the fixed and current assets and investments, less the current and long-term liabilities.

The second reason why it is called a balance sheet is that it should balance. That is to say that the value of the net assets (which should normally be a positive number) will then in the case of a limited liability company match the value of the shareholders’ funds which consist of:

• the share capital, which are the funds introduced to the company by the shareholders;
• the P&L account or retained profits, which is essentially the sum of money left in the business from profits over this and previous years;
• any other reserves such as will have been created, for example, by a revaluation of the company’s property.

For a partnership the net assets will be matched by the total of the partners’ capital and current accounts.

If the balance sheet does not balance in this way it shows that there is a fundamental problem in the business’s bookkeeping system.

WHAT DOES THE BALANCE SHEET TELL YOU?

If the profit and loss account tells you about the business’s profitability, then the balance sheet tells you about its financial position and in particular the following.

Financial stability

How risky are the finances? This means looking at its:

• liquidity, which can show how much risk the business has of running out of cash in the short term; and
• gearing, which shows how reliant on, and exposed to, borrowed money the business is.

Financial efficiency

How well is the business managing the cash it needs?

This means looking at its:

• stock turn and debtor and creditor days, which brings us back to the working capital cycle;
• return on capital employed; and
• return on investment.

UNDERSTANDING FINANCIAL STABILITY

Liquidity

Sometimes a business’s balance sheet will show a very positive position, but it still has financial problems in meeting its bills. This can be because it has its cash tied up in illiquid assets. For example, a business had a balance sheet that showed net assets of well over £10m. However, looking more closely at the make up of the assets, £12m of this asset base was farming land which could not be used as such to meet day-to-day payments required by the business and so the business had a liquidity problem.

Liquidity is an indication of the business’s likely ability to pay its current liabilities. Quite simply it measures: does it have enough cash to hand?

The basic measure is the liquidity or the current ratio which divides:

• the current assets, the cash and the assets that should turn into cash over the next 12 months such as the debtors and the stock; by
• the current liabilities, the sums that need to be paid over the next 12 months:

Simplistically, one would expect that a ratio of more than one would indicate financial stability, and significantly less than one would indicate problems. Whilst this is generally a safe working hypothesis, you must compare the ratio calculated against that of other businesses in the same industry as in some sectors an apparent low liquidity is normal. As for all ratios discussed in this book, what you need to know for any figures calculated is:

• whether for your industry the ratio is relatively good or bad, so why not obtain a copy of your competitors’ accounts from Companies House and benchmark your ratios against theirs; and
• what the trend is over time (in this case, increasing or decreasing liquidity).

In the case of Widget Co Ltd the answer is 0.94 which would suggest that the company has reasonable liquidity:

In order to generate cash at a known value, however, stock must first be sold. Stock is therefore less liquid than debtors and cash, and is therefore less reliable for meeting existing liabilities than these assets.

For example, an importer of summer goods had a poor season, and was left at the end of September with stock at a value equal to almost half the normal annual turnover and little or no prospects of sales until the following spring. While the current ratio still showed a reasonable position, the trading position worsened over October and November, as the debtors paid and the cash was used to meet overheads and pay some creditors. Despite having stock (a current asset) the business obviously had a liquidity problem.

The acid test (N ratio) measure of liquidity therefore excludes stock to see how readily the business can pay its current liabilities from the cash and near cash assets on hand:

Again the trend over time (improving or worsening) and relative performance to the norm for your industry is as important, if not more so, than the actual number.

In the case of Widget Co Ltd the answer is 0.65 which might start to give some cause for concern:

By contrast a shop which is buying on credit and selling for cash will typically have no debtors, but will still have a large value of creditors. You would therefore expect most shops to show a very low acid test measure; however, you would also expect most shops to be able to turn stock into cash fairly quickly, so in this sector a low ratio is not necessarily a cause for concern.

Gearing

Gearing (also known by the American term leverage) measures how financially exposed the company is by looking at to what extent the business’s long-term finance is based on borrowed money rather than the shareholders’ funds or equity. There are a number of different ways to calculate a gearing figure. The simplest is:

Again, the importance of the figures lies less in the absolute number, and more in how it compares with other businesses in the sector and the long-term trends.

Now you may well want and need to gear up your business by borrowing funds to invest in plant or to fund increasing working capital requirements caused by growth. This may, for example, allow you to expand your business faster than you could otherwise manage by putting in more of your own money or retaining profits generated. If you can borrow money to fund trading that makes you an additional profit of well in excess of the interest charge involved then it may well make sense to do so.

Indeed some businesses fail because their level of trading expands faster than their supply of funding to meet the funding gap, a problem known as overtrading.

However, this is at a risk as interest charges on long-term loans will need to be paid whatever the profits generated by the business. So, the higher the gearing (ie the greater the proportion of the business’s long-term funding that is borrowed money), the higher the financial risk of the business.

Widget Co Ltd’s gearing is:

Long-term loans (the mortgage) Total capital employed (shareholders’ funds)

However, last year the gearing ratio was 2.94 (£150,000/£51,000), so the company has degeared by paying off £50,000 of its long-term debt and building up its shareholders’ funds by retaining profits in the business, rather than paying these out by way of a dividend to shareholders. This action has reduced the financial risk of the business.

So have Widget Co Ltd’s directors decided that things are becoming a bit more difficult, and decided to cut their interest costs and reduce the business’s financial risks by using cash generated by the business to pay down its long-term debt?

Widget Co Ltd must pay £20,000 a year interest on its debt or default on its loan. By contrast, its competitor Thingumy Ltd, whose finances are more highly geared and is borrowing at the same interest rate of 20%, has to find £35,000 a year:

So if times are getting hard, Thingumy Ltd will be more financially stretched by having to meet its interest payments (and don’t forget, also its repayments of the principal elements) than Widget Co Ltd.

So why is Thingumy Limited taking this risk? The shareholders of Thingumy limited have only had to invest £6,000 in shareholders’ funds and are using £175,000 of someone else’s money which they have borrowed to fund their business. Widget Co Ltd’s shareholders have much more of their own money tied up in the business (£81,000) as they are less reliant on borrowed cash.

You therefore need to balance the advantage gained by being able to borrow against the risk that this may pose to your business if things slow down.

UNDERSTANDING FINANCIAL EFFICIENCY

Cash is a critical resource for your business. As I hope will be becoming clear, a given level of trading for your business will require a certain amount of cash, so if your business is growing you will need to either:

• raise more cash to support this level of trading; or
• improve the efficiency with which you manage cash so that each pound can support more trading.

Calculating how efficiently a business’s working capital is being managed is a matter of calculating the stock, debtor and creditor days as below. Again the trends over time and how these compare with your competition can provide important information.

There are a number of ways that these ratios can be calculated (eg you can take the year end figure for the balance concerned, or you can take an average of the opening and closing balance to get an average balance for the year).

In some ways, so long as you are consistent, it doesn’t really matter. What is important is seeing the overall picture, and being consistent in approach when doing so over time, to monitor changes and trends or to benchmark against competitors.

The key ratios (and the way I prefer to calculate these) are as follows.

Stock days

On average Widget Co Ltd is holding stocks equivalent to two months’ worth of purchases and this stock represents cash tied up in the business. So perhaps the company should investigate why it is carrying this amount of stock.

By looking more closely it may be possible to further calculate the following.

• Raw material days (say in the company’s case 21). Is the business purchasing raw materials in over-large volumes to get good prices? If so, is this an efficient use of the cash available? How long does it take to get a delivery of raw materials? If these can be bought for next day delivery why hold three weeks’ worth of supplies?
• Work in progress (WIP) days (say these are ten). Is this realistic? Does it really take ten days on average to make a widget? If it should only really take three days does this mean there is an inefficiency on the shopfloor which is tying up cash?
• Finished goods days (say these are 31). Now the business may need to hold a large range or quantity of finished goods in order to ensure it is able to give customers the service they want by always having the widget they want in stock. But is there cash tied up in lines that are rarely asked for? And if it takes ten days on average to make an item of stock, why does the business need to have 31 days’ worth of finished items on hand?

Debtor days

Once you have made a sale to your customers you then have to collect payment and until the customer pays, this is more cash tied up in the business:

Debtors at year end
Sales (+ VAT if applicable so as to
be comparable with debtors)

So it is taking Widget Co Ltd about two months on average to obtain payment from its customers. There may be ways that the company can speed up the process by improved credit control, introducing tighter payment terms (eg 14 days not 30), offering settlement discounts (eg X% if paid within 14 days of invoice). It may also be worthwhile calculating this figure for some of its individual key customers to see if it can spot any particularly bad payers who are pushing the average up and targeting these for particular action.

However, it can be an important part of your service to customers to offer credit terms. If you don’t, customers may go elsewhere to buy from suppliers who do.

The company might also explore raising money against its debtor book by either invoice discounting or factoring, where it obtains an advance of normally 60% to 80% of the invoice value when the sale is made, with the balance of the invoice value being received (less the lenders’ charges) once the customer pays. The pros and cons of these types of finance are set out in Chapter 9.

Creditor days

The other side of the coin of course is that you also have to pay your suppliers:

So Widget Co Ltd is taking 67 days on average to pay its suppliers. In effect this is a free loan of cash from the suppliers to the company. So could Widget Co Ltd eke out its own cash by taking advantage of this loan for longer by taking longer to pay?

Possibly, but what risks is it then running of suppliers putting the company on stop, or taking legal action to recover their cash which may make obtaining credit in future more difficult?

Managing your working capital is therefore a matter of:

• measuring and tracking where you stand; and
• taking action to manage how much cash is tied up in working capital; but
• balancing the costs and consequences of the actions:
  • cutting down on stock frees up cash, but may cause customer service levels and operating efficiencies to suffer;
  • reducing the level of credit to customers saves cash, but may lose you sales;
  • taking longer to pay suppliers conserves cash, but can cost you in missed settlement discounts and disruptions as you go on stop.

It is important though to appreciate that different industries and businesses will have very different profiles. For example, Widget Co Ltd is obviously a manufacturer of widgets, selling these to other businesses on credit so it will have both stock and debtors.

A services business selling say consultancy to other firms will probably have debtors, but other than unbilled time on any project is unlikely to have any ‘stock’.

By contrast, a shop will carry a lot of stock, after all, that’s what they are there for, to have stock of the item the customer wants when they come in to buy it. However, shops will normally be selling for cash and so have few or no debtors. But even here there may be things that a shop can do to limit its investment in stock.

• Can it buy items on sale or return? So if a line does not move, it can go back to the supplier and the shop is not stuck with cash tied up in items which are not selling.
• Can it let out pitches in its premises to concessions which will sell their own goods and pay the shop a mix of rent for the pitch and a commission on value sold?
• Can it sell on commission for the suppliers, so that the stock in the shop doesn’t actually belong to it and the business only has to pay the supplier for an item out of the proceeds when it is actually sold?

Taking Widget Co Ltd’s figures from above you can quickly see in Figure 3 where the business’s requirement for trading finance comes from:

From the moment the company buys something until it pays for it is on average some 67 days. But on average from the moment it buys the raw material the company takes 21 days before it goes into production, which takes 10 days, and the finished item then sits on the books for a further 31 days before being sold. So 62 days have ticked by before the goods purchased have actually made it through to a sale, meanwhile the company only has another five days left before the company is to pay the supplier.

Yet it is going to be a further 62 days from the point of sale before the company has the cash in from the customer, leaving a funding gap of on average 57 days which needs to be filled by borrowing.

This may be easier to see by looking at Whatsit Ltd, which only deals with one item at a time. Its current transactions are summarised below:

01/01	Purchases a whatsit at £100,000 on one month’s credit
31/01	Pays supplier for whatsit
28/02	Sells whatsit at 200% mark up on one month’s credit after normal two months in stock
31/03	Customer pays £300,000

Plotting these transactions over time we can show how borrowing requirement to fund this working capital cycle is £100 over two months:

On average therefore it will be another month after the supplier wants paying for the goods before Whatsit Ltd sells them and a further month before the cash comes in from its customer. So Whatsit Ltd has to fund two months’ worth of working capital from somewhere.

A bank would see this as an appropriate use of an overdraft facility which will swing back into credit as the transaction unwinds into realised profit and cash. However, in practice:

• Whatsit Ltd will need to agree the facility in advance with the bank;
• and it will need to offer some other security such as personal guarantees as the bank will be unlikely to lend against 100% of stock value without security agreed.

Recognising the nature of the business’s funding requirement is therefore a critical first step to planning how you will manage its cash requirements by working capital management.

Reducing the requirement to tie up cash in working capital will mean that whatever cash is available will be available to fund a higher level of trading. In the case of Whatsit Ltd, its management could reduce its borrowing requirements to nothing if they can do the following.

• Reduce the investment in stock and debtors if it:
  • only bought in the whatsit when it had a firm order and could ship it straight out (a back-to-back deal), then the debtor would pay at exactly the same time as the creditor was due; or
  • only stocked what it could sell in a month for cash; or
  • took all its whatsits on a sale or return basis where they could be returned if they did not sell;
  • took all its whatsits on a consignment stock basis where, while it physically held the whatsits on site, the business only bought them from the supplier when a customer took one.
• Replace bank lending with supplier credit:
  • by taking three months’ credit which would match the date of receipt and payment.
• Or a mixture:
  • eg take two months’ credit from suppliers and only stock items which turn over in a month.

If you are anticipating expanding your business, you will need to ensure that you put in place the finance required to cover the funding gap as this expands with it. Businesses that expand faster than their financing is able to keep up with eventually run out of cash and fail through ‘overtrading’.

RETURN ON CAPITAL EMPLOYED

The different activities of different parts of the business will generate different levels of profit and require different levels of investment. They will therefore produce different rates of return on the assets (capital) employed in that area of the business.

Widget Co Ltd has a manufacturing arm making widgets for sale to third parties, an installation business and a repair division. If the analysis of profitability is extended to include overheads, by making an assumption as to how overheads are allocated or apportioned between the divisions, it is possible to find a net profit for each division.

It may also be possible to allocate the assets used to each division (eg the vans may be allocated to installation, the bulk of the factory and the raw material stock to production and so on) to estimate the assets each division employs.

This exercise allows you to calculate the return you are getting by investing money in each part of the business.

So in the case of Widget Co Ltd, if there is cash to invest it would appear to make sense to try to expand the installation side of the business as this generates a much higher return than production.

Occasionally this type of analysis will suggest that you may be best off disposing of some aspect of the business, such as the repair arm which is tying up cash only to make a loss. This in theory should allow you to redeploy resources to areas where you’ll get a high return. However, before planning to shut any operation you do need to be careful as you must ensure that you are not simply removing some contribution towards the overall overheads, which will then need to be borne by the remaining parts of the business.

Again, if your accounting system can be set up to capture the relevant data this can be a useful exercise to do on a key customer by key customer basis, or for individual large contracts.

RETURN ON INVESTMENT

A related concept is the one of return on investment, which is the profits generated by the business (usually shown before tax) divided by the shareholders’ funds invested in the business.

This also helps to explain why the owners of Thingumy Ltd have decided to gear up or leverage their company, as it shows how borrowings act as a multiplier of the investor’s return:

By using borrowed money rather than their own, the owners of Thingumy Ltd have made the company more financially risky as it has lower profits through a higher interest cost and a greater exposure to default on its borrowings in times of difficulty.

However, in doing so they have increased their return from a business generating exactly the same level of underlying trading profits as Widget Co Ltd; which is giving them 1,000% return on the cash they have invested compared with the 93% return enjoyed by Widget Co Ltd’s owners.

HAVING FAITH IN NUMBERS

If you are not familiar with reading accounts there are some general rules that you should bear in mind throughout these chapters.

• The trends in the numbers (say over time, such as growth, or in comparison with other similar businesses known as benchmarking) tend to be more important than any individual absolute figure.
• Do not be fooled into thinking that the numbers are ever absolutely true as any set of accounts will always be a matter of judgement. For example, a company should provide for its bad debts, which means recognising the cost of the bad debts in its P&L and reducing the value of debtors on the balance sheet. But how much it should prudently provide is a matter for the directors’ judgement.
• The numbers are produced as a result of how the business is being run; they are symptoms and evidence of what is happening, not the cause. As a result the numbers by themselves don’t tell you what you need to know; they are guides to help you work out the questions to ask and consider what plans to put in place.
• So the numbers should be used to plan your actions for the future by setting quantified and measurable financial targets for the business (eg reducing its average debtor payment time to 45 days by the end of the year) as part of your plan for your business, and you can then use the numbers to monitor your progress.
• The actions you will have to take to make these financial results appear will, though, be real actions in the real world. They may include setting tight credit terms for the customers, issuing statements, picking up the telephone to chase in the money when it is due and putting customers on stop if they don’t pay.