The balance sheet is the cumulative total of all the transactions that have been recorded in the business since the beginning of its life.  It contains elements, such as assets (debit balances), liabilites (credit balances), accumulated reserves (credit balances or debit balances), shares(credit balances) and other ownership interests. To view a working example of how it is calculated, download our financial statements template spreadsheet.

The bottom line value (book value) is largely a meaningless figure and hard to compare to the bottom line value of another business, as accounting standards offer various options available to businesses when recording transactions. Accounting policies in the notes to the accounts indicate what practices have been used to record values in the balance sheet. The balance sheet records all the elements that form the asset and financing structure on which performance is based.  It has a direct relationship with the profit or loss achieved during each accounting period, and shows a snapshot of the health of a business at a specific period in time.

Business valuations for the purpose of selling shares are based on realisable values of assets and settlement values of liabilities, or performance related valuations such as Net Present Value of the future cash flows and PE valuations. A PE valuation is a multiple applied to the operating profit generated annually to approximate the net present value of the shares at a specific point in time. Asset based valuations may be more relevant for entities like investment property companies, whilst performance based valuations are more likely to be used for entities relying heavily on trade for growth in the net asset position.

What is meaningful to assess whether the balance sheet total is growing or declining year on year, indicating the stages of its life cycle.  If the balance sheet total is negative, the business is insolvent, as its liablities exceed its assets. (This is not revealed where liabilities are grouped together with owership interests in the balance sheet.)  An insolvent business can have a positive balance sheet if the assets have been overvalued, such as pension assets that are based on actuarial valuations that use certain subjective variables in the valuation models.  A good example to look at is the report and accounts of Marks & Spencer for 2008, where £1,089 million of £1,964 million of the net assets have been created through increasing the discount rate applied to pension obligations.

IFRS2, share based payments, is another standard that allows non cash expenses to be recorded in the accounts, affecting the balance sheet values and share prices. Similarly, there is a risk that stock and debtors can be overstated.

Assets purchased for use in the business can be recorded at cost or market value, based on the discretion of management and allowances in financial reporting standards.  Market values are usually supported by valuations performed by external valuers, but this is not always the case.  External valuations are carried out every three years, and may therefore be out of date.  To see what values have been used, analyse the accounting policies published in the financial statements.

Useful ratios 

Return on capital employed = profit before interest and tax/share capital + reserves + long-term debt OR profit margin x asset turnover (PBIT/CE x PBIT/turnover x turnover/CE)

Return on shareholders funds = profit before tax/share capital + reserves

Current ratio = current assets/current liabilities

Quick ratio = current assets/current liabilities

Gearing ratio = debt/equity OR debt/debt + equity

Interest cover = Profit before interest / interest

Inventory turnover = COS/inventories OR inventories/COS x 365

Debtor days = trade debtors/sales x 365

Creditor days = trade creditors/purchases x 365

To create the balance sheet, read the introduction below, and carefully follow the instructions on our spreadsheet templates, starting with the cashbook and extended trial balance, and ending with the financial statements template.

1. List all your assets (Land, buildings, plant, machinery, stock, debtors, cash) and liabilities (money you will have to pay in the future) from the extended trial balance. Typically, these are financial transactions that are not income or expenses. These should include:

   1. Fixed (long term) Assets: Land, buildings, fixed plant and machinery, cars, etc. Also include accumulated depreciation on all assets, reducing the cost over the number of years that the asset will be in use.

   2. Current (short term) Assets: Stock, Work in Progress, Debtors (money owed to you), Prepaid expenses, Cash, Bank balances

   3. Current Liabilities: Creditors (money owed by you), accrued expenses, bank overdrafts, loans, finance leases.

   4. Non-current liabilities: total cash received from all loans less all repayments less interest included in the repayments.

2. State your interest in the business.

   1. Profit and loss account: The total profits and losses earned since the very beginning. Add in the current year's net profit.

   2. Share capital (companies) or capital introduced (sole traders and partnerships): Personal money you paid to the business to get it started up and keep it running.

   3. Drawings: Money you have drawn from the business. (If your business is a company, your drawings will show as directors' remuneration in the income statement or loan to director in the balance sheet. If you are trading as a sole trader or partnership, your drawings will be included in the balance sheet)

   4. Reserves: If your assets are worth more than what you paid for them, the revaluation reserve is used to record the changes in value. For example, if land has increased by £10,000, the Fixed Assets will be stated at cost plus £10,000 and revaluation reserve will be £10,000.

3. Calculate the following totals:

   1. Net assets in '1' above

   2. Your interest in the business in '2' above (this should be the same amount as the net assets.

   3. When your balance sheet balances ('1' equals '2') you can calculate totals for fixed assets, current assets, current liabilities and long term liabilities. 

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