Balance Sheets

This is a financial snapshot of a firm on a particular day.  It displays the assets and liabilities of the company and shows how capital has been raised and used.

A simplified balance sheet will look as follows:

Long-term assets can include:

Tangible assets

• Land and buildings
• Machinery and equipment
• Vehicles

Intangible assets

• Goodwill
• Patents and copyrights

Current assets (stock, debtors and cash) are treated differently from fixed assets as they can change on a daily basis.  Current liabilities are deducted from the current assets to give net current assets (also known as working capital).

Firms will receive their capital from one of three main sources:

• Banks in the form of loan capital – in addition to the loan interest will have to be paid
• Shareholders in the form of share capital – individuals can buy shares in the company and in return they may receive a dividend
• Reserves which are known as reinvested profits – the company ploughs profits previously earned back into the business in the hope of achieving greater profits in the future

Share capital and reserves are both owed to the shareholders but they do not have to be repaid, therefore they are treated differently from loan capital which has to be repaid to the bank.  It is now possible to add greater detail to the balance sheet shown earlier:

Profit and Loss Account

This is a record of all revenues and expenditures and therefore it will total the profit or loss over a given period of time.  The profit is what remain when all of the costs have been deducted, however some companies may have objectives other than making a profit, such as charities, co-ops, hospitals and schools.  In order to help financial analysis we identify different types of profit:

Accountants distinguish between different qualities of profit.  Profit that occurs simply because the company has sold a large fixed asset is a one off and therefore deemed to be of low quality.  High quality profit is described as  profit that will continue for a number of years.

The profit and loss account is divided into three sections:

• The trading account – calculates the gross profit made on trading activities
• The profit and loss account – calculates the operating profit that a business makes. 
• The appropriation account – this outlines how the profits are distributed.  The operating profit will be split between ax, dividends and retained profits.

It is possible to show a profit and loss account that includes all three sections:

Uses of Company Accounts

A number of different stake holders will take an interest in the balance sheet and profit and loss account:

• Governments will use the financial information to calculate the amount of tax (VAT and corporation tax) that a company has to pay
• Shareholders will analyse the accounts and decide whether their investment capital is being used effectively
• Directors and senior managers will use the accounts to assist their medium and long-term planning
• Potential investors will analyse the accounts to determine whether or not the company would make a good investment
• Creditors will use the accounts to ascertain the company’s ability to pay their bills

The accounts can be used to obtain a variety of information:

• Looking at the accounts over a number of years can allow trends to be identified
• Assess how the company raises its capital and evaluate how it is being used.  Could the capital be used more effectively?
• Assist in placing a value on the company
• Comparison of the accounts of different companies is relatively simple as private and limited companies are required by law to produce balance sheets and profit and loss accounts.  This may assist in deciding which company to merge with or take over.
• Make full use of ratio analysis
• Can the company afford to take on extra debt if it deciding whether or not to go ahead with a particular investment project
• It may highlight problems within the company, such as a relatively low operating profit may be an indication that the overheads may be too high.

Window dressing

This occurs when a company will present its accounts in a favourable manner that attempts to flatter the financial position of the company.  There is a fine line between window dressing and fraud, it is important that accountants don not cross the line because fraud is a serious criminal offence.  There are a number of ways that a business can window dress its accounts:

• Overvaluing assets or minimising the level of depreciation.  It is easier to overstate the value of intangible assets
• Bringing forward sales to just before the accounts are published.  This can include selling fixed assets to improve the cash reserves held by the business
• Delaying the payment to creditors which will again artificially raise the amount of cash held by the business

Window dressing is rather rare in the business world as most businesses present a fair and true picture of their financial situation.  Firms may be tempted to window dress if the company may be sold in the future or if it is in financial trouble.

Limitations of financial accounts

Company accounts have a number of limitations:

• If they show a company has very high costs one would assume this to be bad for the future, however the company may be investing heavily hoping to achieve growth and larger profits in the future
• Because the balance sheet is a snap shot of one day in the life of the firm it may not be truly representative of the whole financial year
• Window dressing may lead to the accounts being manipulated and therefore not representing the financial situation of the company
• Only financial information is included; no information regarding the state of the market, level of interest rates, economic growth, strength of competitors, loyalty of customers etc. is represented.  These factors are very important to the business and its stakeholders
• The accounts do not make any statement regarding the ethical standpoint and its attitude to social responsibility