6.10 - Analysing Statements of Financial Position
The purpose and structure of the statement of financial position
The statement of financial position, also known as the balance sheet, provides a snapshot of a business's financial situation at a specific point in time, typically the end of the financial year. It details the sources of the business's funds and how those funds have been used, showing what the business owns and what it owes.
Main sections of the statement of financial position
- Assets - Items owned by the business, divided into fixed and current categories based on their expected lifespan and liquidity.
- Liabilities - Amounts owed by the business, split into current and long-term based on when they must be paid.
- Equity - The owners' investment in the business, including shareholders' funds.
- Balancing requirement - The total assets must equal the total of liabilities plus equity, ensuring the statement balances.
Key components including assets and liabilities
The statement of financial position lists various elements that reflect the business's resources and obligations. Assets are what the business owns, while liabilities are what it owes.
Fixed assets
Fixed assets are long-term resources expected to last more than one year. Examples include premises, machinery, and vehicles. Their value is recorded as at the statement date, accounting for depreciation, which is already reflected in the income statement. These represent investments that support ongoing business activities.
Current assets
Current assets are short-term items, typically lasting a few months, listed in order of increasing liquidity (how easily they can be turned into cash).
Examples of current assets:
- Stock - The least liquid, including raw materials and unsold finished goods.
- Debtors - Money owed to the business from credit sales that have not yet been paid.
- Cash - The most liquid, referring to money held in bank accounts.
Current liabilities
Current liabilities are short-term debts that must be settled within one year of the statement date.
Examples of current liabilities:
- Creditors - Amounts owed to suppliers for goods or services received on credit.
- Unpaid corporation tax - Tax due to the government based on profits.
- Unpaid dividends - Profits allocated to shareholders but not yet distributed.
Shareholders' funds
Shareholders' funds represent the owners' contributions to the business. Share capital refers to funds raised from issuing shares originally. Businesses can raise additional funds by issuing new shares or through rights issues. Retained profit and reserves are profits not distributed as dividends but kept within the business for reinvestment.
Long-term liabilities
Long-term liabilities are debts repayable after more than one year. Examples include bank loans or mortgages. These differ from current liabilities, which are due sooner, and provide stable funding for major investments.
Calculations for net assets and capital employed
Several key calculations derived from the statement of financial position help assess the business's financial health and value.
Calculating net current assets
Where:
- Net current assets = Also known as working capital, representing funds available for daily operations
- Current assets = Short-term resources like stock, debtors, and cash
- Current liabilities = Short-term debts like creditors and unpaid taxes
Calculating net assets
Where:
- Net assets = The overall value of the business if all assets were sold and liabilities paid off
- Net current assets = Working capital as calculated above
- Fixed assets = Long-term resources like machinery and premises
Calculating capital employed
Where:
- Capital employed = Total funds used to acquire assets (equals net assets)
- Shareholders' funds = Owners' investments including share capital and retained profits
- Long-term liabilities = Debts due after one year, such as loans
These calculations show how funds are sourced and used, with liquidity indicating how quickly assets can be converted to cash.
Analysing the statement and identifying trends
Analysing the statement of financial position provides insights into a business's stability and performance at a single point in time, while comparing statements over years reveals patterns.
Key aspects of analysis
- Snapshot of performance - Highlights the business's net worth and liquidity, aiding decisions on investments or expansions.
- Sources of capital - Indicates reliance on stable funding like long-term loans rather than short-term options like overdrafts.
- Working capital and liquidity - Ensures the business has enough short-term funds to operate without cash flow issues.
Trends from comparing consecutive years
- Increases in fixed assets - Suggest investment in growth, potentially leading to higher future profits.
- Growth in retained profits - Indicates strong profitability and reinvestment for expansion.
- Changes in liabilities - High levels of loans compared to share capital could signal risks, especially if interest rates rise; the type and amount reflect management quality.
Stakeholders interested in the statement of financial position
Various groups use the statement of financial position to make informed decisions about their involvement with the business.
Key stakeholders and their interests
- Existing shareholders - Review performance to assess dividend potential and overall returns.
- Potential shareholders and lenders - Evaluate profitability and stability to decide on investments or loans.
- Employees - Examine profitability for insights into job security, pay rises, and working conditions.
- Government - Uses the information to calculate corporation tax liabilities.
- Suppliers - Check liquidity to determine if the business can reliably pay bills on time.