3.6 - Statements of Financial Position
The purpose and structure of a statement of financial position
A statement of financial position provides a snapshot of a business's financial situation at a specific moment, summarising its assets, liabilities, and capital. It is often referred to as a balance sheet and is typically prepared at the end of a financial year.
Key components of a statement of financial position
- Assets - Resources owned or used by the business, such as cash, inventories, machinery, tools, and equipment.
- Liabilities - Debts owed by the business to others, which act as sources of funding. These can be short-term (e.g., overdrafts) or long-term (e.g., mortgages).
- Capital - Funds provided by the owners, such as share capital in limited companies.
The statement follows a fundamental equation where the total value of assets equals the combined value of liabilities and capital.
Assets = Liabilities + Capital
The statement captures a business's financial position at one point in time, similar to a photograph, providing a summary of a firm's assets, liabilities and capital.
Types of assets and their liquidity
Assets are divided into categories based on their expected lifespan and how easily they can be converted into cash, known as liquidity.
Non-current assets
Non-current assets last for more than one year.
Examples include:
- Property, such as buildings or land.
- Fixtures and fittings, like doors, windows, and flooring.
Current assets
Current assets are expected to be converted into cash within a year and are considered liquid.
Examples include:
- Inventories, covering raw materials, semi-finished goods, and finished products.
- Trade receivables, which are amounts owed by customers.
- Cash held in hand or in bank accounts.
Liquidity measures how quickly and easily an asset can be turned into cash.
Types of liabilities and their timeframes
Liabilities represent debts that must be repaid, classified by the timeframe for settlement.
Current liabilities
Current liabilities are debts due within one year.
Examples include:
- Trade payables, which are amounts owed to suppliers.
- Taxation owed to authorities.
- Leases and hire purchase agreements.
- Short-term loans and overdrafts repayable within 12 months.
Non-current liabilities
Non-current liabilities are debts payable after 12 months.
Examples include:
- Mortgages, which are long-term secured loans often used to purchase property.
- Other long-term borrowings exceeding one year.
Calculating net current assets, net assets, and capital employed
Several key figures are derived from the statement of financial position to assess a business's financial health.
Net current assets
Net current assets, also known as working capital, represent the liquid resources available for day-to-day operations.
A shortage of net current assets can lead to cash flow issues.
Net assets
Net assets show the overall value of the business after accounting for all liabilities.
Capital employed
Capital employed indicates the total funds invested by owners, equivalent to net assets.
It includes elements like share capital (funds from shareholders), retained profit (earnings kept in the business), and other reserves owed to shareholders. This section may also be labelled as shareholders' equity or capital and reserves.
Worked example - Calculating net current assets and net assets
A business has non-current assets of £280,000, current assets of £75,000, current liabilities of £30,000, and non-current liabilities of £110,000. Calculate the net current assets and net assets.
Step 1: Identify the values
- Non-current assets = £280,000
- Current assets = £75,000
- Current liabilities = £30,000
- Non-current liabilities = £110,000
Step 2: Calculate net current assets
Step 3: Calculate net assets
Interpreting the statement of financial position
The statement of financial position offers insights into a business's financial structure and value.
Key insights from the statement
- Asset structure - Shows how funds have been allocated across different asset types.
- Capital structure - Analyses the mix of funding sources, including liabilities and capital.
- Working capital position - Indicates liquidity through net current assets.
- Business value - Approximated by net assets, though this may not account for intangible assets like goodwill.
Assets are challenging to value accurately, and some non-physical assets such as goodwill may not be fully reflected.
Use in large and small businesses
- Large businesses and limited companies must produce a statement of financial position by law.
- Many small businesses do not prepare one.
- Shareholders and managers in larger firms rely on it to evaluate performance and potential.