10 Accounting-balance Sheet Rev1

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9. Accounting – Balance sheet

The value of your businessTo operate any business you need to have assets. This

means that your business must own something. Depending on the

type of business, this may include equipment, office, raw material,

etc. In addition, you will need some cash, which is also recognized as

an asset. Without assets, your business will not be able to produce

anything, nor to provide any service. On the other hand, to acquire

those assets your business will need to raise funds from different

sources. First of all you can personally invest in it, or you can borrow

it from the bank or some other creditor. You can also owe money to

other businesses for materials you have received but not yet paid.

Money that your business owes to others is considered to be the

liabilities of a business. The money you as the owner invested in the

business together with the part of the profit you decide to retain and reinvest in the business is

called owner's equity .

It seems logical for there to be some balance between the assets that is between what the

business owns, and its liabilities, what it owes. Before you start to dwell about this last statement

and worry whether your expected fortune has vanished in this balance, remember that the business

also owes some money to you as the owner. That is, your expected fortune is hidden under the

"owner's equity". In addition, you as the owner of the business implicitly own assets as well. What

you really need to focus on is keeping your liabilities under control.

Hoping that we managed to put your worries aside we can turn towards the basic accounting

equation

Assets = Liabilities + Owner's Equity

When running a business you need to keep track of what your business owns (assets), how it paid for

them, what it owes (liabilities) and what amount is left after satisfying the liabilities. This information

is recorded on the balance sheet , which is a listing of items making up the two sides of the basic

accounting equation. Unlike the income statement, which shows the results of operations over a

period of time, a balance sheet shows the state of affairs at one point in time. It is a snapshot, rather

than a motion picture, and has to be analysed with reference to prior balance sheets.

In order to produce a balance sheet a business must keep assets, liabilities and owner's

equity accounts. Each of these accounts can be further subdivided to reflect different types of

transactions.

AssetsAn asset is any valuable item that a business owns, benefits from, or has use in generating

income. Typically when you consider Accounting, an asset will be something which has money value

that your business has acquired or purchased. There seems to be no doubt that you will recognise

assets as all physical possessions, such as cash, machinery, inventory, building, etc. These are called

tangible assets.

However, you should be aware that there are other assets which have no physical existence.

For example, you may have provided some service or sell some product but still have not received

the money for it. Hence, you do not have cash, which means that you cannot consider it as a tangible

asset. On the other hand, due payment is legally yours which means that it is an asset for which you

have an enforceable claim. Similarly, you might have invented something, or produce something

original and protect it by patent or copyright. The potential revenues you might draw from patents

and copyright are also assets, but again they are not tangible.Assets which have no physical existence but derive their value from intellectual or legal rights



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are considered to be intangible assets. Some of them have limited-life, like patents and copyrights.

Others, like trademarks, have unlimited life. It is also important to realize that reputation and

business contacts represent significant intangible assets, which will be effectuated if you decide to

sell your business. This intangible asset is called goodwill .

The obvious difference between tangible and intangible assets lies in the fact that while first

can be destroyed by some accident or disaster, the latter are not destroyable, unless by some sideeffects. For example, the business that owes you money might bankrupt. The other difference

concerns the way in which their value is counted. Tangible assets add to the current market value of

a business and can be used as collateral to raise loans, and can be readily sold to raise cash. On the

other hand, intangible assets add to the business's future worth, and cannot be readily sold or used

as collateral.

When drawing a balance sheet, assets are usually classified according to their nature. The

typical categorization might look as follows.

Current assetsCurrent assets are any assets that can be easily converted into cash within one calendar

year.

o Cash – money available immediately (on checking account)

o Petty cash – amount of available cash for making small disbursements for postal due,

supplies, etc.

o Accounts receivables – sales made, or services delivered but not paid-for; money owed to

the business for purchases made by customers, or for services delivered

o Notes receivables – written promises to receive stated sums of money at future dates

o Inventory – a cost of a merchandiser's product awaiting to be sold; the inventory of a

manufacturer should report the cost of its raw material, work-in-process, and finished

goods

o Supplies – cost of supplies on hand

Investments - listed in this category would be a bond sinking fund, funds held for

construction, the cash surrender value of a life insurance policy owned by the company, and long

term investments in stocks and bonds

Fixed assetsFixed assets are not consumed or sold during the normal course of a business but their

owner uses them to carry on its operations. They include land, buildings, machinery, equipment,

vehicles that are used in connection with the business. With the exception of land all other fixed

assets are depreciated over time.

Intangible assets

LiabilitiesAll debts and obligations owed by the business to outside creditors, vendors, or banks are

considered to be business's liabilities. This includes amount payable (money owned) and obligation

to render services.

Current liabilitiesAny debt or obligation that must be paid within a one-year frame is considered a current

liability

o Accounts payable – short-term obligations owed by a business, such as supplies and

materials acquired on credit and for which there was not a promissory note

o Notes payable – the amount due on a formal written promise to pay; money owed on a



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short-term collection cycle, such as bank notes, mortgage obligations, vehicle payments,

etc.

o Accrued payroll and withholding – earned wages, salaries or withholdings that are owed

to or for employees

o Warranty liability

–

amount that a business will have to spend to repair or replace aproduct during its warranty period

o Unearned revenue – amount received in advance of providing goods or services

o Income tax – amount which reflects the amount of income tax currently due

Long Term LiabilitiesObligations of the business that are not payable within one year are long term liabilities.

Typical examples include bonds payable and long term notes payable, such as mortgage.

Owner's equityOwner's equity refers to the initial investment in the business as well as any retained

earnings that are reinvested in the business. In essence the retained revenue is the differencebetween the net income since the business began and the draws the owner made in this period.

Throughout the year the net income will be recorded in the temporary revenue and cost

accounts, while draws will be recorded in the drawing account. At the end of the year temporary

revenue and cost accounts will become final accounts as presented in the income statement. At the

same time together with the drawing account they will be used to calculate the sum transferred to

the owner's equity account. After that all temporary accounts will be cleared.

The owner's equity part on the balance sheet will typically have the following categories.

o Paid-in-capital – initial investment and eventual additional investments

o Retained earnings – part of net profit reinvested in the business

o Drawings – amount drew by the owner

CASE STUDY 1 - BALANCE SHEET

Facts and data

"Times" is a fashionable coffee shop in Belgrade, Serbia. The company was founded by 4

people, each of whom put up €50,000 to finance the business. They bought a nice coffee shop and

today, the premises are valued at €260,000. The fixtures and equipment within the premises are

valued at €60,000.

They had to take a bank loan of €200,000 to finance buying the shop and equipment, and

there is still €110,000 to pay for it. Twenty percent of this sum is due this year. In addition they have

a bank overdraft which together with interest amounts to €12,000, and owe €45,000 to differenttrade creditors, to whom they have to repay €20 000 within the next year. Finally, they owe €9,000

for taxes.

During this year the owners drew €14,000 from the business.

The coffee shop is very successful. The company also has €36,000 in the bank and €700 cash

in the office. In addition company has €35,000 stock made up of drink. Some customers run credit

accounts and the shop is owned €24,000 by them.

a. Calculate the net profit the coffee shop made at the end of the year and draw up a balance sheet.

Solution

Identifying accounts

Looking back at the basic accounting equation we know that the owners' equity will have tobe calculated so to keep the balance between the assets, liabilities and owners' equity. Hence it is



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first necessary to translate the given data into the appropriate accounts on the balance sheet.

Assets

The money the company has in the bank together with the equipment obviously represents

its cash current asset. Similarly, the stock of drink should be recorded on the inventory account,

while the customers' credit belongs to the notes receivable category.

In addition, the coffee shop and equipment are also assets.

Liabilities

Though the liabilities are obviously all amounts the company owes, here we have to

distinguish between current and long-term liabilities.

Bank loan is, in general, a long-term liability, with the exception of the sum which is due this

year. Hence 20% of the bank loan will be considered as current liability (note payable), while the

remaining 80% is a long term liability.

Similarly, out of the total amount the business owes to creditors, €20 000 which is due this

year represents the short time liability (accounts payable). The remaining debt is a long term liability.

Finally, the bank overdraft is an obligation which has to be a part of the written agreement

with the bank when the business checking account was opened. Consequently, it is a current liability

which falls into the notes payable category. The same is true for tax dues, but the category is

different.

Owners' equity

There is no doubt that the money owners invested at the beginning make the part of theirs

equity. This has been reduced by the money they drew throughout the year, but will be increased by

this year's net profit. It can be calculated from the basic accounting equation which states that the

total assets are equal to liabilities together with owner's equity.

The balance sheet

The preceding analysis yield the balance sheet as depicted in Table 1.

RemarksIn preparing this balance sheet we assumed that the business has decided to keep track of

the accounts which are listed. Therefore we added all the accounts included those which do not have

any amount on them, like investments, accrued payroll, etc. It is understandable that the business

might have opted to keep track of some other accounts as well. In that case they will also be listed

with zero for this year in the corresponding fields.

From the given data which states the actual value of equipment and premises it is also seen

that the business decided to run assets accounts Equipment and Premises with depreciation

included. The other possibility would have been to run separately two accounts stating the initial

value of the equipment and premises, and two accounts that would reveal the corresponding

depreciation accumulated over the years up to that moment. In this case both depreciation accounts

would have negative numbers (since they have to be subtracted from initial values).It should be noticed that Notes payable represent the sum of 20% of the bank loan (€22,000)

and total of bank overdraft (€12,000).

The Net profit was calculated from the following equation

Next profit = Total assets - Total liabilities - (Paid-in-capital + Drawings)

Here, it is important to realize that Drawings are entered in the table as a negative number.

Consequently, they are actually subtracted from the Paid-in-capital .



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Current assets Current liabilities

Cash 36,000 Accounts payable 20,000

Petty cash 700 Notes payable 34,000

Accounts receivable 0 Accrued payroll and … 0

Notes receivable 24,000 Income tax 9,000

Inventory (merchandise) 35,000 Total current liabilities 63,000

Supplies 8,000 Long term liabilities

Total current assets 103,700 Bank loan (remaining 80%) 88,000

Other assets Creditors (not due this year) 25,000

Equipment (depreciation included) 60,000 Total long term liabilities 113,000

Premisses (depreciation included) 260,000 Total liabilities 176,000

Investments 0

Total other assets 320,000 Paid-in-capital 200,000

Total assets 423,700 Drawings -14,000

Net profit (year 2010) 61,700

Total owners' equity 247,700

Total liabilities + equity 423,700

Owners' equity

Assets Liabilities

Balance Sheet

Coffe Shop TIMES

31-Dec-10

TABLE 1 – THE BALANCE SHEET FOR THE "TIMES" COFFEE SHOP

Rate of returnBy now you should able to cover most of the calculations which will help you to monitor your

business' finances. Yet there is the ultimate question whether your business is successful or not.

Namely, at the beginning you put a certain amount of money into it. Instead you might deposit the

same amount in a bank and earn interest on it. Or you might buy some stocks and collect dividends,

or buy some property and take rent, or do a number of different things. The key question is whether

you have made a right choice, or to put it differently, are you better off in the long term by running a

business than you might have been if you invested your money in something else. Once you have

made the decision, the value of the income that could be earned by investing in the most attractive

alternative to the one you have chosen is called the opportunity cost . Very often the time deposit

interest rate may be considered as a relevant opportunity cost.

Planning the investment Fundamental rule of investment is that your rate of investment is greater than the

opportunity cost of the capital. When you are planning a business you try to estimate how many

years will have to pass by until your initial investment (the cash you put in plus any long term bank

loan you took at the beginning) is completely returned. When you set the number of years you can

easily calculated the net profit you would have to get each year.

If we define Internal rate of return (IRR), as annual percentage of the return on the amount

invested.

Net profit

IIR(%) = 100Initial investement



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This indicator will tell you what percentage of the initial investment you got back in the current year.

Consequently the number of years until the investment is returned can be evaluated as follows

100 N =

IIR(%)

The obvious drawback of the proposed calculation is the fact that you cannot count on theconstant net profit over the certain period. However, it can serve as an indicator, showing whether

you are doing at least relatively well. Assume that you would like your investment to return in 10

years. Then, under the ideal circumstances of constant net profit you IIR should be 10% each year.

Hence as long as you manage to keep this index in the vicinity of 10% you can be satisfied. The

greater it is over this threshold the faster you will return your investment.

Efficiency of the businessA somewhat more informative measure on business performance may be drawn from the

Return index . It measures net profit with respect to the capital in the business. In general, all indices

serve as a measure of profitability, which indicate whether or not a business is using its resources in

an efficient manner. If in the long run the index of some company is lower than one would get by

employing the same capital in a different endeavour (opportunity cost), then the business is

definitely not successful.

In practice several different ratios are used. The following three are most commonly

encountered.

ROCE – Return on capital employed

Net profitROCE(%) = 100

Capital employed

The capital employed is considered to be all the capital the business owns which can be

employed elsewhere. Therefore it is evaluated as total assets decreased by current liabilities (since

they have to be paid in a short term).

Capital employed = Total asets - Current liabilities = Fixed assets + Working capital

ROA – Return on assets

Net profitROA(%) = 100

Total Assets

ROE – return on equity

Net profitROE(%) = 100

Owner's equity

Though all indices seem to be rather similar we are going to demonstrate why they should

not be considered separately.

CASE STUDY 2

a. Assume that Time has had a constant net profit since its opening and that it will continue to do it

in the coming years. Verify whether it can return all the investments within the period of 5 years.

Solution

The total initial investment the Time made at the beginning amounts to

Initial investment Paid-in capital Bank loan , , , 200 000 2000 000 400 000

Consequently, the yearly return is going to be



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Net profit 61,700IIR(%) = 100 100 15%

Initial investement 400, 000

Since each year Time is returning slightly over 15% of the initial investments the number of years (N)

in which the return is going to amount to 100% can be calculated as follows

100 N IIR(%) = 100 N 5.515

It is seen that under this ideal conditions the Time will return its initial investments during its

6th year of operation. It will miss the set target for around the half of the year.

b. Assume that the opportunity cost is time deposit interest of 8% per year verify the efficiency of

Time's business

Solution

The efficiency of the business will be estimated by comparing the return indices to the rate

the employed capital would bring if deposited in the bank.

Capital employed Total assets - Current liabilities = 360,700 Net profit 61,700

ROCE(%) = 100 17%Capital employed 360, 700

Net profit 61,700ROA(%) = 100 15%

Total assets 423,700

Net profitROE(%) =

Owner's e

61,700100 25%

quity 247,700

We can see that Time's business owners made a wise decision. Their business is bringing two

or three times as much as their saving account might have brought.

Remark If you look only at the ROE index you'll find out that for every euro the owners put into the

business they are generating 25 cents profit. This indeed looks like a great success. However if you

analyse ROCE and ROA the percentages are significantly lower. Though in this particular example the

business is still very successful even from this point of view it is important to notice the difference.

Namely those two indices are actually telling us what profit we are gaining on assets, or if you want

on capital we put into the business and might have had put somewhere else.

FIGURE 1 ASSETS, LIABILITIES AND EQUITY BEFORE AND AFTER THE LARGE BANK LOAN HAD BEEN TAKEN

Assets

Liabilities

Equity

Assets

Liabilities

Equity

ROA ROE ROA ROE



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Obviously the difference lies in liabilities. If they are small there will not be much difference

in assets and owner's equity, so the ROA and ROE would also be very close. On the other hand, if the

company takes a significant bank loan it increases its assets thanks to the cash that comes in. But at

the same time since its long-term liabilities will increase, the basic accounting equation tells us that

equity will relatively decrease. Since assets and equity are in the denominator, ROA will sink, and ROE

will boost. Hence, the debt amplifies ROE in relation to ROA. Therefore, one should be careful whenlooking at the ROE itself. It may indicate a very successful business, but also a very large debt, as

illustrated in Figure 1.

In general, the current liabilities are never particularly high, so there is no significant

difference between capital employed and assets, that is between ROCE and ROA. It should be said

though that ROCE is a slightly more realistic indicator, since it is taking the current liabilities into

account.

Assignment "Micromotors" is a small factory founded and owned by 5 persons and organised as

partnership. The factory bought premises for 430,000$, and equipment for 120,000$. Up to now the

accumulated depreciation is 120,000$ for the premises and 15,000$ for the equipment.

When going into business the company took a bank loan of 350,000$, and there is still

200,000$ to pay for it. Ten percent of this sum is due this year. At the end of this year the company

has a bank overdraft which together with interest amounts to 20,000$. It also owes 36,000$ in

wages, and 12,000 in income tax.

The company bought raw materials for which it still owes 70,000$. The value of raw material

accumulated in the stock is 21,000$, while the value of final products waiting to be sold is 18,000$.

The trade was good this year so that the net profit was 44,500$. The companies to which

Micromotors sold its products are still owing it 44,000$.

By the end of the year, Micromotors disposes with 52,000$ in the bank, and with 2,500$ in

cash.

a. Calculate the total amount the owners initially put in the business, and draw up a balance sheet.

b. Assume that Micromotors had the constant net profit since its opening and that it will continue to

do it in the coming years determine the number of years in which the initial investment will be

returned.

c. Assume that the opportunity cost is time deposit interest of 9% per year verify the efficiency of

Micromotors's business.

Key words for the day

CREDITORS – the individuals, other businesses and governments to which the business owes

money

DEBTORS – people, other businesses or governments which owe a business money

BALANCE SHEET – condensed statement that shows the financial position of an entity on a specified

date

ASSETS – what is owned by a business

o Current assets (or L iquid assets) – assets of the business which can easily be

turned into cash or which are cash

o Investments – money committed with the object of profit

o Fixed assets – what is owned by a business which it uses over a long period of time

o Security – an asset, like property, which can be sold if a borrower fails to repay a loanand the money used to pay off the rest of the loan



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LIABILITIES –the monetary value of what business owes

o Current l iabil it ies – what the business owes and will have to pay within the next 12

months

o Long term liabil it ies – what the business owes and will have to pay in more than 12

months time OWNER'S EQUITY - initial investment in the business together with the retained earnings that are

reinvested in the business

LOAN – borrowing a sum of money which then has to be repaid with interest over a period of

time, typically in fixed monthly instalments

o Mortgage – a loan where property is used as security

o Overdraft – borrowing money from a bank by drawing more money than is actually in a

current account; interest is charged on the amount overdrawn

o Debenture – a long term loan to a business

o Hire purchase – legally, renting equipment prior to buying it; in effect it is a type of loan

LEASING – renting equipment or premises

OPPORTUNITY COST – highest price or rate an alternative course of action would provide

CAPITAL EMPLOYED – the value of the assets that contribute to a business' ability to generate

revenues

RATE OF RETURN – yield obtained on invested capital; the earning power of assets

Documents

10 Accounting-balance Sheet Rev1