How to read a balance sheet.

A snapshot of one day

Most financial reports cover a period, such as a month or a year. The balance sheet is different. It is a picture of the business at one moment, usually the last day of the financial year or the last day of a month.

GOV.UK describes the balance sheet in a company's annual accounts as showing the value of everything the company owns, owes and is owed on the last day of the financial year. That is a good working definition.

Because it is a snapshot, the date at the top matters. A balance sheet dated the day after a big customer pays will look very different from one dated the day before.

The one rule behind every balance sheet

Every balance sheet follows the same rule:

This is why the two halves always match. If a business buys a £1,000 machine on credit, its assets go up by £1,000 and so do its liabilities. If it pays the supplier from the bank, one asset falls and one liability falls by the same amount. Each entry has two sides, so the totals stay equal.

If a balance sheet does not balance, something has been recorded wrongly or left out. Accounting software will not let it happen in normal use, but a figure parked in a "suspense" account can hide the same problem.

Assets: what the business owns or is owed

Assets are split into two groups, based on how long the business expects to hold them.

Fixed assets

These are things the business keeps and uses for more than a year. Examples include vans, machinery, computers, fixtures and property. They are usually shown at cost minus depreciation, which spreads the cost over their useful life. So the figure is a book value, not what they would fetch if sold today.

Current assets

These are things that will turn into cash, or be used up, within a year:

• Stock. Goods held to sell or materials held to use.
• Debtors. Money customers owe for work already invoiced. You may also see this called trade receivables.
• Prepayments. Costs paid in advance, such as insurance covering months after the balance sheet date.
• Cash at bank. The balance in the business bank accounts on that date.

Liabilities: what the business owes

Liabilities are split the same way, by when they must be paid.

Current liabilities

These are due within a year. They often include:

• Creditors. Bills from suppliers that have not been paid yet. Also called trade payables.
• Tax owed. VAT, PAYE and Corporation Tax due to HMRC.
• Accruals. Costs the business has used but not yet been billed for.
• Short-term borrowing. Overdrafts, credit cards and loan repayments due in the next 12 months.

Long-term liabilities

These fall due after more than a year, such as the later years of a bank loan or a hire purchase agreement. They may be labelled "creditors: amounts falling due after more than one year".

Equity: what belongs to the owners

Equity is what would be left if every asset were turned into cash at its book value and every liability paid. It is also called net assets, capital and reserves, or shareholders' funds.

For a limited company, equity usually has two main parts:

• Share capital. What the shareholders paid for their shares. For many small companies this is a small, fixed number.
• Retained earnings. Profits made since the company started, minus losses and minus dividends paid out. This is often called the profit and loss reserve.

For a sole trader or partnership, equity is usually shown as a capital account. It starts with the money the owner put in, goes up with profit and goes down with the owner's drawings.

Equity is not a pot of cash. A business can have high equity and an empty bank account if its value is tied up in equipment, stock or unpaid invoices.

A worked example

Five checks that tell you the most

You do not need to study every line. These checks give a quick read on the health of a business.

1. Net current assets

Current assets minus current liabilities. A positive figure means the business has more coming in over the next year than it must pay out. A negative figure is a warning that bills may be hard to meet. In the example, it is £7,400.

2. The current ratio

Current assets divided by current liabilities. In the example, £17,700 divided by £10,300 gives about 1.72. So there is £1.72 of short-term assets for every £1 due within a year.

3. The quick ratio

The same sum, but with stock taken out, because stock is not always quick to sell. In the example, £14,700 divided by £10,300 gives about 1.43. For a business holding a lot of stock, this is the more honest test.

4. Borrowing against equity

Compare total loans to equity. Heavy borrowing is not wrong in itself, but it means more of the profit goes on repayments and interest, and less room if trade dips.

5. The trend

One balance sheet tells you a little. Two or three side by side tell you much more. Are debtors growing faster than sales? Is cash falling while profit rises? Is the tax line growing each year? Trends show problems early.

Balance sheet and profit and loss: how they connect

The profit and loss account shows sales, costs and profit over a period. The balance sheet shows the position at the end of it. They are linked. Profit for the year, less any dividends or drawings, adds to the equity on the balance sheet.

This is why a business can show a profit and still run short of cash. If customers are slow to pay, the profit sits in debtors rather than the bank. If profit is spent on stock or equipment, it moves into those assets. The balance sheet shows where the profit went.

Who has to produce a balance sheet

Every limited company must prepare annual accounts, and a balance sheet is part of them. GOV.UK says the balance sheet must have a director's name printed on it and be signed by a director.

The time limits for filing with Companies House are:

• First accounts: usually 21 months after the date the company registered with Companies House (sooner if the first accounting period is shortened)
• Later accounts: 9 months after the company's financial year ends

Smaller companies can send less. A micro-entity can send only a simpler balance sheet to Companies House. A company is a micro-entity if it meets at least 2 of these: turnover of £1 million or less, £500,000 or less on its balance sheet, and 10 employees or less.

Sole traders and partnerships do not file a balance sheet with Companies House. Many still prepare one, because a lender or landlord may ask for one, and it is the best way to check the books are complete.

Companies must also keep their accounting records for 6 years from the end of the last financial year they relate to, and sometimes longer.

Signs the books behind it need work

A balance sheet is only as reliable as the bookkeeping that feeds it. These lines are worth a second look:

• Cash at bank that does not match the bank statement on the same date
• Suspense or "uncategorised" balances that never clear
• Old debtors from customers who will clearly never pay
• Old creditors for bills that were paid but never matched to the payment
• A VAT balance that does not agree with the latest VAT return
• Negative stock or a negative bank balance on an account that cannot go overdrawn
• A director's loan account that nobody can explain

Each of these usually comes from transactions entered late, entered twice or not matched to their invoice or receipt.

Why up-to-date books make the balance sheet useful

If the books are only brought up to date once a year, the balance sheet is a historical document by the time anyone reads it. If the books are kept daily, you can run a balance sheet on any day and trust it.

Daily bookkeeping reconciles every bank account, so cash is right. It matches sales and purchase invoices to payments, so debtors and creditors are real. And it chases missing paperwork while it is still easy to find, so nothing ends up in suspense.