The matching principle

Like it is the case for the income statement, you can summarize what is going on on the balance sheet in two words: ASSETS and LIABILITIES. 

For the moment, I want you to picture your financial situation. In an ideal world, you own various things, such as a house or a flat, a car, and maybe some cash that you keep in your bank account. These are your assets which we shall put to one side! On the other side, we sum up all that is owed to other people or institutions; after all, it is often necessary to borrow money to buy ourselves a house or a car. As such, liabilities are nothing other than all sorts of different types of borrowings like mortgages, bank loans, leasing facilities (for example, car leases), credit cards, and bank overdrafts. There is much more out there to seduce us to keep buying stuff, although it sends a slight shiver down my spine when people call it financial innovations or engineering. You probably noticed while browsing my website that I am not overly keen on credit as it creates all sorts of dependencies and weaknesses if consumed in excess, much like alcohol, but I digress...

So we have established how the balance sheet is made up in principle. Still, to help any interested reader a bit further, any balance sheet should be presented in order of liquidity. Each section (whether it is assets or liabilities) should start with the most liquid assets or liabilities. When financial geeks talk about "liquid," we mean how easy it is to turn things into hard cold cash :-) So any balance sheet presentation should start with cash or any cash equivalents as such! I want to give you an illustrative example by referring to our imaginative brewing company:

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I have put together all the information provided by Jolly Brew Ltd. so that we can draft our first balance sheet after the end of Q1-2022 (see above). In the next paragraph, I will explain how we determined the various figures. But to start, I want you to focus purely on the presentation of the figures. Do you notice how neat the figures appear and how easy it is to find your way? This is important because, as a finance manager, I think a good portion of my job is dedicated to the suave communication of figures! The better things are outlined, the more interested and at ease any reader will feel! Hence, I am also a big fan of coloring! Everything is allowed to convey a message!

 

Taking a look at the assets

Back to the explanation of how we arrived at the various figures!, Let's start with the cash position: We started our business with 20,000GBP of our own money. Still, we knew this was not enough, so we needed to approach various people to get our venture going! For any start-up, family and friends are a must-go-to point; lucky us, they gave us 50,000GBP. With this backing, we approached our bank, and they were so impressed with our business plan that they lent us an additional 36,000GBP. A little disclaimer, it sounds that raising money is a doddle, but in the real world, it is much more difficult as family and friends rarely have some spare cash rolling around, and banks are much more risk-averse these days. But for this article, I keep it jolly. In total, we got 106.000GBP of cash to start our business! Then it was time to spend it!

First, we bought the brewing equipment for 18.000GBP and some inventory such as hops, barley, and other ingredients for a hefty 16.000GBP. Then we needed to make smaller purchases such as the building and equipment insurance, which cost 2.400GBP for the first 6 months and 1.200GBP for energy. We also need to take care of the wages of our co-worker for 3.600GBP. Last but not least, we need to pay rent (1.000GBP) and the interest for the various loans, which are 900GBP to our family friends and 625GP to the bank. In total, this makes up 45.725GBP which, after subtracting from 106.000GBP cash received, leaves a bank balance of 60.265GBP.

The next position is accounts receivable which summarizes the cash from invoices NOT YET received. Accounts receivable is followed by inventory which totals 9.000GBP. In my personal experience, inventory figures are a bit of a grey area. They can be subject to quite creative accounting shenanigans, especially when there is pressure on management to "hide" costs or when there are inadequate controls in place which can lead to "phantom" stock, basically stuff that does not exist anymore. In our case, everything is fine, as we did a physical verification by doing a stock take. In our case, we gave our customer time to pay for the beer 30 days after receiving the invoice. 

The last position in the asset section is prepayments or prepaid expenses, as they are sometimes called. This position in the balance sheet summarizes all the things for which a company paid cash in advance and therefore expects to receive something in return, whether a service or a product. The Jolly Brew Ltd paid for the insurance in advance, as you can see from the notes. This, in turn, means that the insurance company must perform a service for the company for a given amount of time, usually a year. Once the insurance has expired, it will no longer be an asset to us, at which point it will be recorded as an actual expense. You can also see it like this:

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The fact that we record the 1.200GBP is almost like a reminder: "Look here, we have sth in the books that we shall receive at a later point in the future"!

 

To summarize: It is a placeholder to account for the fact that money has left the company, but sth will be received for it.

Now let's look at the more durable assets, which have the rather unimaginative but quite to the point name "Fixed Assets." The name says it all, under Fixed assets, a company records everything that is meant to last for a while, such as machinery, computers, office furniture, etc... the sticky stuff. 

The Jolly Brew Ltd records its brewing equipment there and its loss of value over time underneath it called Accumulated Depreciation. To translate: We purchased equipment worth 18.000GBP, but at the end of Q1, it lost 900GBP of its original value. The easiest/laziest way jolly accountants calculate this loss of value is by simply dividing the machines' value by its useful life, and presto!

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The stuff that makes everyone nervous: Liabilities

Like it is the case within the asset section, the liabilities start in order of liquidity, and the position that is listed first is accounts payable. 

Accounts payable summarizes all invoices that need paying at the end of any given period, in our case, Q1. It is pretty much the opposite of accounts receivable. In business, it is pretty standard that suppliers grant you credit terms that sometimes can even reach 90 days. This is quite desirable as it allows you to get the cash for your products first. After all, you already had a significant outlay for getting all your inventory; the last thing you need is to push even more cash out the door before you see any cash coming back in. The accounts payable for the Jolly Brew Ltd are made up of the 1.200GBP shipping costs,s which were invoiced at the end of Q1, and the marketing expenses for 2.000GBP.

Next are the accrued expenses. It works the opposite way of prepaid expenses. Remember, with prepaid expenses, we paid for sth in advance, but we need to record an asset to properly account for this fact because we haven't received a service or product yet. With accrued expenses, we have already consumed a service or a product in advance but have yet to be invoiced. In our case, it is rent. We are already using the building to brew our beer in the first month. It would only be fair to record an expense for it.

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Memory alert: Remember the matching principle; it is essential to account for all income and expenses in a given period, in our case, the first month. 

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By recording an expense in the income statement, we must also make a corresponding entry on the balance sheet to account for the fact that we need to pay money in the future for rent. And in this case, the other account is accrued expenses. As we record an expense in each of the first three months worth a 1.000GBP, we also increase the accrued expenses by a 1.000GBP each month. This will leave us with 3.000GBP at the end of Q1, which is the total rent liability we owe the landlord. It is usually expected that the supplier will invoice you at the start of the new period (Q2). When this happens, the liability (accrued expenses of 3.000GBP) will disappear, and your cash in the bank will go down. 

The next position is relatively straightforward to explain: The current portion of Long Term Debt is quite simply the portion of the debt that falls due within 1 year. For example, in our case, the bank requires us to repay the loan of 36.000GBP in equal portions over 3 years. So the current amount payable at the end of year 1 is 12.000GBP. 

Therefore the rest of our debt forms part of the Long Term Liabilities as the remaining term of the loan is greater than 1 year. Again this is a handy way for any interested party to make an informed judgment on the overall liquidity of a business. 

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The golden nugget at the end: Equity

It sounds as if I am glorifying this position in the balance sheet. I like to see it through the lens of control and flexibility; some colleagues would also add cost to this. Still, realistically speaking, if you remember the magic accounting formula: Assets = Liabilities + Equity, it merely shows how much of the assets are financed with the company owner's resources. It is not easy to make a 100% judgment on what is a better way to fund your business, either equity or credit. I don't want to go into too much detail but let me show it like this:

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CONTROL: The more money you get from outside parties, the more you are dependent on and tied to them! They could require stringent controls and regular updates, even threaten to withdraw their commitment if they think you breach their conditions.

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FLEXIBILITY: If you finance your business with your own money/equity, you can pretty much do whatever you like, and should you require more, you can always approach a bank. But your initial negotiation position would undoubtedly be better with less external credit on your books. It only becomes tricky if your equity is made up of money from external shareholders as they could equally set high demands, which leads me to:

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COST: It eventually is done to cost again! Banks require you to pay interest, but equally, shareholders would require you to make a certain return; after all, why would you invest in a business without ever seeing a return on your investment? So eventually you have to decide what is cheaper for you and easier to live with!

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This is it! A crash course in balance sheet workings completed. The last piece in the puzzle is the cash-flow statement.