Welcome to part four of our Understanding Financial Reports series. We’ve worked through context, Accounting 101 and the Profit & Loss, and this month’s instalment brings us to the Balance Sheet.
Nothing can strike terror into the heart of a non-finance manager or Board member like a Balance Sheet, so let’s improve your comfort level by exploring the key components of the Balance Sheet.
We encourage you to refer to your own organisation’s financial reports while reading this, as well as accessing financial statements via the ACNC or organisations’ websites to give you some more practice and to be able to compare organisations of different shapes and sizes.
One of the key things to understand about the Balance Sheet is the period it refers to. The Balance Sheet is a snapshot of an organisation’s finances at a point in time. It tells the story of what the entity owns and what it owes to others, over the whole lifetime of the entity and at a point in time. This is different to the , which provides data for a specific period.
The purpose of the Balance Sheet is to show the net value of an entity – the summary or balance of what the entity owns, less what it owes to others. It is also known as the Statement of Financial Position.
You might recall from our earlier Accounting 101 there are only five classifications in accounting: Assets, Liabilities, Equity, Income and Expenditure. Assets, Liabilities and Equity are reported on the Balance Sheet and the report presents those three groups of accounts to calculate the answer to Assets – Liabilities = Equity.
It is called a balance sheet because, at any given point in time, each side of this equation must balance – that is, ‘Assets minus Liabilities’ must equal Equity. This is evident in two spots in the report: at Net Assets, which is the calculation of Assets minus Liabilities, and at Total Equity – sometimes referred to as Members’ Equity or Accumulated Reserves on NFP balance sheets.
While a balance sheet report only shows the asset, liability and equity accounts, there is also a distinction between current (expected to be used or resolved within 12 months of the report date) and non-current (long-term) items.
- Current assets include cash in the bank, short-term investments, inventory, trade debtors or accounts receivable, petty cash and prepaid expenses. Generally speaking, they are items that are, or can readily be exchanged for, cash).
- Non-current assets include long-term investments, such as a multi-year term deposit or other long-term investments, and fixed assets which might include land and buildings, leasehold improvements, plant and equipment, motor vehicles and office equipment. You might also see intangible assets as a classification, commonly intellectual property in a non-profit organisation, although you may occasionally see goodwill and trademarks in this category.
- Current liabilities may include trade creditors or accounts payable, credit card balances and bank overdrafts, GST, and payroll liabilities including superannuation and PAYG tax payable.
- Non-current liabilities will include long-term loans such as mortgages and the residual value of leases greater than 12 months.
Equity — which NFPs commonly call Members’ Equity or Accumulated Reserves — is the residual value of the organisation, after deducting total liabilities from total assets, that nobody else has claim to.
A balance sheet is especially helpful when presented against a comparative period – it might be last month, same time last year or end of last financial year. The comparative figures help you to gauge whether the balance in an account is reasonable and also provides a check that the accounts you would expect to see moving are being cleared periodically. For example, you would expect to see the Superannuation Payable liability account growing each pay then being cleared when remitted to super funds quarterly, and Income in Advance balance to jump up when a grant is received and be drawn down over the course of the funded project.
What does the Balance Sheet tell me?
The balance sheet is the report that demonstrates an organisation is solvent. The first big indicator is equity – too small a number there could indicate potential viability problems.
The balance sheet helps you answer the question, “Can we meet our debts as they fall due?” The working capital calculation gives you a couple of measures. Current assets minus current liabilities is your working capital, the funds you have available.
Current assets divided by current liabilities gives you a working capital ratio, also known as current ratio, showing the ratio of assets to debts or liabilities. The larger the number, the stronger financial buffer you have.
You would want to see the following as indicators of balance sheet health:
- A positive (as opposed to negative) net asset figure
- There are sufficient cash assets – it will be hard to pay the bills if all your assets are specialist equipment that can’t be sold quickly.
- Clearing type accounts move over time – superannuation payable, GST, leave balances will build up but should also reduce, sometimes to nil, as your obligations to pay come around.
- Debtors and creditors accounts are reasonable amounts and ebb and flow. You certainly wouldn’t want to see debtors steadily increasing – why aren’t you being paid? – and you also wouldn’t want to see creditors going up, which could point to cash flow problems.
Some common questions
Depreciation – often a misunderstood concept, so we will explore it here as it is important to understand its impact on both the balance sheet and P&L. In short, depreciation spreads the cost of a fixed asset over its lifetime – referred to as its effective life.
When an asset is purchased – a building, a bus, a fitout, a computer – the transaction is recorded against the relevant asset account on the balance sheet (the fixed asset account increases in value, the bank account decreases). Depreciation is then applied to expense that cost over the life of the asset.
The depreciation transaction increases the expense account in the Profit & Loss and reduces the ‘book value’ of the asset on the balance sheet. Depreciation therefore gives you a reasonably accurate market value on your balance sheet of assets as they get older and also acts to prevent the P&L taking a big expense hit in the year you purchase an asset. For example, a $6,000 commercial dishwasher is depreciated over ten years, so the depreciation expense in the P&L will be about $600 each year.
Accruals – we touched on cash vs accrual accounting in our earlier post and the balance sheet is where you see the other side of the accrual story. Let’s take leave accruals as an example.
In each pay run, an amount is accrued for employee leave entitlements – there is an expense side of that transaction in the Profit & Loss, and the other side of the story is a liability account on the balance sheet.
The leave entitlements are a liability, as you owe those amounts to your employees when they take holidays or exit your employment.
Another common NFP example is income in advance – that could be a grant, membership dues or event registrations.
Income received in advance is recorded in a liability account on the balance sheet (both bank and liability accounts increase), and then moves into an income account in the Profit & Loss when the entity becomes entitled to the income, either by meeting contractual obligations, delivering a service for the period, etc (income increases, liability decreases). Over the duration of the contract period, or when the event occurs, the liability is reduced to nil and the full amount is recorded as income in the Profit & Loss.
That could be a grant, membership dues or event registrations. Income received in advance is recorded in a liability account on the balance sheet (both bank and liability accounts increase), and then moves into an income account in the Profit & Loss when the entity becomes entitled to the income, either by meeting contractual obligations, delivering a service for the period, etc (income increases, liability decreases). Over the duration of the contract period, or when the event occurs, the liability is reduced to nil and the full amount is recorded as income in the Profit & Loss.
Getting familiar with the Balance Sheet
In our Understanding Financial Reports training, we often prepare a ‘personal balance sheet’, asking participants to list the kinds of assets and liabilities that a household might have. Typically, they come up with cash in the bank (current asset), a house and a car (fixed assets), maybe a deposit on a holiday (prepayment = current asset), balance owing on a credit card (current liability), mortgage on the house (non-current liability) – try jotting down your own personal balance sheet to help you get familiar with the mechanics and purpose of the balance sheet.
Another great way to gain familiarity with your organisation’s balance sheet is to spend some time reviewing line by line and considering what each line represents, what kind of transactions make up the balance and what might be a reasonable balance for those accounts to have.
Accounting For Good offers our Understanding Financial Reports training as custom training, delivered in the comfort of your boardroom or ours. Contact our team of dedicated professionals to find out how we can help you.
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