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9. Accounting Balance sheet The value of your business


To 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.

Assets
An 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

2 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 side effects. 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 assets
Current 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 assets
Fixed 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

Liabilities
All 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 liabilities
Any 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

3 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 a product 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 Liabilities


Obligations 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 equity
Owner'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 difference between 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 different trade 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 to be calculated so to keep the balance between the assets, liabilities and owners' equity. Hence it is

4 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. Remarks In 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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Coffe Shop TIMES Balance Sheet 31-Dec-10 Assets Current assets Cash Petty cash Accounts receivable Notes receivable Inventory (merchandise) Supplies Total current assets Other assets Equipment (depreciation included) Premisses (depreciation included) Investments Total other assets Total assets 36,000 700 0 24,000 35,000 8,000 103,700 60,000 260,000 0 320,000 423,700 Liabilities Current liabilities Accounts payable Notes payable Accrued payroll and Income tax Total current liabilities Long term liabilities Bank loan (remaining 80%) Creditors (not due this year) Total long term liabilities Total liabilities Owners' equity Paid-in-capital Drawings Net profit (year 2010) Total owners' equity Total liabilities + equity
TABLE 1 THE BALANCE SHEET FOR THE "TIMES" COFFEE SHOP

20,000 34,000 0 9,000 63,000 88,000 25,000 113,000 176,000

200,000 -14,000 61,700 247,700 423,700

Rate of return
By 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.

IIR(%) =

Net profit 100 Initial investement

6 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

N=

100 IIR(%)

The obvious drawback of the proposed calculation is the fact that you cannot count on the constant 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 business


A 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

ROCE(%) =

Net profit 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

ROA(%) =

Net profit 100 Total Assets

ROE return on equity

ROE(%) =

Net profit 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 61,700 100 100 15% Initial investement 400,000

IIR(%) =

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

N IIR(%) = 100 N

100 5.5 15

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 61,700 ROA(%) = 100 15% Total assets 423,700 Net profit 61,700 ROE(%) = 100 25% Owner's equity 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.

Liabilities Liabilities Assets Equity Assets Equity

ROA ROE

ROA ROE

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

8 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 when looking 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 Liquid 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 loan and the money used to pay off the rest of the loan

9 LIABILITIES the monetary value of what business owes o Current liabilities what the business owes and will have to pay within the next 12 months o Long term liabilities 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