‘Understanding Your Accounts’ Part 2 – Balance sheets, debtors, creditors – all accountant gobbledegook?

It possibly is, but businesses typically go bust because they run out of cash even if they initially show a profit.  Understanding the balance sheet can help – in its simplest form it is there to:

• show the accounting value of your business, and to;

• manage the timing differences between recording a profit or loss, and the point when cash is paid out or received in.

‘Show me what you mean’

Let’s look at a very simple example. You buy a bike kit to assemble and sell. You pay the wholesaler £150 straightaway. You build the bike and sell it immediately to a lady cyclist, who pays £400 for the new bike again, straightaway.

Assuming you’re not paying yourself a wage, you’ve made a profit of £250 (£400 – £150), all of which has gone through your bank account. So all the profit is represented by cash in the bank, and your balance sheet shows an accounting value of £250.

‘OK – but I get credit from my suppliers and I also have to wait to get paid’

Exactly, this is more typical. So take the above example, but this time your wholesaler gives you 30 days credit, and similarly you allow your cyclist to pay 14 days after she collects the bike (unusual!).

You still show £250 profit, but you owe £150 to your wholesaler and you need to collect £400 from your cyclist. Now your balance sheet shows the bank account is zero; you owe £150 to your wholesaler (liability/creditor), and £400 to be collected from your cyclist (asset/debtor). Your business is still worth £250.

‘So I still show a profit even though I haven’t paid or received any cash?’

That’s right – the balance sheet shows the accounting value still being equal to the profit of £250 in this example. It also records the “temporary” transactions awaiting for the cash to be paid and received – the timing differences bit above.

‘But what if I don’t get paid?’

Good point – which is why it is so important to understand what monies you are owed and also the amounts you need to pay to your suppliers. If your cyclist doesn’t pay, you will have made a loss and if you don’t pay your wholesaler, you will get severely chased by them for the money you owe.

‘So what should I look for?’

• Take your last set of accounts and find the debtors and creditors – is the debtors value larger than the creditors? If it is, then on the face of it you will be collecting in more cash than you have to pay out. If it is the other way around, then this could be a worry.

• Look at the detail of the debtors and reassure yourself that you will be able to collect all the individual amounts shown. Likewise, check the creditors and be comfortable you recognise the payments you have to make.

This second blog has outlined how a basic balance sheet works – real life can be more complicated! But by taking these simple steps to look and understand your balance sheet you can find essential data to assist you in managing your business profitably.

My final blog in this series will look at:

• Getting under the skin of your numbers in order to grow your business.

Blog by Richard Colling, Associate Director at SouthWestfd