The balance sheet: if it’s not an absolute requirement, why bother?
There’s no legal obligation, as a sole trader, to compile a balance sheet each year. Nevertheless, it’s good practice to prepare and maintain a summary of assets (what you own) and liabilities every year (what you owe). Here’s why:
Looking at the big picture
Are unused stock levels creeping up? Are you yet to see the fruits of those investments you made in new machinery? Is the level of debt owed to your business increasing? Is too much cash lying dormant when it could be put to better use elsewhere? The snapshot provided in a balance sheet can give you vital indicators on all of this.
Showing off to lenders, investors, and potential new business partners or buyers
A third party probably won’t come back to you unless it’s clear that their money is in safe hands. Being able to compare a couple of years’ balance sheets and setting out the net worth of your business can really help show where your business has evolved from, and where it’s going. This goes a long way in providing the information any third party need to make an informed decision.
You’ll need to prepare a balance sheet each year when you ‘incorporate’
The next milestone on the near horizon for many-a-small business owner is setting up as a company. As a company owner, you file company accounts – including a balance sheet – along with profit & loss accounts with Companies House and HMRC (some examples are here). Getting into the habit of it now means you’re well prepared for that next step.
What exactly is a balance sheet?
A balance sheet sets out the following:
For a small business, this could include stock, machinery, and equipment (fixed assets). It will also include cash in your business account and in your petty cash, as well as money owed by customers (current assets).
This is money that you owe other parties, such as suppliers and your tax and loan repayments due that year (short-term liabilities). Long term commitments, such as the amounts due to be repaid in loans after that year, are listed as long-term liabilities.
Have you heard of the ‘bottom line’? This is it. It’s what you can legitimately say you ‘own’ within the business after subtracting liabilities from assets.
Let’s look at a simple balance sheet in black and white:
|Less Accumulated Depreciation||
|Total Fixed Assets||
|Total Current Assets||
|Business Credit Card||
Assets minus Liabilities = Total Equity. In other words, the figure for total equity will always be the same as net assets (otherwise you’ve made a mistake somewhere along the line).
We’ve deliberately kept this example simple to give you a feel for what your first balance sheet will probably look like. Taking the three sections: Assets, Liabilities, and Equity we’ll look in more detail at some of the entries that you might need to make as your business evolves.
Fixed assets refer to those items that your business owns over the long term. The physical or ‘tangible’ assets you own (such as machinery and equipment) are the most obvious examples. However, as your business grows, certain ‘intangible’ assets may need to be included here too. These could include ‘goodwill’ to reflect growing brand recognition and/or a valuable client base. It could also include the value of any trademarks or patents you have acquired – valuing these intangible assets requires specialist help from your accountant.
The figure next to ‘Fixed Assets’ refers to the current ‘net book value’ of your assets, which usually refers to the price you paid for them, minus their depreciation. You can find out more about how small businesses calculate this in our article dedicated to asset depreciation.
This is a snapshot of the short-term possessions of your business at the time the balance sheet is prepared. A glance at this section can be a useful way of flagging up cash flow problems that may need looking at. For instance, in the example above, the low bank balance may suggest that the business isn’t doing enough to cover itself for ‘rainy day’ contingencies. However, at the same time, it seems to have £3,000 outstanding in customer invoices. Therefore, depending on how long this money has been owed, the business might need to consider getting serious about chasing up its debts.
If these are creeping upwards from one year’s balance sheet to the next, is there a problem with cash flow? Additionally, once you get better established and build up a relationship with your regular suppliers, is there scope for discounts and more favourable terms?
If you take out a loan, the amount due within a year will be listed as a current liability. The remainder will be listed separately as a long-term liability. Under this section, you will also list any capital (financial assets, such as a brand name, rather than money) invested in the business by you, your partners, and outside investors.
In the case of a small business owner, this section details everything that is yours within the business. In the example given, the business owner is keeping their money in the business for the time being. If they had withdrawn, say, £2,000 from it in the previous year, the ‘Equity’ section would look like this:
Retained Profit £3,400
(Less Drawings) £2,000
Total Equity £1,400