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[O40]Off The Balance Sheet

by Rahim Abu Fattah, Rah

A balance sheet is a quick picture of the financial condition of a business at a specific period in time. The activities of a business fall into two separate groups that are reported by an accountant. They are profit-making activities, which includes sales and expenses. This can also be referred to as operating activities. There are also financing and investing activities that include securing money from debt and equity sources of capital, returning capital to these sources, making distributions from profit to the owners, making investments in assets and eventually disposing of the assets.

Profit making activities are reported in the income statement; financing and investing activities are found in the statement of cash flows. In other words, two different financial statements are prepared for the two different types of transactions. The statement of cash flows also reports the cash increase or decrease from profit during the year as opposed to the amount of profit that is reported in the income statement.

The balance sheet is different from the income and cash flow statements which report, as it says, income of cash and outgoing cash. The balance sheet represents the balances, or amounts, or a company's assets, liabilities and owners' equity at an instant in time. The word balance has different meanings at different times. As it's used in the term balance sheet, it refers to the balance of the two opposite sides of a business, total assets on one side and total liabilities on the other. However, the balance of an account, such as the asset, liability, revenue and expense accounts, refers to the amount in the account after recording increases and decreases in the account, just like the balance in your checking account. Accountants can prepare a balance sheet any time that a manager requests it. But they're generally prepared at the end of each month, quarter and year. It's always prepared at the close of business on the last day of the profit period.

There are two key aspects to consider in a business balance sheet, how efficiently it is funded ("Funding") and how efficiently it is operated ("Operations”). Both are important but separate parts of a business; the bank overdraft is part of funding. Changes to funding arrangements do not impact on operating performance.

Traditionally accounting balance sheets are arranged into Assets, Liabilities and Equity in accordance with the balance sheet equation i.e. Assets = Liabilities + Equity. With a two column format, Assets are in the left column and Liabilities and Equity on the right. In a traditional balance sheet Current Assets may contain “cash at bank” and Current Liabilities may contain entries for “bank overdraft”. Both Current Assets and Current Liabilities are components of Working Capital which is the operational aspect of the business. In traditional accounting format it can therefore be difficult to distinguish funding from operations.

However the presence or absence of an overdraft only affects the funding aspect. This is clearly seen if the format of the balance sheet is rearranged to reflect the separation of Finance and Operations. In this financial analysis format the left column contains the funding entries (Debt and Equity), and the right column the operational entries (Working capital and Non-current assets) . Instead of cash and overdraft being included with Working Capital they are moved to the Debt section in the left column. The Debt section includes cash, bank overdraft and long term debt. All cash assets or cash liabilities are shown as debt (cash is regarded as negative debt).

In this format you can clearly see what effect an overdraft has on the balance sheet. An overdraft will raise debt. The overdraft affects the Income statement because debt incurs interest (an expense) so interest payments will rise, there will be less profit and therefore less tax to be paid. The retained income entry on the balance sheet (under Equity) will reflect this. However nothing on the Operations side of the balance sheet will be affected by whether the operations are funded by debt or equity or both.

Most businesses are financed by a combination of equity and debt. Exactly what debt/equity mix (leverage) is best for the business is part of the funding strategy determined by management.

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