Balance sheet

Working capital and accruals and prepayments

Understanding accounts series

Introduction

The balance sheet is in one sense the most misunderstood of the two principal financial statements. Everyone easily understands that the business generates either a profit or loss and the profit and loss account explains what sales took place and what expenses came off to arrive at the profit. Technically though, the balance sheet is a presentation of the assets and liabilities of the business or all of the “balances” remaining after the profit and loss account has been prepared. This factsheet covers mainly working capital as this is one of the key elements of the balance sheet.

Definitions and terminology

Let’s start with some of the words used above. Assets An asset is something that will generate economic benefits for the business in the future, so what that means is that assets are things which will support your business in trading, making profit. Typical examples of assets could include computers, buildings, vehicles, bank balances, stock and trade debtors. I’m going to talk about another asset, prepayments, later in this factsheet. Liabilities A liability is an amount or obligations owed to others. Typical examples are suppliers unpaid invoices (trade creditors), amounts of tax (PAYE/VAT/corporation tax) owed to HM Revenue & Customs, bank loans and overdrafts, hire purchase or lease obligations. Another liability covered later in this factsheet is accrued expenses.

Working capital

Businesses operate using their working capital. To understand working capital we need to understand what capital is. Capital is another word for resources or, in this case, money. So working capital is another way of describing the money which is working in the business. The usual components of working capital are: Current assets • Stock and work in progress • Trade debtors • Prepayments • Bank balances and cash Current liabilities • Bank loans and overdrafts • Hire purchase and lease liabilities • Trade creditors • Taxation • Accrued expenses You’ll notice that there is an extra description on these groups – the word current. All that this means is that the entitlement to the money (current assets) or the obligation to pay (current liabilities) must be completed within the next 12 months. So if we develop that logically, current assets represents money due in within the next 12 months and current liabilities is amounts due to be paid out in the same period. Consequently, current assets less current liabilities represents the net amount of cash receivable or payable and it is a small short step to interpreting working capital as a statement of cashflow potential. We measure the adequacy of working capital by using some ratios. The easiest and most accessible is the current ratio. This ratio is calculated as follows: Total current assets Total current liabilities The result is a ratio with a number from zero upwards. Here are some examples of how it looks:

Current assets	150	250	380	400	600
Current liabilities	250	275	320	350	400
Current ratio	0.6	0.91	1.19	1.14	1.5

We should be aiming to keep the ratio out of the red zone because this means that more cash is due to go out of the business than come in and keep the ratio moving to the right, in the direction of the arrow. There are some business sectors that operate on marginal cashflow but it is not a recommended strategy – it is always better to have good cash surpluses in the business to cope with emergencies such as customer bad debts, downturns in sales and rising materials costs.

Accruals and prepayments

Both of these terms are accounting jargon so let me first explain what they mean. Accruals Accruals are expenses that your business has incurred, which can be estimated fairly accurately and for which no invoice has been received. Prepayments Prepayments represent expenses incurred by the business and where the invoices have been received during the year. The expenses, however, cover a period that stretches into the next financial year. The prepayment is the portion that refers to the next financial year. In both cases, the accounts are adjusted so that only the expenses related to this financial year are included in the accounts. This means that items that have been accrued (accruals) will have increased the expenses shown in the profit and loss account:

	Invoices received in the year	Work done by accountant but no invoices received yet	Total shown in the accounts
Accountant's fees	£1200	£450	£1650

Items that have prepayments are always going to be those items invoiced in advance such as rent. Because the supplier has invoiced these items in advance we need to reduce the expenses shown in the profit and loss account. Rent invoiced annually in advance from 01/01/10 to 31/12/10: £12000. Year end is March 31, so amount prepaid is from April 1 to December 31 = 9/12 x £12000 = £9000. Assuming this is the first year in business,

	Invoices received in the year	Period invoiced in advance	Total Shown in the accounts
Rent	£12000	-£9000	£3000

These are two simple and typical examples of each of these entries but it is mainly down to the accountant to do the calculations and make the decisions – but at least you know now what they are and how they are calculated.

Disclaimer

The information contained within this factsheet is factual but may contain opinion and express different ways of considering the topic. No responsibility is accepted by NGM Accountants for any losses or profits foregone by acting on or refraining from acting on any information contained within this factsheet or any factsheets to which this refers. Before making any decisions concerning the accounts of your business or enterprise, you should consult a professionally qualified accountant. Return to Advice page.