Definitions
→ Statement of Financial Position → a financial statement showing the assets, liabilities and equity of a business at a particular point in time
→ Purpose of the Statement of Financial Position → to show the financial position of a business on a specific date → helps assess its liquidity, financial stability and capital structure
→ Non-current assets → assets held for long-term use in the business and not intended for resale in the normal course of business
→ Current assets → assets expected to be converted into cash, sold or used within the normal operating cycle, usually within one year
→ Current liabilities → amounts owed by a business that are normally due to be paid within one year
→ Net current assets (working capital) → current assets minus current liabilities
→ Net assets → total assets minus total liabilities
→ Non-current liabilities → amounts owed by a business that are due for repayment after more than one year
→ Reserves → amounts included within equity that represent accumulated profits or other reserves of the business
→ Equity → the owners’ claim on the assets of the business after all liabilities have been deducted
→ Capital employed → the long-term finance invested in the business → often calculated as net assets or equity + non-current liabilities
Core Concepts
Purpose of the Statement of Financial Position
→ Shows what the business owns → assets
→ Shows what the business owes → liabilities
→ Shows the owners’ financial interest → equity
→ Provides information about liquidity → ability to meet short-term financial obligations
→ Provides information about financial stability → relationship between assets, liabilities and equity
→ Helps managers assess the financing structure of the business → amount of finance provided by owners compared with borrowed finance
→ Allows comparison of the business’s financial position over time → changes in assets, liabilities and equity can be identified
Non-Current Assets
→ Non-current assets are held for long-term use in business operations
→ Examples → property, machinery, equipment, vehicles and long-term investments
→ Non-current assets help the business generate revenue over several accounting periods
→ Depreciation → reduction in the recorded value of a non-current asset over its useful life
→ Increase in non-current assets → may indicate investment and expansion → but may require significant finance
Current Assets
→ Current assets are expected to be converted into cash or used within the short term
→ Examples → inventory, trade receivables, cash and cash equivalents
→ Current assets contribute to the business’s ability to meet short-term obligations
→ Excessively high inventory → cash may be tied up in unsold goods → liquidity may be reduced
→ High trade receivables → customers owe the business money → cash may not yet have been received
Current Liabilities
→ Current liabilities are obligations due within the short term
→ Examples → trade payables, overdrafts and short-term borrowings
→ Increase in current liabilities → short-term financial obligations increase → liquidity may weaken
→ A business needs sufficient current assets to meet current liabilities when they become due
Net Current Assets
→ Net current assets = Current assets − Current liabilities
→ Also known as working capital
→ Positive net current assets → current assets exceed current liabilities → generally provides greater short-term financial security
→ Negative net current assets → current liabilities exceed current assets → may indicate liquidity problems
→ However → the appropriate level of working capital depends on the nature and size of the business
Net Assets
→ Net assets = Total assets − Total liabilities
→ Net assets represent the value of the business’s assets after all liabilities have been deducted
→ Net assets should equal the total of equity and reserves in the Statement of Financial Position
Non-Current Liabilities
→ Non-current liabilities are obligations due after more than one year
→ Examples → long-term bank loans, debentures and long-term finance
→ Long-term borrowing → provides finance for investment and expansion → but creates future interest and repayment obligations
Reserves and Equity
→ Equity = Share capital + Reserves for a company
→ Share capital → finance raised by issuing shares to shareholders
→ Reserves → accumulated profits and other amounts retained within the business
→ Retained profit → increases reserves → increases equity
→ Dividends paid → reduce retained earnings → reduce reserves and equity
Accounting Equation
→ Assets = Equity + Liabilities
→ This is the fundamental accounting relationship
→ Every transaction must maintain this relationship
→ Increase in an asset → must be matched by an increase in another asset, a liability, equity or a combination
→ Example → business buys machinery using a bank loan → non-current assets increase → non-current liabilities increase by the same amount
Examples
→ A business has current assets of $200,000 and current liabilities of $120,000
→ Net current assets = $200,000 − $120,000 = $80,000
→ A business has total assets of $800,000 and total liabilities of $300,000
→ Net assets = $800,000 − $300,000 = $500,000
→ A business purchases machinery for $100,000 using a long-term bank loan → non-current assets increase by $100,000 → non-current liabilities increase by $100,000 → accounting equation remains balanced
→ A business makes a profit of $50,000 and pays dividends of $20,000 → retained profit increases by $30,000 → reserves and equity increase by $30,000
Analysis
Relationship Between the Statement of Profit or Loss and Statement of Financial Position
→ Profit for the year → increases retained earnings → increases reserves → increases equity in the Statement of Financial Position
→ Loss for the year → reduces retained earnings → reduces reserves → reduces equity
→ Dividends → reduce retained earnings → reduce reserves → reduce equity
→ Revenue earned → increases profit → increases retained earnings → increases equity, assuming the revenue is recognised and all other factors remain unchanged
→ Expenses → reduce profit → reduce retained earnings → reduce equity
→ Depreciation expense → reduces profit → reduces retained earnings → reduces the carrying value of the relevant non-current asset
→ Purchase of non-current assets → increases non-current assets → may reduce cash if purchased using existing funds
→ Purchase of inventory for cash → inventory increases → cash decreases → total current assets may remain unchanged initially
→ Purchase of inventory on credit → inventory increases → trade payables increase → current assets and current liabilities both increase
→ Sale of inventory for cash → cash increases → inventory decreases → profit increases by the gross profit earned → equity increases
→ Sale of inventory on credit → trade receivables increase → revenue and profit increase → equity increases
→ Payment to suppliers → cash decreases → trade payables decrease → net current assets may remain unchanged
→ Repayment of a loan → cash decreases → loan liability decreases → total assets and total liabilities both decrease
→ New share capital issued for cash → cash increases → share capital increases → equity increases
→ Therefore → transactions affecting the Statement of Profit or Loss can often have a corresponding effect on the Statement of Financial Position
Amendment of a Statement of Financial Position
→ An amendment is required when an error or omission in the original statement is identified
→ Identify the incorrect item → determine the correct treatment → amend the relevant asset, liability or equity figure → recalculate totals
→ If an asset is understated → total assets are understated → net assets are understated
→ If a liability is understated → total liabilities are understated → net assets are overstated
→ If retained profit is understated → reserves and equity are understated → net assets are understated
→ If depreciation has been omitted → non-current assets are overstated → expenses and profit are overstated → retained earnings are overstated
→ If an expense has been omitted → profit is overstated → retained earnings are overstated → equity is overstated
→ After an amendment → Assets must still equal Equity + Liabilities
Evaluation
→ Statement of Financial Position is a snapshot → it shows the position on one specific date → it does not show how the position changed throughout the year
→ Asset values may not represent current market values → accounting rules and depreciation methods affect recorded values → book value may differ from actual selling value
→ Liquidity depends on asset quality → a high level of current assets does not automatically mean strong liquidity → inventory may be difficult to sell and receivables may be difficult to collect
→ High equity is not necessarily better → a business may have substantial equity but still generate low returns for shareholders
→ Borrowing can support growth → non-current liabilities may increase → but excessive borrowing creates interest and repayment obligations → financial risk increases
→ Working capital requirements differ between businesses → a supermarket may require high inventory but have rapid cash sales → a construction business may have very different working-capital needs
→ Profit and financial position are connected but different → a profitable business can experience liquidity problems → therefore the Statement of Profit or Loss should not be analysed in isolation
→ Judgement → the Statement of Financial Position provides essential information about assets, liabilities, liquidity and financial structure → but its usefulness is greatest when combined with the Statement of Profit or Loss and other financial information
Exam Tip
→ Memorise the key relationships → Current assets − Current liabilities = Net current assets → Total assets − Total liabilities = Net assets → Assets = Equity + Liabilities
→ For questions linking the two statements → remember profit increases retained earnings and equity, while dividends reduce retained earnings and equity
→ For amendment questions → check the final accounting equation → Assets must equal Equity + Liabilities → if they do not, an adjustment has been missed