For many people, the world of financial jargon is a complete mystery. Wouldn't you love to understand terms like "gearing", in a language that everyone speaks?
The truth is that it's all reasonably straightforward, but like many professions, the financial sector does like to deal in a mysterious code. One of the best has to be the "terminal hiatus", a phrase you wouldn't want to hear your doctor use to describe the state of your health! In reality, this means nothing more than a payment rest period, built into a financial agreement. If it had been called a three month payment pause, then you would have understood it, but then again it wouldn't be finance, would it?
The balance sheet tells us where the money has come from to finance a business (sources), and how the business has used the money (uses), at a given point in time. It has to balance because sources and uses are essentially one and the same.
The sources of money are termed liabilities, because the business is liable to these sources. Liabilities will include funding lines, mortgages, bank overdrafts, directors' investment, and of course the profits the business makes. Liabilities can be current ones, ie they could be called in immediately, or they have to be made good in a 12 month period. An example of a current liability that can be called in immediately is an overdraft. An example of a current liability that has to be made good within the financial year, would be the 12 monthly payments due on a commercial mortgage. The mortgage itself is of course a long term liability as would be the loan to the business from one of its directors.
Uses of money are termed assets. Assets include the following - land, buildings, stock for sale, furniture and cash in the bank. Again, assets can be current ones, such as your sale stock, which you would hope to sell fairly quickly, as well as cash held in the bank. We will look at the relationship between current assets and current liabilities later, but a business should have more current assets than it does current liabilities. Shown below, is perhaps the simplest example of a balance sheet - a typical house purchase shown in balance sheet format.
Directors share equity
(Deposit paid on house) 50,000
Long term liability
(12 month capital payment off the mortgage) 3,000
Total Liabilities 120,000
Purchase price of house 120,000
Total Assets 120,000
The level of shareholders' equity in a business. Generally speaking, a strong equity position is desirable. Take the example of the house above. Most of us would willingly accept that it's better to own more of it than less of it. The key to understanding equity lies in understanding the relationship between ownership and debt. In the example of the house, the owner has a 41.7% equity percentage. The house cost £120,000, the mortgage debt is £70,000 total, therefore the householder owns £50,000 of the house's value. Expressed as a percentage of the house's value, we arrive at the equity %. Exactly the same logic applies to business equity measurement.
This is another way of looking at equity. It's all about how much a company owns of itself, set against how much it borrows. Again, looking at the house ownership example, if you divide the total shareholders' stake into the value of total liabilities, it goes 3.79 times; or, to express it in financial terminology, it is geared 3.8:1.
Sometimes called working capital, cash flow is the business's ability to pay for things. The ability to draw on financial reserves to finance opportunities as well as to protect against downturns is essential. The best example depicted in personal terms is the monthly relationship an employee has with net income and monthly outgoings. Cash flow would be said to be very tight if a £2,000 net family income had to cover £1,800 worth of fixed outgoings. Clearly, an increase in mortgage rate for example, would leave this family exposed and with little cash left over for day-to-day living. Cash flow can be measured on the balance sheet of a company by looking at the relationship between current assets and current liabilities. As a rule a business with considerably more current assets than current liabilities will have better cash flow.
The profit a business makes after tax has been paid, expressed as a percentage of the company's total turnover. Therefore a business with a turnover of £10,000,000 making £200,000 net profit would be making a net profit return of 2%.
Let's say that the same business making £200,000 has total liabilities of £2,000,000 (less accruals and unofficial lines of credit to be precise), its return on funds will be 10%.
If the total liabilities of this same business contain £500,000 worth of investment from the shareholders, the same £200,000 expressed as a percentage of their stake would now be 40%.
There is no point having money tied up doing nothing. This is a very important measure and should be considered as the financial stock turn of the business. We know it has funds employed of £2,000,000 and achieves a turnover of £10,000,000. The circulation of funds would be five times per annum. A supermarket for example would not be too pleased about this. The general idea is to invest as little as possible, generate the largest possible turnover and make the highest possible net profit. Easy to write about - much tougher to do.
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