Purpose and Use.—The balance sheet of a business is designed to show its financial condition at a given time. As previously illustrated, it marshals the assets in one list or schedule, and the liabilities in another. The difference between the totals of the two schedules gives the present or net worth of the business. In compiling a balance sheet it is not sufficient to give simply the figures of proprietorship or net worth; schedules of assets and liabilities must be drawn up to show the items making up that net worth. From the viewpoint of a prospective investor or purchaser, a banker to whom the business has applied for a loan, or a concern considering the advisability of extending it credit on a bill of goods, it makes all the difference in the world to know that with a net value of $10,000 the business has assets of $15,000 and liabilities of $5,000; or to know that its assets are $260,000 and its liabilities $250,000.

The ratio of total assets to total liabilities is almost as important information to an investor, purchaser, banker, or creditor as is the character of the assets and liabilities. If the assets are in properties for which there is not a ready market and the liabilities are claims which mature soon and will have to be met, the situation is unfavorable. If there are large values invested in easily salable assets; if there is a large balance of cash on hand after meeting current claims and providing for those which will soon mature; if other liabilities are of a more permanent nature, such as mortgages or long-time notes not requiring immediate attention—the situation may show evidence of too large a capital, or of inefficient management as indicated by the failure to invest a part of the surplus cash in properties from which some return might be secured.

Form and Content.—Questions of the kind raised above are not usually capable of definite answer from the information contained on the balance sheet alone. Oftentimes information as to the volume of business done, future plans for expansion or contraction of business operations, and so forth, is needed in addition to that supplied by the balance sheet. Of immediate interest to us, however, is the information contained in the balance sheet. Here two main problems are met: that relating to the form of the balance sheet, and that concerned with the content of the balance sheet.

By form of the balance sheet is meant its physical appearance—the arrangement and classification of its items. The form is not standard. In this country there are few legal regulations governing the way in which the records of a business are to be kept or its reports are to be made. Some efforts have been made, however, to establish a more or less standard form of balance sheet and to secure the use of standard titles in the balance sheet so that wherever found those titles can be relied upon to mean one and only one thing. Because balance sheets are not always drawn up for similar purposes, such regulations should not be too inflexible. The form of any business statement or report should always have regard to the purposes it is to serve. Standardization of form is desirable within this limitation.

By content of the balance sheet is meant the items that are admitted to it and the basis of their valuation.

These two problems of the balance sheet—form and content—are fundamental and will be briefly considered here.

Titles—Main and Group.—Instead of “Balance Sheet,” other terms are used as names for the statement itself, such as “Financial Statement,” “Statement of Resources and Liabilities,” “Statement of Assets and Liabilities.” Within the statement, Resources is an alternative title for Assets; and Net Worth, Present Worth, and Net Assets, for Proprietorship. For the present, use of the terminology previously employed will be continued, with the substitution, however, of the term Net Worth for Proprietorship.

The title of a statement should be full; it should include the name of the business enterprise and date, and should appear somewhat as follows:

Shongood & Goodwell
Balance Sheet
December 31, 19—

As stated, this should be followed by the schedules of Assets, Liabilities, and Net Worth. Since the statement is a formal one, due regard should be had for its general appearance, which should be neat and attractive. Further consideration will be given to some of these features in Chapters XXVI and XXVII.

Classification and Arrangement.—As indicated above, the balance sheet is used to picture the financial condition of a business at a given time. Some of the questions which arise in determining the financial condition of a business have already been mentioned. The chief use to which a balance sheet is put is the determination of the solvency of the business for purposes of getting credit extensions. By solvency is meant the ability of the business to pay its debts when due. Regardless of how great the excess of assets over liabilities is, if it is tied up in assets which cannot be used for the payment of debts, the creditors of the business will become impatient and may ask a court to take the control of the business away from its owners and place it in the hands of a representative of the court and the creditors, who will conduct the business for the purpose of converting assets into cash to a sufficient extent to pay all debts.

A balance sheet should therefore be so arranged that the condition of the business, viewed from the standpoint of its ability to pay its debts, will be clearly and easily determinable. Cash is usually the only medium used for the payment of debts. In the regular course of business, debts are incurred which come due at different dates. Hence it is not necessary to have on hand at a given time cash sufficient to pay all of the debts of the business. Certain classes of debts will not wait. The sums owed employees for services must usually be paid when due. The debt to the government for taxes, to the public service company for heat, light, and power, to the landlord for rent, to the bank for money borrowed—all these debts must usually be paid immediately as they come due.

The cycle of business operation includes the purchase of merchandise, the payment of operating expenses, and the conversion of merchandise into cash through sale, either directly, as when the sale is for cash, or indirectly as when credit is extended a customer and cash is later collected from him. This cycle or turnover of merchandise recurs constantly in the management of the financial affairs of a business. It is necessary so to order the buying and selling of goods and the collection of accounts from customers that there will be on hand at all times sufficient cash to pay the expenses of operating the business and the debts contracted in the purchase of merchandise. This is the vital and fundamental problem of the business executive. In the solution of that problem it may sometimes be necessary to borrow funds from the bank. Before lending money, the banker assures himself that the business will be in a position to repay the borrowed money when due.

The balance sheet, accordingly, should be so arranged that the condition of the business as related to its ability to pay its debts will be apparent. This requires a classification or marshaling of the assets which are concerned in the trading cycle on the one side, and the liabilities which must be assumed in conducting the business during the trading cycle, on the other.

At the head of the list of assets is the item Cash, the most liquid of all, as it can be used directly for the payment of debts. Following Cash come in order Notes Receivable, which, with proper indorsement, can be sold to the banker and converted into cash almost immediately; Accounts Receivable, which represent the claims against customers for merchandise sold and which are collectible within the term of credit extended to the customer; and finally, the Merchandise on Hand, which must be sold either for cash or on credit and then converted into cash by the collection of the outstanding accounts. Sometimes, also, there is included in this group the asset Investments, representing stocks and bonds of other companies which can be converted into cash by sale on a stock exchange. On such securities, and also on the notes receivable, there is usually at the date of the balance sheet some interest which has accrued and may not yet be collectible. It is customary to include the amount of this interest receivable in the same group with the assets from which it arises.

This group of assets, comprising Cash, Notes and Accounts Receivable, Merchandise, and so forth, is called the group of Current Assets. Asset items are classified as current if conversion into cash is expected within three to six months. These are the assets to which the current creditors of the business will have to look for the payment of their claims.

The claims of current creditors are usually included under the titles Notes Payable, Accounts Payable, and Accrued or Unpaid Expenses. The classification of a creditor in the current liability group is usually determined on a time basis. Thus, all debts that will have to be met within six months’ or one year’s time from the date of the balance sheet are usually classed as Current Liabilities.

The excess of current assets over current liabilities is called the working capital of the business; that is, an amount of the current assets equal to the current liabilities will have to be used for the payment of these debts, leaving the excess or difference free for use within the business. While it is not possible to determine, without considering all the circumstances in a given case, how large this working capital should be, the standard rule-of-thumb is that it should equal the amount of the current liabilities. It will thus be seen that the standard ratio of current assets to current liabilities is two to one. The solvency of a given business is always judged by a comparison of the current asset group with the current liability group.

The next main group of assets is given the title Deferred Charges. The content of this item was explained on page 12. Thus, if a management has paid some of its expense bills in advance—rent for January paid during December, for example—when showing its financial condition as at the end of December it is proper and necessary, in order to make an accurate showing, that all such prepaid expenses be listed as assets; for, had the payment not been made until the service which it purchased had been used up, the asset cash would have been larger by the amount of the prepaid expenses.

Similarly, with regard to the Accrued Expenses mentioned on page 14, whatever expenses have been incurred that properly belong to the past period, such as wages due but unpaid, are liabilities; for the cash would be smaller by the amount of such postponed or accrued items had the claims been met during the period. The close relationship of both deferred charges and accrued expenses to cash is thus apparent—the one as an indirect addition to the cash, the other as an indirect deduction from or claim against cash. Accordingly, deferred charges are shown on the balance sheet immediately following the group of current assets, whereas accrued expenses are listed with the current liabilities as noted above.

The next group of assets is called Fixed Assets. Under this title are listed those assets which are used for carrying on the business but are not bought for the purpose of being resold. A certain amount of capital must be invested in the physical business plant. Furniture and fixtures, delivery equipment, buildings, land, machinery and tools, and so forth, must be purchased before the business can commence operating. It is assets of this type that comprise the class of fixed assets. There is a corresponding group among the liabilities which are known as Fixed or Long-Term Liabilities. All debts maturing a year or more after the date of the balance sheet are classed as fixed liabilities. As examples of this class, we have long-term notes payable, mortgages payable, bonds payable, and so forth.

The difference between the fixed assets and the fixed liabilities indicates the amount of owner’s capital which has been invested in the business plant.

The final group of assets is called simply Other Assets, and includes all assets which cannot be classified in any other groups, such as good-will, patents, trade-marks, accounts and notes receivable having a credit term longer than six months, and other similar items. If there are any liabilities not capable of classification in the two groups of liabilities given above, they may be put in a group called Other Liabilities.

For the purpose of an easy showing of these various groups and their titles, it is customary to list the amounts of the several detailed items of each group in an inner money column, and to extend the total into the adjoining money column on the line of the last item in the group. A similar arrangement is made of the groups of liabilities so that not only the items in the various groups but the group totals as well are available. The totals of the various groups give the grand totals for the assets and the liabilities respectively.

The balance sheet as now classified and arranged provides first a formal title, giving the name of the business and the date of the balance sheet; then the assets, under which appear the groups Current Assets, Deferred Charges, Fixed Assets, and Other Assets; under the liabilities appear the groups Current Liabilities, Fixed Liabilities, and Other Liabilities. The showing of Proprietorship or Net Worth under the three different kinds of ownership has already been set forth. The illustration on page 31 shows a typical form of classified balance sheet. This should be studied carefully, as it is the type which will be used hereafter.

The Problem of Content.—The form of the balance sheet serves the purpose of making easily available the information contained in the balance sheet. Form is of little value unless the content is accurate. What a balance sheet contains is, after all, far more important than its form. The problem of content comprises a consideration of two points: (1) the proper inclusion of all items, both assets and liabilities, belonging in the balance sheet; and (2) the correct valuation of the items so included.

With regard to the first, it may be said briefly that care must be exercised to see that all assets belonging to the business and having value, and that all claims against the business of whatever nature, are included.

Assuming that a given balance sheet contains a list of all the assets and all the liabilities, the further problem of the proper valuation of these items must be considered. A balance sheet in which the title Cash includes counterfeit bills, N. G. (that is, uncollectible) checks and other similar items, would not be considered a reliable balance sheet. Similarly, the basis for the valuation of each of the asset items must be investigated and determined correct before the balance sheet may be considered to represent the true financial condition of the business. It is the experience of every business that it cannot collect all of the credits extended to customers. Regardless of how carefully credit is granted, it will be found that some customers do not pay their debts. Accounts and notes receivable must, accordingly, be valued with a proper consideration for the estimated amount of the uncollectible portion. The stock of merchandise on hand must be valued according to the standard formula, at cost or market, whichever is the lower. The deferred charges group of assets will show the value of the unconsumed portions of the assets purchased, with due regard to the time element. Thus, a three-year insurance policy purchased at the beginning of the year will at the close of the year be valued at two-thirds of its original cost. The fixed asset group will be valued at cost less depreciation, which represents the amount of the loss in value of the assets due to wear and tear, lapse of time, and obsolescence.

In determining liabilities, providing they have all been included, there is not the danger of an understatement, because their amount is subject to verification on the basis of the creditors’ claims. For obvious reasons the liabilities are seldom overstated.

General Principles Governing Form and Content.—In drawing up a balance sheet, the form must be flexible enough to meet whatever requirements for information may be placed upon it. Thus, a balance sheet to be presented to the banker as the basis of a loan should be carefully classified so as to show clearly the financial condition, and sufficient detail should be given to indicate the basis used in valuing the various items. A balance sheet drawn up for publication may, on the other hand, contain less detailed information and less attention need be given to its form. A balance sheet drawn up for use within the business itself may well contain very full information and its form should be such as will accurately portray the status of affairs. A balance sheet which shows on its face that cognizance is taken of uncollectible accounts and of the loss in fixed assets due to depreciation, is much more valuable as a financial statement than one lacking that information, provided of course it is to be used to indicate that consideration has been taken of those elements. Excepting for the general remark that regard must always be had to the purpose for which the balance sheet is drawn up, no hard-and-fast rule can be laid down in the matter of the relative fullness of detail with which it should be made.

Illustration. To illustrate the features of the balance sheet discussed in this chapter, the following statement showing the financial condition of the partnership of Jackson & Edwards is given:

Jackson & Edwards
Balance Sheet June 30, 19—