Karen Szotek BSc ACCA
Joanna Grant BSc ACA
On a day to day basis it will be the ability to access cash which will determine whether you can continue in business - if you can’t then you are insolvent. However, the real test of solvency is whether you have more assets than liabilities. If you compare the value of all the things you own plus everything you are owed by others to all the amounts you owe you can see whether you are solvent. This picture is encapsulated in your accounts by the balance sheet.
This shows your business’s position at the end of the financial period, usually the year end. It is a snapshot of the business at an instant in time. It shows one measure of the worth of the business, the amount that would be left had you stopped trading at that moment, sold all the property, fixtures, vehicles, stock etc, collected customer balances, paid all suppliers and other creditors then emptied the bank account. In theory you would be left with the balance sheet total in cash. We say in theory because the balance sheet only contains estimates of the market value of each asset and it is unlikely that precisely these amounts would be realised in a disposal. For accounting purposes we assume that assets reduce in value at a consistent rate called depreciation. The Revenue has its own rates of depreciation for most assets and this will not normally coincide with the market value.
The worth of the business is balanced by, or financed by, the capital you have introduced into the business plus the profit made each year less the amount you have withdrawn for personal use (your drawings). Drawings are the amount you withdraw from the business for your own personal use; you may think of this as your wages but it will not form the basis of your taxable profit. You may withdraw from the business as little or as much as you want but if you withdraw more than you make in profit, or if you make a continuing loss, your business will become insolvent and the balance will become a negative figure (represented by brackets around the figure). This would mean that even the sale of all your assets and stock and collecting all your debtors would not provide you with enough funds to pay off your suppliers and creditors.
There may be some accounting expressions, especially in the balance sheet, you do not recognise. Prepayments are expenses which have been incurred already on behalf of next years accounts, for example insurance paid in advance. Accruals are estimates of expenses which have been incurred but not yet billed, for example our fees!