Statement of Financial Position (AQA A Level Business): Revision Note

What is the statement of financial position?

• The statement of financial position provides a snapshot of a business’s financial position at a given point in time.

  • It shows what the business owns (assets), what it owes (liabilities), and how it is funded (capital and reserves)

  • It is sometimes called the balance sheet

• The statement of financial position contains the financial information required to draw conclusions about the liquidity of the business

How stakeholders use the statement of financial position

• Assessing financial stability and solvency

  • Shareholders, employees and suppliers use the statement of financial position to judge whether the business is in a sound financial position

    • Whether it can meet its short-term obligations

    • Whether it can sustain long-term growth

    • Whether it can remain a reliable employer and trading partner

• Evaluating debt and risk

  • Shareholders and lenders assess the level of liabilities relative to equity to understand how much financial risk the business is carrying

  • It can also show whether it is in a position to pay dividends or raise further finance

• Informing operational and strategic decisions

  • Managers use asset, liability and working capital figures to make decisions about investment, resource allocation

  • It can show how efficiently the business is using the capital available to it

Structure of the statement of financial position

• The statement of financial position details the following elements at a specific point in time

An example balance sheet showing key elements

• In this example, drawings refers to the money (capital) removed from the business by its owner(s)

Interpreting the statement of financial position

• By analysing key elements of the statement of financial position, businesses and stakeholders can assess

1. Working capital situation

• Working capital shows whether a company can meet its short-term financial obligations and is calculated using the formula:

$\mathrm{Working}\mathrm{capital}=\mathrm{Current}\mathrm{assets}–\mathrm{Current}\mathrm{liabilities}$

• Positive working capital (more current assets than current liabilities) suggests the business can cover short-term bills from its short-term assets

• Negative working capital can indicate cash-efficient operations (e.g. getting paid by customers before paying suppliers) but may also risk liquidity problems

  • E.g. Tesco plc often has low working capital because it turns over stock quickly and negotiates extended payment terms with suppliers, effectively using supplier credit to fund day-to-day operations

• In the example above the business has working capital of

$$\begin{gathered} \mathrm{Working}\mathrm{capital}=\pounds 23,240-\pounds 11,890 \\ =\pounds 11,350 \end{gathered}$$

2. Level of non-current assets

• A high proportion of non-current assets to total assets indicates a capital-intensive business, common in primary and secondary sector businesses

  • It can offer competitive advantage (e.g. efficient factories), but ties up capital and risks obsolescence

• A low proportion suggests a business owns few non-current assets, common in service or software businesses

  • This reduces depreciation costs but may limit capacity or scalability

• In the example above, the business has a mortgage of £28,000 compared to capital employed of £49,850

3. Gearing

• High gearing (more debt than equity) can boost profits when things go well but risks bankruptcy if income drops

• Low gearing (less debt) makes the business safer but can slow growth because issuing new shares or equity can be costly

4. Level of reserves

• Strong reserves enable a business to pay dividends, fund projects without the need to borrow and absorb unexpected losses

  • They also signal consistent profitability and good financial management

• Low or negative reserves limit dividend payments and may force the business to seek external finance such as loans

  • Depleting reserves can indicate poor business performance and recurring losses

Liquidity and the statement of financial position

• This involves comparing current assets with current liabilities

  • If current liabilities are close to or exceed current assets, the business may struggle to meet short-term obligations (link to the current ratio and acid test ratio)

• In the example above, the business has current assets of £23,240 and current liabilities of £11,890

• Its current ratio is

$$\begin{gathered} \mathrm{Current}\mathrm{ratio}=\frac{\mathrm{Current}\mathrm{assets}}{\mathrm{Current}\mathrm{liabilities}} \\ =\frac{\pounds 23,240}{\pounds 11,890} \\ =1.95:1 \end{gathered}$$

• Its acid test ratio is

$$\begin{gathered} \mathrm{Acid}\mathrm{test}=\frac{\left(\mathrm{Current}\mathrm{assets}-\mathrm{Inventory}\right)}{\mathrm{Current}\mathrm{liabilities}} \\ =\frac{\left(\pounds 23,240-\pounds 9,750\right)}{\pounds 11,890} \\ =1.13:1 \end{gathered}$$

• This indicates a healthy liquidity position

Window dressing

• Window dressing is the use of short-term techniques to make a firm’s financial statements look stronger than they really are, even though the underlying performance hasn’t changed

Common window dressing techniques

Amending the statement of financial position

• Amending a statement of financial position means recalculating figures when a transaction occurs

• Every transaction affects at least two lines - the balance must always be maintained

• The business's liquidity position has improved

• Its current ratio is

$$\begin{gathered} \mathrm{Current}\mathrm{ratio}=\frac{\mathrm{Current}\mathrm{assets}}{\mathrm{Current}\mathrm{liabilities}} \\ =\frac{\pounds 25,730}{\pounds 10,396} \\ =2.47:1 \end{gathered}$$

• Its acid test ratio is

$$\begin{gathered} \mathrm{Acid}\mathrm{test}=\frac{\left(\mathrm{Current}\mathrm{assets}-\mathrm{Inventory}\right)}{\mathrm{Current}\mathrm{liabilities}} \\ =\frac{\left(\pounds 25,730-\pounds 10,200\right)}{\pounds 10,396} \\ =1.49:1 \end{gathered}$$