the meaning and purpose of the statement of financial position

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10.1 Financial Statements – Statement of Financial Position (Balance Sheet)

10.1.1 Meaning & Purpose

  • What it is – a formal, compulsory financial statement required by the Companies Act and the Cambridge 9609 syllabus. It records the business’s financial position **at a single point in time** (the reporting date).
  • Primary purpose – to show the resources owned by the entity (assets) and the claims on those resources (liabilities and owners’ equity). This enables users to assess:
    • Solvency – can the business meet its long‑term obligations?
    • Liquidity – can it meet short‑term obligations?
    • Financial structure – the mix of debt and equity financing.
  • Secondary purposes
    • Provides the basis for key ratio analysis (current ratio, debt‑to‑equity, ROCE, etc.).
    • Links directly to the profit‑or‑loss account through retained earnings.
    • Supplies information for internal decision‑making (budgeting, cash‑flow planning, investment appraisal).

10.1.2 Compulsory Contents (What must be shown?)

Section Headings (minimum requirement) Typical items included
Non‑current assets Property, plant & equipment (net); Intangible assets; Long‑term investments Land & buildings, machinery, patents, bonds held to maturity
Current assets Stock / inventory; Trade receivables; Cash and cash equivalents Finished goods, raw materials, amounts owed by customers, bank balance
Non‑current liabilities Long‑term loans; Deferred tax liabilities Bank loan repayable after 12 months, tax payable on future periods
Current liabilities Trade payables; Short‑term borrowings; Accrued expenses Amounts owed to suppliers, overdraft, wages owing
Equity (Owners’ interest) Share capital; Retained earnings; Other reserves Nominal value of issued shares, accumulated profits, revaluation reserve

All figures must be presented comparatively – the current year’s amounts alongside the previous year’s amounts.

10.1.3 Inventory Valuation

  • Classification – inventory is a current asset and must be measured at the lower of cost or net realisable value (NRV).
  • Methods taught at A‑Level
    • First‑in, first‑out (FIFO) – earliest purchases are considered sold first; the ending inventory consists of the most recent purchases.
    • Weighted‑average cost (WAC) – a single average cost per unit is calculated and applied to all units on hand.
  • Impact on the statements
    • Changes the amount of Cost of Goods Sold (COGS) in the profit‑or‑loss account.
    • Alters the value of “Stock / Inventory” shown under current assets on the balance sheet.
  • Example (FIFO)
    PurchasesUnitsCost per unit
    Jan100£5
    Apr150£6
    Oct120£7

    If 200 units are sold during the year, FIFO records COGS = (100 × £5) + (100 × £6) = £1 100. The ending inventory (70 units) is valued at £7 each = £490.

10.1.4 Depreciation

  • Purpose – to allocate the cost of a non‑current asset over its useful life, reflecting the reduction in economic benefits.
  • Common systematic methods
    • Straight‑line – equal charge each year:
      Depreciation expense = (Cost – Residual value) ÷ Useful life
    • Reducing balance – a fixed percentage of the carrying amount each year (e.g., 20 % of net book value).
  • Effect on the statement of financial position
    • Reduces the **gross carrying amount** of the asset, so the net book value shown on the balance sheet falls.
    • Through the profit‑or‑loss account, depreciation expense reduces profit, which in turn reduces retained earnings – a component of equity.
  • Example (Straight‑line)

    Machine cost £12 000, residual value £2 000, useful life 5 years.

    Annual depreciation = (£12 000 – £2 000) ÷ 5 = £2 000.

    After two years the net book value = £12 000 – (2 × £2 000) = £8 000, which is the amount shown under “Property, plant & equipment (net)”.

10.1 Overall Structure – The Accounting Equation

The statement must always satisfy:

Assets = Liabilities + Equity

Sample Layout (Comparative)

Statement of Financial Position 31 Dec 2024 31 Dec 2023
Assets
Non‑current assets £150 000 £140 000
Current assets £80 000 £70 000
Total assets £230 000 £210 000
Liabilities and Equity
Non‑current liabilities £50 000 £45 000
Current liabilities £30 000 £25 000
Equity
  • Share capital – £100 000
  • Retained earnings – £50 000 (2024) / £40 000 (2023)
 £150 000 £140 000
Total liabilities & equity £230 000 £210 000

How to Read & Analyse the Statement

  1. Check the date – figures relate to a single point in time.
  2. Validate the equation – total assets must equal total liabilities + equity.
  3. Examine asset composition
    • High proportion of current assets ⇒ good short‑term liquidity.
    • Large non‑current assets ⇒ capital‑intensive operation.
  4. Assess liabilities
    • Current liabilities vs. current assets give the current ratio.
    • Significant long‑term debt signals higher financial risk.
  5. Review equity
    • Retained earnings show accumulated profits retained for growth.
    • Changes in share capital indicate new issues or buy‑backs.
  6. Look for year‑on‑year trends – identify improvements or deteriorations in liquidity, solvency and capital structure.

Key Ratios Derived from the Statement of Financial Position

Ratio Formula Interpretation
Current Ratio \(\displaystyle \frac{\text{Current Assets}}{\text{Current Liabilities}}\) Measures ability to meet short‑term obligations; > 1 is generally satisfactory.
Debt‑to‑Equity Ratio \(\displaystyle \frac{\text{Total Liabilities}}{\text{Equity}}\) Shows the proportion of finance supplied by creditors versus owners; higher values indicate greater financial risk.
Return on Capital Employed (ROCE) \(\displaystyle \frac{\text{Operating Profit}}{\text{Total Assets} - \text{Current Liabilities}}\) Assesses efficiency of capital utilisation; the higher the better.

Link with the Profit‑or‑Loss Account

Profit‑or‑Loss Item Effect on Statement of Financial Position
Net profit for the period Added to retained earnings (equity).
Dividends declared Deducted from retained earnings (reduces equity).
Depreciation expense Reduces the net book value of non‑current assets and, via profit, reduces retained earnings.
Inventory valuation adjustment Alters the amount shown as “Stock / Inventory” (current asset) and, through profit, changes retained earnings.

Connection box: Profit → Retained earnings → Equity

Summary

The Statement of Financial Position is a compulsory, comparative financial statement that records a business’s assets, liabilities and owners’ equity at a specific reporting date. It demonstrates the accounting equation, links directly to the profit‑or‑loss account via retained earnings, and is affected by inventory valuation and depreciation. By reading its structure, checking the equation, and applying key ratios, users—both internal and external—can evaluate liquidity, solvency, financial risk and overall business health.

Suggested diagram: a simple balance‑sheet layout with assets on the left, liabilities and equity on the right, and arrows illustrating the accounting equation (Assets = Liabilities + Equity).

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