Understanding the Balance Sheet of a Business: A Case Study of XYZ Ltd.

 

Understanding the Balance Sheet of a Business: A Case Study of XYZ Ltd.

In this blog post, we will analyze the balance sheet of XYZ Ltd., focusing on its assets, liabilities, liquidity, and shareholders' equity. This case study provides valuable insights into how the balance sheet is structured and how key financial figures are calculated. Let’s break down the financials and key takeaways step by step.

Step 1: Breakdown of the Assets

Fixed Assets (Non-Current Assets):

Fixed assets are long-term resources that the company uses in its operations, typically with a lifespan longer than one year. Here are the details for XYZ Ltd.:

• Building: £400,000
• Machinery: £58,000
• Trade Name: £80,000

Total Fixed Assets = £538,000

Current Assets:

Current assets are short-term resources expected to be used or converted into cash within one year. XYZ Ltd. has the following current assets:

• Cash at Bank: £15,000
• Customer Debts: £210,000
• Work in Progress (WIP): £280,000

Total Current Assets = £505,000

Step 2: Breakdown of the Liabilities

Current Liabilities:

Current liabilities are short-term debts and obligations due within one year. XYZ Ltd. has the following:

• Supplier Invoice: £183,000
• Customer Deposits: £150,000
• Bank Overdraft: £135,000

Total Current Liabilities = £468,000

Fixed Liabilities (Long-Term Liabilities):

Fixed liabilities are obligations that extend beyond one year. XYZ Ltd.'s long-term liabilities include:

• Bank Loan: £350,000
• Warranty Claim: £25,000
• Loan from Shareholder: £65,000

Total Long-Term Liabilities = £440,000

Step 3: Net Assets

The Net Assets of the company represent the difference between total assets and total liabilities:

• Total Assets = Fixed Assets + Current Assets = £538,000 + £505,000 = £1,043,000
• Total Liabilities = Current Liabilities + Long-Term Liabilities = £468,000 + £440,000 = £908,000

Net Assets = £1,043,000 - £908,000 = £135,000

This shows the company's financial strength, with positive net assets indicating that it has more assets than liabilities.

Step 4: Liquidity

Liquidity measures a company's ability to cover its short-term obligations. It is calculated as the difference between current assets and current liabilities:

• Liquidity = Current Assets - Current Liabilities
• Liquidity = £505,000 - £468,000 = £37,000

XYZ Ltd. has a positive liquidity of £37,000, meaning it can comfortably meet its short-term debts with the available assets.

Step 5: Shareholders' Equity

The Shareholders' Equity represents the ownership value of the company, which is composed of share capital, retained earnings, and reserves:

• Share Capital: £1
• Accumulated Profit and Loss: £134,000
• Reserves: £0

Total Equity (Shareholders' Equity) = £1 + £134,000 = £134,001

This reflects the value of the company owned by its shareholders, which in this case is £134,001.

Balance Sheet Summary

Assets	£	Liabilities	£
Fixed Assets	538,000	Current Liabilities	468,000
- Building	400,000	- Supplier Invoice	183,000
- Machinery	58,000	- Customer Deposits	150,000
- Trade Name	80,000	- Bank Overdraft	135,000
Total Fixed Assets	538,000	Total Current Liabilities	468,000
Current Assets	505,000	Long-Term Liabilities	440,000
- Cash at Bank	15,000	- Bank Loan	350,000
- Customer Debts	210,000	- Warranty Claim	25,000
- Work in Progress (WIP)	280,000	- Loan from Shareholder	65,000
Total Current Assets	505,000	Total Long-Term Liabilities	440,000
Total Assets	1,043,000	Total Liabilities	908,000
Net Assets	135,000	Shareholders' Equity	134,001
Liquidity	37,000

1. Comment on the Liquidity and Solvency of the Company

Liquidity:

Liquidity refers to a company's ability to meet its short-term obligations using its short-term assets. The company’s liquidity is represented by its current ratio (current assets divided by current liabilities) and the absolute liquidity (cash minus current liabilities).

From the balance sheet:

• Current Assets = £505,000
• Current Liabilities = £468,000
• Liquidity = £505,000 - £468,000 = £37,000

This suggests that the company has a positive liquidity position, meaning it has enough short-term assets to cover its short-term liabilities. 

Solvency:

Solvency refers to a company’s ability to meet its long-term obligations. The company’s solvency can be assessed by looking at its net assets and long-term liabilities.

• Net Assets = £135,000
• Long-Term Liabilities = £440,000

The company’s solvency position is negative, meaning it has more long-term liabilities than its net worth (equity). This suggests the company may face challenges in the long term if it cannot generate enough income to cover its debts.

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Customer Default (Scenario B)

• Customer Debts: Reduced from £210k to £165k due to the £45k unpaid bill.
• Current Assets: Reduced from £505k to £460k.
• Liquidity: $460k - 468k = -£8k$ (negative liquidity indicates the company is unable to meet short-term obligations with current assets).
• Net Assets:

$$\text{Net Assets} = (\text{CA} + \text{FA}) - (\text{CL} + \text{TL}) \\ = (460k + 538k) - (468k + 440k) = -£90k$$

The net assets have decreased due to the loss, but the company still shows accumulated profit and loss of £135k, which indicates a strong operating position. Despite the loss, the company remains solvent and can continue trading.

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New Shareholder Investing £300k in Newly Issued Shares

If the company issues new shares to the new shareholder:

• Cash at Bank: Increases from £15k to $15k + 300k = £315k$.
• Current Assets: Increase due to the cash injection. $$\text{Current Assets} = 315k \text{ (Cash)} + 165k \text{ (Customer Debts)} + 280k \text{ (WIP)} = £760k$$
• Fixed Assets: Remain unchanged at £538k.
• Current Liabilities: Remain unchanged at £468k.
• Total Liabilities: Long-term liabilities also remain unchanged at £440k.
• Liquidity: Improves significantly: $$\text{Liquidity} = 760k - 468k = £292k$$
• Net Assets: $$\text{Net Assets} = (\text{CA} + \text{FA}) - (\text{CL} + \text{TL}) \\ = (760k + 538k) - (468k + 440k) = £390k$$
• Shareholders’ Equity: Reflects the new investment. $$\text{Shareholders’ Equity} = 300k \text{ (New Equity)} + 89k \text{ (Accumulated Profit and Loss)} + 0 \text{ (Reserves)} = £390k$$

This scenario significantly improves liquidity and turns net assets positive, making the company more attractive to potential lenders and investors.

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Shares Purchased from an Existing Shareholder

f the new shareholder purchases the shares from an existing shareholder instead of the company issuing new shares:

• Cash at Bank: Unchanged at £15k.
• Current Assets: Remain £460k.
• Fixed Assets: Remain £538k.
• Current Liabilities and Total Liabilities: Unchanged.
• Net Assets: $$\text{Net Assets} = (\text{CA} + \text{FA}) - (\text{CL} + \text{TL}) \\ = (460k + 538k) - (468k + 440k) = -£90k$$

In this case, the company sees no financial benefit from the transaction because the cash goes directly to the existing shareholder, not into the business. The balance sheet remains unchanged, and the company continues to have negative net assets.

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Bank’s Reaction to a £300k Loan Request

Scenario A: New Shares Issued

If the new shareholder invests £300k via newly issued shares:

• The company’s liquidity improves to £292k.
• Net assets are now positive at £390k.
• This improved financial position makes the company more attractive to the bank. The bank is likely to approve the loan at favorable terms because:
  • The company has sufficient liquidity to handle short-term obligations.
  • Positive net assets indicate solvency.
  • The equity injection shows that investors have confidence in the company.

Scenario B: Shares Purchased from an Existing Shareholder

If the shares are purchased from an existing shareholder:

• Liquidity remains negative at -£8k.
• Net assets remain negative at -£90k.
• In this scenario, the bank is less likely to approve the loan or may impose stricter conditions, such as:
  • Higher interest rates to compensate for risk.
  • Additional security or guarantees to back the loan.
  • A smaller loan amount or shorter repayment term.

The negative net assets and weak liquidity suggest financial vulnerability, making the company a less attractive borrower.

Conclusion

• The customer default reduces liquidity and worsens the company’s net asset position, highlighting the importance of effective receivables management.
• If new shares are issued, the company gains a significant financial boost, improving liquidity and solvency, making it more likely to secure favorable terms for a bank loan.
• If shares are purchased from an existing shareholder, the company does not benefit financially, leaving its position weak and reducing the likelihood of securing a bank loan.
• For the company to succeed in obtaining a bank loan, it is critical to ensure positive liquidity and net assets, which can be achieved by issuing new shares or demonstrating strong operating performance.

Pooja Mattapalli