1.3 Financial Position and The Accounting Equation

The balance sheet follows the double entry concept. The reasoning behind this concept is that for an organisation to have economic resources there must be claims to those resources (capital) and or obligations (liabilities) created in their acquisition. This is the basis of the accounting equation:


As explained above, this equation will always be followed and thus the concept of the 'balance sheet'. For instance, an increase in the value of assets held cannot occur without a corresponding increase in claims to those assets either from the owners (capital) or financiers (liabilities).

Assets are further classified according to their maturity profiles. Those that are likely to be converted into cash within 12 months are termed as current assets. The other class of assets is referred to as noncurrent and will include motor vehicles and equipments such as fridges and cookers.

Owners' claims to assets could either refer to the amounts injected by the owners into the business (share capital) or the excess resources generated by the entity in the past and reinvested in the business (revenue reserves).

Just like assets, liabilities are also classified into two broad categories, short term and long term depending on their age profiles. They are short term where financial obligations are likely to be settled within the next 12 months such as in the case of amounts owed to suppliers (trade payables), short term loans from say banks...

1.3 Financial Position and The Accounting Equation

...and unpaid bills as at the reporting period (accruals). Obligations are long term if their settlement is expected to be done after duration of more than 12 months such as mortgage loans.

Organisation which relies on liabilities to acquire assets are said to be highly levered. This means that their debt obligations are higher than the contributions from the business owners. They are at risk of being wound up by debt holders for failure to honor their obligations to repay loans as per their agreement with lenders. Such companies are therefore regarded as risky for investment. They are also said to have a weak balance sheet.

Strong organisations tend to rely on capital contribution from owners. They also generate excess resources that are ploughed back into the business to support future growth. Such companies have low levels of debt and thus are said to have low leverage. They are attractive to invest in due to their low risk since they have a strong balance sheet.