Statement of financial position | IGCSE Class 10 Business Studies Notes

This note covers the statement of financial position: what it is and when it is prepared, the main classifications of assets (non-current and current, including intangible assets) and liabilities (non-current and current), how equity and the accounting equation fit together, how to read a simple statement of financial position to work out how a business is financed and what assets it owns, what it means when a business sells inventories to raise finance, and the uses and limitations of the statement.

What is a statement of financial position?

A statement of financial position is a financial statement that shows a business's assets, liabilities and equity at one particular point in time, usually the last day of the financial year. It is sometimes still called a balance sheet.

Unlike the income statement, which covers a period of trading, the statement of financial position is a snapshot: it records what the business owns and what it owes on that single date.

Definition: statement of financial position. A statement, prepared at a particular date, which lists a business's assets, liabilities and equity (capital) and shows the financial position of the business on that date.

The statement is built on a simple rule called the accounting equation: what a business owns (its assets) has been paid for either by the owner (equity) or by outsiders (liabilities).

Because of this, the two totals in the statement must always balance, which is why the older name for the document was "balance sheet".

Accounting equation: Assets = Equity + Liabilities

Whenever an item is added to one side of this equation, something of equal value must change on the other side, so the statement always balances.

What are assets, and how are they classified?

An asset is a resource owned or controlled by the business that is expected to bring it future economic benefit. Assets are grouped into two broad classes in a statement of financial position: non-current assets and current assets.

Non-current assets

Non-current assets (also called fixed assets) are resources that a business holds and uses on a long-term basis, not acquired for resale. Examples include land, buildings, plant and machinery, and furniture and fixtures.

These items keep their value to the business over several accounting periods rather than being sold on quickly.

Within non-current assets there is a further category called intangible assets, which have no physical substance but still have value, such as goodwill, patents and trademarks.

There may also be a line for investments, which are funds placed in shares or securities of other organisations; investments are normally shown at cost unless their market value has fallen below cost, in which case a note is usually added.

Current assets

Current assets are assets that are either already cash or are expected to be converted into cash within a year.

Examples include cash in hand and at the bank, amounts owed to the business by customers who bought on credit (called trade receivables), inventories of raw materials, work in progress and finished goods, short-term investments, and amounts paid in advance (prepaid expenses).

Current assets are generally more liquid than non-current assets, meaning they can be turned into cash more quickly.

What are liabilities, and how are they classified?

A liability is an amount that a business owes to an outside party. Like assets, liabilities are split into two classes according to how soon they must be repaid, and this split matters because it tells a reader how soon cash will be needed to clear each debt.

Non-current liabilities

Non-current liabilities are debts that do not have to be repaid within a year of the date of the statement. The main example is a long-term loan from a bank or another financial institution, which the business is expected to repay over several years, often with interest. Because repayment is spread over a long period, a non-current liability is generally seen as a less pressing source of finance than a current liability, even though it usually carries an ongoing interest cost.

Current liabilities

Current liabilities are debts that must be settled within one year, usually out of current assets. Examples include a bank overdraft, bills payable, amounts owed to suppliers for goods bought on credit (called trade payables), short-term loans and outstanding expenses.

A business with a large amount of current liabilities compared with its current assets may struggle to pay its short-term debts on time, so readers of a statement of financial position often compare the two totals before judging how exposed a business is to short-term pressure.

Definition: current liabilities. Liabilities expected to be paid within a year, usually settled out of current assets, such as a bank overdraft, trade payables and short-term loans.

The table below summarises how the main categories that appear in a statement of financial position differ by timeframe, together with typical examples of each, so that the two classes of asset and the two classes of liability can be compared at a glance.

What is equity, and how does drawing affect it?

Equity (also called capital) is the owner's stake in the business. It is calculated as the excess of total assets over total liabilities owed to outsiders.

Equity usually starts as the amount originally invested by the owner and then changes each year: it increases by the profit earned (and any further amounts the owner puts in), and it decreases by any losses and by drawings, which are amounts of cash or goods that the owner withdraws for personal use.

Because drawings reduce the owner's stake in the business, they are shown as a deduction from equity in the statement of financial position rather than as an expense of the business.

Equity therefore appears in the statement as the opening balance, plus profit for the year, less drawings, giving the closing figure carried forward to the next period.

Because equity is worked out from the other two figures on the statement, it is sometimes described as a residual claim: whatever is left of the business's assets once every outside claim (every liability) has been accounted for belongs to the owner.

This also means that equity can fall even when the business is trading well, if the owner withdraws more in drawings during the year than the profit the business earns; a reader comparing two years of statements should check both the profit figure and the drawings figure before judging why equity has changed.

How is a statement of financial position structured and set out?

There is no single compulsory layout for a sole trader's statement of financial position, but most follow the same logic: equity and liabilities are listed on one side (or at the top), and assets on the other side (or below), with the two totals equal.

Items are normally grouped under headings, such as "equity", "non-current liabilities", "current liabilities", "non-current assets" and "current assets", so that a reader can see at a glance which figures belong together.

Grouping items of a similar nature under one heading in this way is known as grouping.

Draw two columns. On the left, list "Equity" (opening capital, plus profit for the year, less drawings), then "Non-current liabilities" (for example a long-term loan), then "Current liabilities" (for example trade payables and a bank overdraft).

On the right, list "Non-current assets" (for example buildings, equipment), then "Current assets" (for example inventories, trade receivables, cash).

Draw a line under each column and write the same total figure at the bottom of both, to show that the statement balances.

Within each section, items are arranged in a deliberate order rather than at random. Arranging assets and liabilities in a particular sequence is called marshalling.

Two common orders are used: in order of permanence, the most long-lasting item is listed first and the most liquid last; in order of liquidity, the order is reversed, so cash and near-cash items are listed first and the most permanent item last.

Either order is acceptable, but a business should apply it consistently from year to year so that figures can be compared.

A business operating internationally, for example a retailer with stores in several countries, still applies the same basic grouping and marshalling logic, classifying items as equity, non-current liabilities, current liabilities, non-current assets and current assets, although the exact presentation can vary between accounting frameworks used in different countries.

How do you interpret a simple statement of financial position?

Interpreting a statement of financial position means reading the figures already given and drawing sensible conclusions from them, rather than preparing the statement from scratch. Two questions the statement helps to answer are how the business is financing its activities, and what assets it actually owns.

How is the business financing its activities?

The liabilities-and-equity side of the statement shows where the money funding the business has come from. A large equity figure relative to liabilities suggests the owner has financed most of the assets themselves.

A large non-current liability, such as a long-term loan, shows that the business is relying on borrowed long-term finance, which usually carries an interest cost.

A business that depends heavily on current liabilities, such as a bank overdraft, is financing itself in the short term, which can be riskier because these amounts fall due quickly.

What assets does the business own?

The assets side shows the mix of resources the business holds. A business with mostly non-current assets, such as buildings and equipment, has invested in long-term capacity.

A business with a large proportion of current assets, especially cash, is holding resources that are readily available to meet short-term needs or to be reinvested.

Worked example 1. An extract from a business's statement of financial position shows: Equity $60,000, Non-current liabilities (long-term loan) $20,000, Current liabilities $20,000, Non-current assets $70,000, Current assets $30,000.

Answer: Total equity and liabilities = $60,000 + $20,000 + $20,000 = $100,000. Total assets = $70,000 + $30,000 = $100,000, so the statement balances.

Most of the finance (60%) has come from the owner's own equity, with the remaining 40% split equally between long-term borrowing and short-term liabilities.

Most of the resources (70%) are tied up in non-current assets, so the business has invested heavily in long-term capacity rather than holding cash or stock.

What does selling inventories to raise finance tell you?

Because inventories are a current asset, converting them into cash by selling them is one of the ways a business can raise finance without taking on new debt or asking the owner for more capital.

If a comparison between two statements of financial position (for example, at the start and end of a period) shows inventories falling while cash has risen by a similar amount, this is evidence that the business has sold off stock and used the proceeds as a source of finance, perhaps to pay a liability or to fund another part of the business.

This kind of deduction has a limit: a fall in inventories combined with a rise in cash could also simply reflect normal trading, where goods are sold at their usual pace during the year.

A reader has to look at the size and timing of the change, and at other figures in the statement, before concluding that inventories were deliberately run down to raise finance rather than sold through ordinary business.

Worked example 2. At the start of the year, Business Z's statement of financial position showed inventories of $25,000 and cash of $4,000. By the end of the year, inventories had fallen to $9,000 and cash had risen to $18,000, while all other current asset and liability figures were unchanged.

Answer: Inventories fell by $25,000 - $9,000 = $16,000, and cash rose by $18,000 - $4,000 = $14,000.

The two changes are close in size, which suggests Business Z deliberately sold off a large part of its inventories during the year and used most of the proceeds to build up its cash balance, rather than this simply reflecting the normal pace of trading.

What are the uses and limitations of a statement of financial position?

Advantages of a statement of financial position

• It shows stakeholders, such as owners, lenders and prospective investors, the business's assets, liabilities and equity at a clear point in time.
• Lenders use it to judge how safe a loan is, by checking how much equity and non-current liability there is backing the business, and how liquid its current assets are.
• Prospective owners use it, together with past profits, as an indication of likely future performance before deciding to invest.
• Comparing statements from one year to the next shows whether assets, liabilities and equity are growing, shrinking or changing in mix, such as more borrowing or more cash.

Limitations of a statement of financial position

• It is a snapshot of a single date; the figures can change significantly the very next day and may not represent a "typical" position.
• Many assets, especially non-current assets such as land and buildings, are recorded at their original cost rather than their current market value, so the statement may understate or overstate what the business is really worth.
• It does not directly show profitability; a business can have a strong statement of financial position yet be struggling to make a profit, or the reverse.
• It does not show non-financial information, such as the skill of the workforce or customer satisfaction, which can matter just as much to the business's future.

How do assets and liabilities fit together in the accounting equation?

Every entry that changes the statement of financial position must keep the accounting equation in balance.

If a business buys a non-current asset for cash, one asset (cash) falls and another asset (the new equipment) rises by the same amount, so the total of assets is unchanged.

If a business takes out a long-term loan, cash (an asset) rises and the non-current liability also rises by the same amount, so the two sides stay equal.

Understanding this equation helps a reader check that a statement of financial position makes sense and explains why the statement always balances.

Equity = Total assets - Total liabilities

So equity can always be worked out even where only the asset and liability totals are given.

The equation also explains why reading one side of the statement is never enough on its own. For example, a business with non-current assets of $90,000 and current assets of $10,000 has total assets of $100,000, but this figure alone does not say whether the business is financed mainly by the owner or mainly by lenders; the liabilities-and-equity side must be read alongside it before any conclusion about how the business is financed can be drawn.

Because every transaction keeps both sides equal, a statement that does not balance signals that an item has been recorded only once, or recorded under the wrong heading, rather than that the accounting equation itself has failed.

Going beyond the syllabus

Businesses sometimes publish ratios calculated from the statement of financial position, such as the current ratio (current assets divided by current liabilities), to judge liquidity more precisely than by inspection alone.

A high current ratio suggests a comfortable ability to pay short-term debts, while a low one is a warning sign.

This kind of ratio analysis builds directly on the classifications of current assets and current liabilities covered above, even though it goes beyond simply reading and interpreting a statement that is already given.

A similar idea applies to the liabilities-and-equity side: comparing total liabilities with total equity gives a rough sense of how dependent a business is on outside finance rather than on the owner's own stake, and it is this comparison, rather than any single figure in isolation, that lenders and prospective owners tend to find most useful when weighing up the risk of investing in or lending to a business.

Glossary

• Statement of financial position: a statement showing a business's assets, liabilities and equity at a particular date.
• Asset: a resource owned or controlled by a business that is expected to bring future economic benefit.
• Liability: an amount owed by a business to an outside party.
• Equity: the owner's stake in the business, equal to total assets minus total liabilities.
• Non-current assets: assets held and used by the business for more than one year, not intended for resale.
• Current assets: assets that are cash or are expected to become cash within one year.
• Intangible assets: assets with no physical substance, such as goodwill, patents and trademarks.
• Non-current liabilities: amounts owed that are not due to be repaid within one year, such as a long-term loan.
• Current liabilities: amounts owed that must be repaid within one year, such as a bank overdraft.
• Inventories: goods held for resale or materials and partly finished goods held for production.
• Trade receivables: amounts owed to the business by customers who bought goods on credit.
• Trade payables: amounts owed by the business to suppliers for goods bought on credit.
• Liquidity: how quickly an asset can be turned into cash without loss of value.
• Marshalling: arranging assets and liabilities in a statement in order of liquidity or permanence.
• Accounting equation: the rule that total assets always equal total liabilities plus equity.

Common errors and misconceptions

• Misconception: The statement of financial position shows how much profit a business made during the year. Correct: Profit is shown in the income statement; the statement of financial position only shows assets, liabilities and equity on one date.
• Misconception: Drawings are an expense of the business and reduce profit. Correct: Drawings are a reduction of the owner's equity, shown as a deduction from capital in the statement of financial position, not an expense.
• Misconception: A bank overdraft is a non-current liability because it relates to a bank loan arrangement. Correct: A bank overdraft is normally repayable on demand and is classified as a current liability.
• Misconception: All long-term resources, such as goodwill, are the same type of non-current asset as machinery. Correct: Goodwill, patents and trademarks are intangible assets, a separate category from tangible non-current assets such as machinery.
• Misconception: A statement of financial position must list items in order of liquidity. Correct: Items may be marshalled in order of liquidity or in order of permanence; either is acceptable as long as it is applied consistently.
• Misconception: A business with a high total of non-current assets is automatically more liquid. Correct: Non-current assets are generally the least liquid items; a business can own valuable non-current assets while having too little cash to pay its short-term debts.
• Misconception: The statement of financial position shows what the business is "worth" to a buyer. Correct: Many assets are shown at original cost, not current market value, so the statement may not reflect the business's true worth.

Exam-style questions with model answers

Q1. State two examples of current assets. [2 marks]

1. Cash at the bank (or cash in hand).
2. Trade receivables (amounts owed by customers), or inventories.

Q2. Define the term "non-current liabilities". [2 marks]

1. Amounts owed by a business that do not have to be repaid within one year of the date of the statement of financial position, such as a long-term bank loan.

Q3. Explain why a bank overdraft is classified as a current liability rather than a non-current liability. [3 marks]

1. A current liability is an amount that must be repaid within one year, and a bank overdraft is normally repayable on demand or at short notice by the bank.
2. Because it can be called in quickly, it does not fit the definition of a non-current liability, which does not fall due within a year.
3. Classifying it as a current liability also warns readers that it is a short-term source of finance, which carries more risk than a long-term loan.

Q4. A business's statement of financial position shows equity of $90,000, a long-term loan of $30,000 and current liabilities of $15,000. Calculate the business's total assets, and explain what the equity figure shows about how the business is financed. [4 marks]

1. Total assets = equity + non-current liabilities + current liabilities = $90,000 + $30,000 + $15,000 = $135,000.
2. Equity of $90,000 is the largest single source of finance, making up two-thirds of the total.
3. This shows the owner has financed most of the business's assets from their own stake rather than from borrowing.
4. Because reliance on borrowed finance is relatively low, the business is less exposed to the risk of having to repay large amounts of debt.

Q5. Explain the difference between non-current assets and current assets, giving one example of each. [4 marks]

1. Non-current assets are resources held and used by the business for more than one year and are not bought for resale, for example machinery.
2. Current assets are cash, or assets expected to be turned into cash within one year, for example inventories or trade receivables.
3. Non-current assets tend to be the least liquid items on the statement, while current assets are generally the most liquid.
4. Because of this difference, the two groups are shown separately so that a reader can judge how much of the business's resources are tied up long term and how much is readily available.

Q6. A business's statement of financial position showed inventories of $40,000 and cash of $6,000 at the start of the year. By the end of the year, inventories had fallen to $18,000 and cash had risen to $27,000, with all other figures unchanged. Explain what deduction can be made from these figures about how the business has financed its activities during the year. [5 marks]

1. Inventories fell by $40,000 - $18,000 = $22,000 over the year.
2. Cash rose by $27,000 - $6,000 = $21,000 over the year, a very similar amount.
3. Because the fall in inventories is close in size to the rise in cash, this suggests the business has sold off a large part of its inventories and used the proceeds as a source of finance.
4. This is a short-term way of raising funds that does not require new borrowing or extra equity from the owner.
5. However, it also means the business now holds much less inventories, which could limit future sales unless stock is replaced.

Q7. Explain two limitations of a statement of financial position as a source of information for a prospective owner. [4 marks]

1. It is only a snapshot of one date, so the figures could look quite different only a few weeks later.
2. This means a prospective owner cannot be certain the position shown is typical of the business throughout the year.
3. Many non-current assets are shown at their original cost rather than their current value, so the statement may not reflect what the business is really worth.
4. This could lead a prospective owner to over-value or under-value the business if they rely on the statement alone.

Q8. Business Y's statement of financial position showed the following at the end of two years. Year 1: Equity $50,000, Non-current liabilities (long-term loan) $40,000, Current liabilities $10,000, Non-current assets $70,000, Current assets $30,000. Year 2: Equity $65,000, Non-current liabilities (long-term loan) $25,000, Current liabilities $20,000, Non-current assets $85,000, Current assets $25,000. Explain what this statement tells you about how Business Y is financed and what assets it owns, and comment on any change between the two years. [6 marks]

1. In Year 1, equity of $50,000 and a long-term loan of $40,000 together make up most of the finance, with current liabilities of only $10,000.
2. In Year 2, equity has risen to $65,000 while the long-term loan has fallen to $25,000, so the business relies less on borrowed long-term finance and more on the owner's own stake.
3. Non-current assets have risen from $70,000 to $85,000, showing the business has invested further in long-term resources such as equipment.
4. Current assets have fallen slightly from $30,000 to $25,000, which, together with the fall in the loan, could suggest some current assets, such as inventories or cash, were used to help repay part of the loan.
5. Overall, the business appears to be moving to a more secure financing position, relying less on debt and more on equity.
6. Because the figures are only for two single dates, this conclusion should be checked against other information, such as the business's profit for each year.

Key takeaways

• A statement of financial position shows assets, liabilities and equity at one date, not performance over a period.
• Assets split into non-current assets, including intangible assets, and current assets such as inventories and trade receivables.
• Liabilities split into non-current liabilities, such as long-term loans, and current liabilities, such as bank overdrafts.
• Equity equals total assets minus total liabilities, and is reduced by drawings.
• The accounting equation, assets equal equity plus liabilities, means the statement must always balance.
• Items can be marshalled in order of liquidity or permanence, applied consistently.
• A fall in inventories matched by a rise in cash can suggest inventories were sold to raise finance.
• The statement has limitations: it is only a snapshot, and non-current assets are often shown at original cost.

Test yourself

What is the difference between a non-current liability and a current liability?

A non-current liability does not have to be repaid within a year, such as a long-term loan. A current liability must be repaid within a year, such as a bank overdraft.

Give one example of an intangible asset.

Goodwill, a patent or a trademark; all have value but no physical substance.

How is equity calculated from the other figures in the statement?

Equity equals total assets minus total liabilities; it is also increased by profit and reduced by drawings each year.

Why might a business with a large bank overdraft be seen as more financially risky?

A bank overdraft is a current liability repayable on demand, so the business could be asked to repay it at short notice, which is riskier than long-term finance.

What does marshalling in order of permanence mean?

Listing the most long-lasting asset or liability first and arranging the rest in decreasing order of how long they will remain in the business.

If inventories fall sharply and cash rises by a similar amount, what might this suggest?

That the business sold off a large part of its inventories and used the cash raised as a source of finance.

Name one limitation of using a statement of financial position to judge how much a business is worth.

Non-current assets are often shown at their original cost rather than their current market value, so the figure may not reflect true worth.

Why does a statement of financial position always balance?

Because of the accounting equation: every asset has been financed either by the owner's equity or by liabilities, so the two totals must be equal.