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What is a Balance Sheet?
A balance sheet, also called a "statement of financial position", reveals a company's assets, liabilities and owners' equity (net worth). The balance sheet, together with the income statement and cash flow statement are used to identify/gauge a company’s financial status or position. If you are a shareholder of a company, it is important that you understand how the balance sheet is structured, how to analyze it and how to read it.
How the Balance Sheet Works
The balance sheet is divided into two parts that must equal each other, or balance each other out. The main formula behind balance sheets is:
Assets = Liabilities + Shareholders' Equity
This means that assets, or the monetary means used to operate the company, are balanced by a company's financial obligations along with the equity investment brought into the company and its retained earnings.
It is important to note that a balance sheet is a snapshot of the company’s financial position at a single point in time.
What is an Asset?
Assets are what a company uses to operate its business. Some examples of assets are bank balance, factory building, cash to be received in return for services offered etc.
Types of Assets:
Basically there are two main types of assets:
• Current Assets
o Current assets have a life span of one year or less, meaning they can be converted easily into cash. Such assets classes include cash and cash equivalents, accounts receivable and inventory.
o Cash, the most fundamental of current assets, also includes non-restricted bank accounts and checks.
o Cash equivalents are very safe assets that can be readily converted into cash; U.S. Treasuries or Reserve Bank of India Bonds are examples of this type.
o Accounts receivables consist of the short-term obligations owed to the company by its clients. Companies often sell products or services to customers on credit; these obligations are held in the current assets account until they are paid off by the clients.
o Lastly, inventory represents the raw materials, work-in-progress goods and the company’s finished goods.
o Depending on the company, the exact makeup of the inventory account will differ. For example, a manufacturing firm will carry a large amount of raw materials, while a retail firm caries none. The makeup of a retailer's inventory typically consists of goods purchased from manufacturers and wholesalers.
• Non-Current Assets
o Non-current assets are assets that are not turned into cash easily, are expected to be turned into cash within a year and/or have a life-span of more than a year.
o They can refer to tangible assets such as machinery, computers, buildings and land.
o Non-current assets also can be intangible assets, such as goodwill, patents or copyright.
o While these assets are not physical in nature, they are often the resources that can make or break a company - the value of a brand name, for instance, should not be underestimated.
Depreciation is calculated and deducted from most of these assets, which represents the economic cost of the asset over its useful life. For ex: A machine bought for Rs. 10 lakhs last year may not be worth the same this year. This year it may be worth only Rs. 9 lakhs and this 1 lakh decline in value is the depreciation
What is a Liability?
Liabilities are what a company has to pay in order to operate its business. Some examples of liabilities are, loan EMI, cost of raw materials, employee salary etc.
Types of Liabilities:
• Long-term liabilities are debts and other non-debt financial obligations, which are due after a period of at least one year from the date of the balance sheet.
• Current liabilities are the company’s liabilities which will come due, or must be paid, within one year. This is includes both shorter term borrowings, such as accounts payables, along with the current portion of longer term borrowing, such as the latest interest payment on a 10-year loan.
What is Shareholders' Equity
Shareholders' equity is the initial amount of money invested into a business. If, at the end of the fiscal year, a company decides to reinvest its net earnings into the company (after taxes), these retained earnings will be transferred from the income statement onto the balance sheet into the shareholder’s equity account. This account represents a company's total net worth. In order for the balance sheet to balance, total assets on one side have to equal total liabilities plus shareholders' equity on the other.
A Sample Balance Sheet:
Below is an example of a balance sheet:
As you can see from the balance sheet above, it is broken into two sides. Assets are on the left side and the right side contains the company’s liabilities and shareholders’ equity. It is also clear that this balance sheet is in balance where the value of the assets equals the combined value of the liabilities and shareholders’ equity.
Another interesting aspect of the balance sheet is how it is organized. The assets and liabilities sections of the balance sheet are organized by how current the account is. So for the asset side, the accounts are classified typically from most liquid to least liquid. For the liabilities side, the accounts are organized from short to long-term borrowings and other obligations.
Analyzing the Balance Sheet
Now that we know how a balance sheet looks and how it is organized, the next step is to analyze a company’s balance sheet. Doing so, would give us a fair idea of how the company is performing and how strong it is financially.
We use financial ratios to analyse and gain insight into the company and its operations.
Ratios like “debt to equity ratio” can show us a better picture of the company’s financial condition and its operational efficiency.
What are Financial Ratios?
A financial ratio is a relative magnitude of two selected numerical values taken from a Company’s Financial Statements. There are many standard ratios that can be used to evaluate the overall financial condition of a company. Financial ratios can be used by managers of a firm or shareholders (both current and potential) or banks or anyone else to gauge the financial strength of the company. They can be used also to compare the strengths and weaknesses of two or more organizations.
For Ex: If I were to buy a banking stock from the Indian stock market, I can compare the financial ratios of a few of the country’s leading banks like ICICI, HDFC, SBI etc and then choose the one which I feel has the most impressive financial background and strengths.
Types of Ratios:
There are many different types of financial ratios that can be calculated based on their purpose. They include:
1. Liquidity Ratios – Ability of the company to pay off debt
2. Activity Ratios – How quickly a firm can convert its non-cash assets to cash assets
3. Debt Ratios – Ability of the firm to repay long-term debt
4. Profitability Ratios – To Measure the firms use of its assets and control of its expenses to generate an acceptable rate of return
5. Market Ratios – To Measure the investor response to owning a company’s stock and also the cost of issuing stock
You can visit each of these articles and understand them better.
Note: These articles contain extensive explanations reg. each of these ratios and you can understand them better by reading them.
I hope this article was useful.