The balance sheet of a company summarises its financial position. It presents an account of where a company has obtained its funds and where it has invested them.
Companies receive funds from two sources – lenders and shareholders. The amount invested by shareholders is called equity and the amount borrowed from lenders is called debt. Debt, combined with the company’s other financial obligations is called liability.
Companies invest their equity and borrowings in assets that help them generate revenue. Thus, a company’s liabilities and equity must equal its assets. This gives you the basic equation that is key to understanding what balance sheets is:
Assets = Liabilities + Equity
Sample Format of a Balance Sheet
There are many company balance sheet formats, which help understand its assets and liabilities and other essential things. The format of company balance sheet is categorised as classified, comparative, common size and vertical. The old format of the balance sheet, as shown in figure 1 is known as T-shaped or horizontal format
The new format of balance sheet of a company is known as the vertical format (Figure 2). In this format, equities and liabilities are at the top along while assets are at the bottom.
However, as per amendment in the Companies Act 2013 in 2017, every firm must make its balance sheet as per the format prescribed in Schedule III. You can access more information on the same on the website of Ministry of Corporate Affairs.
How to read a company balance sheet?
For understanding the balance sheet, it is important to first understand its structure. As the equation shows, the balance sheet of a company has two sections:
Liabilities and equity, i.e. sources of funds
Assets or uses of funds
The assets side shows what a company owns, and the liabilities side shows what the company owes. Assets and liabilities are either ‘long-term’ or ‘current’.
Long-term assets and liabilities stay with the company for more than a year. Current assets and liabilities normally have a life of less than one year.
The balance sheet generally starts with sources of funds. It shows all the current liabilities of the company, followed by its long-term debt and other long-term liabilities.
Equity is the next item on the balance sheet of a company. It is also a kind of liability, but it is presented separately because unlike debtors, shareholders are owners of the company. They have more vested interest in the company than debtors. This makes their investment riskier and entitles them to more rights in the company.
The uses of funds section of the balance sheet consist of all the assets of the company. It starts with current assets and then reports long-term (or fixed) assets.
|Balance Sheet of ABC Limited||As at 31st December, 2016|
SOURCES OF FUNDS (LIABILITIES)
|Short Term Debt||[xx]|
|Current Portion of Long Term Debt||[xx]|
|Other Current Liabilities||[xx]|
|Total Current Liabilities||[xxx]|
|Other Long-Term Liabilities||[xxx]|
|Total Liabilities and Equity||[xxxx]|
|USES OF FUNDS (ASSETS)|
|Cash and Cash Equivalents||[xx]|
|Other Current Assets||[xx]|
|Total Current Assets||[xxx]|
|Plant, Machinery, and Equipment||[xx]|
|Other Fixed Assets||[xx[|
|Total Fixed Assets||[xxx]|
|Less: Accumulated Depreciation||[xx]|
|Net Fixed Assets||[xxx]|
Understanding what a company owes is the starting point of balance sheet analysis. All outstanding financial obligations of a company are its liabilities. Long-term liabilities mostly include debt that the company has raised for more than five years. It can be in the form of money borrowed from a bank or funds raised through the sale of bonds (i.e. debentures).
Current liabilities include the following:
Short-term debt and current portion of long-term debt, i.e. funds borrowed for less than one year and the portion of long-term borrowings that is to be repaid within one year.
Accounts payable. the amount yet to be paid to suppliers for materials supplied by them.
Accrued liabilities. the service that a company is yet to render, but for which it has already been paid
Equity or stocks provide their holders ownership interest in the company. Equity capital is initially brought in by the company’s promoters. As the business grows, it requires more funds.
Promoters sell some shares to investors or the general public to raise these funds. These shares are sold at a higher price or a premium on the original. The equity value you see on the balance sheet of a company is based on the original price. It is known as the book value of equity.
The premium is also mentioned in the shareholders’ equity section of the balance sheet. Some other important components of equity are:
Retained earnings or the proportion of a company’s net income that hasn’t been distributed to shareholders.
Capital reserve, i.e. the part of their retained earnings set aside to invest in fixed assets in future.
Reserves and surplus, i.e. funds set aside to meet other future requirements
Assets are the heart of a business. This is where you should spend most of your time when doing a balance sheet analysis. Anything a company owns, tangible or intangible, that can generate revenue in the future, is its asset.
Accounting standards require that a possession be recognised as an asset only if its value can be measured reliably and if it can be sold separately.
In addition to tangible or ‘hard’ assets, like land and machinery, companies own several intangibles that qualify as an asset. These include patents, copyrights, and trademarks. These cannot be touched or felt, but they can generate revenue, be valued reliably, and be sold separately.
Companies record assets as ‘current’ and ‘fixed’ on the balance sheet. Fixed assets include plant & machinery, land, and building etc. All fixed assets, apart from land, lose value over time. This loss in value is called depreciation.
It is reported as an expense on the income statement each year. The value at which a fixed asset is recorded on the balance sheet is the differences between its purchase price and the total depreciation charged till the balance sheet date.
For intangible assets, the annual loss in value is called amortization. It is treated identically to depreciation.
Current assets include the following:
- Short-term investments in financial products, such as commercial papers, t-bills and certificates of deposit (CDs).
- Inventoryof unsold goods, raw material, and unfinished goods
- Accounts receivable, i.e. the amount the company is yet to receive for the goods it has sold on credit
None of these assets is depreciated.
Importance of a Balance Sheet
A company balance sheet is of tremendous importance, and its analysis reveals a lot of information about a firm’s overall performance. By analysing the components of balance sheet you can:
- Understand the company’s financial health
- Measure its growth
- Gauge the business performance and liquidity position of an enterprise
- Find out if a company is funding its operations with profit or debt and how likely it will meet its target for projects
How to Prepare a Balance Sheet?
Preparing balance sheet of a company is a job filled with responsibilities as a lot depends on it. For a business to know what it owns and what it owes, it’s vital to prepare it with due diligence. While the format is given in Schedule III of Companies Act 2013, before preparing:
- Find out the frequency of preparation. Generally, a company balance sheet is prepared quarterly or annually
- Have a correct estimate of assets and liabilities
- Calculate shareholder’s equity
- Prepare it by listing shareholder’s equity, liabilities and then the assets. Note that assets should match shareholder’s equity and liabilities
Seek help from concerned people if you are not sure about any of the components of balance sheet.
The bottom line
The balance sheet is the most important source of information about a company’s financial health. This makes reading the balance sheet one of the most important skills you need as an investor.
It appears challenging with all the jargons, but these jargons are really not as complicated as they sound. Balance sheet analysis is fairly straightforward once you know their meaning.
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