A balance sheet is one of the three financial statements generally made by companies as part of their financial reporting, the other two being income statement and cash flow statement.
It is not a very intuitive document like the income statement but important nonetheless.
A balance statement is a document that shows the assets, liabilities and equity of a company
Unlike income statement, balance sheet is not made for a period of time but for a set date.
It is a snapshot of company’s capital structure at a specific date.
Balance sheet shows how much the company owns in assets, what kinds of assets it owns, as well as its liabilities and what it owes.
In the end, it follows the basic accounting principle: Assets = liabilities + Shareholder’s equity, or in a more intuitive form, Assets - liabilities = Equity/net worth
A balance sheet looks something like this:
As you see, it is divided into 2 sections. It has assets on one side, and liabilities and shareholders’ equity on the other side. And staying true to its name, it needs to “balance” at the end, meaning the sum at the end is equal on both sides.
Let us start with the basic understanding of the 3 terms:
Assets:
Assets are anything the company “owns”.
They can be anything that the company can use or sell to make money.
Assets are of 2 types: Tangible and intangible assets.
Tangible assets mean physical assets like buildings, plants, land, equipments
Intangible assets are assets which are not physical. They cannot be seen or touched like an actual building but they are still assets because they can be used to make money for the company. Intangible assets includes patents, copyrights, licenses and goodwill.
Liabilities:
Liabilities are anything the company “owes”.
Anything that the company needs to repay.
Liabilities includes the loans the company has taken from banks or by issuing bonds.
Not just debt, liabilities also includes money that the company owes to its vendors, employees, contractors, government, etc.
Equity:
Equity is the net worth of the company. It is a value of the all of the shareholders’ holding in the company.
Equity = Assets - liabilities. This is intuitive to understand since the shareholders own all the assets of the company as well as all its debt. So what remains after repaying all the liabilities is what the shareholders actually own.
Equity has the following major components:
1. Share capital: This is the money that the company’s shareholders have put in the company. or in other words, money that the company raised by selling its equity. (Shown as common stock in the balance sheet above)
2. Retained earnings: This is the money that the company is left with after paying all its expenses, interest, taxes, etc as well as dividends to its shareholders. This is akin to a piggy bank where all the profits of the company that it hasn't used is stored until it finds a good opportunity to use it for. This is real hard cash that the company can use to buy new assets, fix existing assets, or invest in something it sees fit. If the company doesn't reinvest this money, it then belongs to the shareholders to distribute amongst themselves.
Now that you know the 3 basic terms in the balance sheet, there's another thing you may notice if you look at the balance sheet. Both assets and liabilities are divided into 2 sections: Current and non-current.
So what is the difference between a current and non-current asset/liability?
Current means something that can be considered to be with the company only within a financial year.
So, if we are talking about current assets, it means something the company "owns" only during the ongoing financial year while current liabilities are something the company will "owe" during this year.
Current assets includes anything the company expects to own only for that year. This includes:
Its products or raw materials, (together known as inventory)
Money that it is expected to get from its customers (known as accounts receivables
Short term investments which will mature within that year
Cash that the company holds which it will use to buy assets or pay debt in that year.
Prepaid expenses like rent, salaries, etc which it may have already paid.
On the other hand, non-current assets are assets that will stay with the company for longer than a year. So all other assets which the company owns but which are not current are in this category. This includes:
Tangible assets like plant, equipment, buildings as well as long term investments which it may have in stocks, real estate or subsidiaries.
Non-tangible assets like patents, copyrights, licenses and goodwill.
Similarly, current liabilities include money that the company is supposed to pay within that year. This includes:
Money it owes to its vendors & contractors
Employee salaries
Taxes
Short-term loans of a year or less
Money it pays to service its long term debt during that financial year
Non-current liabilities are those liabilities that the company will take more than year to repay such as long term loans and bonds that it may have issued to the public.
Now that we know all the components of a balance sheet, it is important to understand how to make sense of all the numbers. Since we are going to use the balance sheet to analyze a company fundamentally, we should know how a balance sheet can tell us if we should invest in that company or not. The question that we must ask then is:
How to differentiate between a good and bad balance sheet?
The most obvious one is debt. The lower, the better. So we look at the liabilities section and see if it is too high or low compared to the equity and assets.
Current liabilities will remain as a part of daily operations of a company but non-current debt like long term loans is the first thing you should look at. The lower this figure, the better. Ideally, a company should be able to pay off its long term debt with its profits of 3 to 4 years. Look at the trend of long term debt year on year. If the debt is being gradually paid off, it is a good sign
An easy way to look at this is debt to equity ratio. Just divide debt by its equity and you get this ratio. The lower, the better. Compare with companies in the same sector though. Some sectors require more debt than others. Analyze if your company has a lower debt to equity ratio than its competitors.
The second important point to look at is retained earnings. Retained earnings show the company's ability to make real hard cash. The faster it grows, the better.
Bottom line:
Balance sheet shows the company's assets, liabilities and equity.
Lesser the long-term debt, the better.
Retained earnings is an important parameter to look at. The more this is, the better.
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