Abstract

Financial statements are a structured presentation of financial information about the firm over/at a point of time in standard formats and consistent terms. Normally there are three types of statements prepared by the accounts branch of a firm

Balance SheetIncome/Profit & Loss StatementCash Flow Statement

Though inter-related and using the same information, all three statements have different formats with different emphasis. Thus the Balance Sheet depicts the liquidity position of the firm, the Income statement shows its Profitability position. On the other hand, Cash Flow Statement reveals its Solvency position.

In other words, the Profit & Loss account measures financial performance over the year whilst the Balance Sheet states the financial position as at the year-end. Cash Flow statement explains the sources of funds generation and heads of their spending.

This article explains what is a balance sheet, how it is presented, how to read it, and what are its limitations

What is a Balance Sheet

The Balance Sheet of a business organisation is the structured presentation of its assets and liabilities in a standard format- how much it owns (assets) and how much it owes to others (liabilities). Always presented on a given date every year in a standard format, it uses consistent well-defined terminology for ease of historical comparison and contrast with the competitors.

Liabilities show the sources of the funds while assets show the uses of these funds. Assets and liabilities can be short term (less than one-year maturity) or long term (more than one-year maturity). Long term liabilities ideally financed by long term assets. Covering long term liabilities with short term assets is recipe for disaster

Importance of a Balance Sheet

Presents the static picture of the short term liquidity status of the firm; can it pay its debts right now if needed?Also shows the long-term financial health of the firm. Is it viable and competitive in the long run?Depicts the operating performance of the firm. How well in managing resources, reducing costsAlso, the test of management performance-too many inventories? Too many receivables?Used for historical comparison (are we doing well over years?)As well as cross-company analysis (how we compare with our competitors in particular and the industry in general)

The Balance Sheet statement- Who needs it and why?

Although preparation and publication of financial statements is a legal requirement, it has multiple uses. Its multiple stakeholders want to know 

Owners: to know how the business is going, how much profit they are earning, who is getting what out of this profit margin, etc. What is happening to my equity?Management: to keep track of the business and carry out timely corrective measures. How is our firm doing? Directors need to control the overall performance of the company and make strategic financing and investment decisions. Middle management needs feedback on whether they are meeting their financial targets.Lenders: to know whether you are worth lending money or not.Competitors: to know where you stand vis a vis them. And if you are a success, then naturally they will like to know the secrets of your success for obvious reasons. Why you are more successful?Government: to tax more or to give generous allowances to the industry as a whole if it realises the importance of the industry for the realisation of its overall national vision.Employees: to know whether we are getting an equitable share in the cake we made. Are our pension contributions safe or being squandered on frivolous heads? What will happen to our bonuses? To our pension funds?Suppliers: to assess the creditworthiness of potential and existing customers to make a decision whether to sell goods and services to you or not and the amount and period of credit allowed. No one would like to supply goods to a firm that is likely to sink under its debt burden.Customers: to minimize the risk of their supplies drying up and disrupting their own output. Firms entering a joint venture will also need mutual reassurance.Civil Society Organisations/Media: to know what is happening to the business as it will affect the working of the national economy and in turn, will affect the quality of life of the citizens.Shareholders: to know your firm’s performance to decide whether to purchase more shares or sell the present ones?Firms entering a joint venture will also need mutual reassurance.

Format of a Balance Sheet

Every Balance Sheet of a firm has two parts, one showing what it owes(Liabilities) and the other showing what it owns(Assets)

Liabilities

Owners’ CapitalEquityReserves/SurplusBorrowers’ FundsLong Term DebtShort Term DebtWorking CapitalCreditorsProvisions

Assets

Fixed AssetsLand and BuildingPlant/machineryInvestmentsBonds,shares,government securitiesWorking CapitalRaw materialFinished goods inventoryDebtorsCash

How to Read a Balance Sheet?

Note the date on the top. By convention, these balance sheets are issued on one of the following dates-31st March/30th June /30th September or 31st December

While preparing for internal use the Accounts Branch uses a horizontal format Liabilities are shown on the left side while assets are shown on the right side. However, when releasing publicly, the format is changed to vertical format, showing the balance sheets in four Columns- Present year / last year / Changes / Reference number for an explanation. This change in the format of presentation of Assets / Liabilities is by convention for comparison purposes

Changes in the values of assets and liabilities are expressed in monetary terms i.e., $ or £, and not in percentage terms. However, while taking decisions based on this information, managers do use percentages. Last column-numbers in parenthesis refer to explanatory notes attached

Reading a Balance Sheet-Assets

Balance Sheet starts with the Assets- the first column shows what the company owns now and the second column shows what it owned last year. The third column is the difference between the two and the last column refers to the number of the explanatory note where you can find out the reason if any for any change or any other necessary information.

Assets are again by convention presented in ascending order of liquidity or ease of sale. For example, cash in the current account of a firm is more liquid and is shown as the first entry; finances used for the purchase of long-term government bonds are not so easy to en-cash; hence they come later. Buildings are hard to sell even in a short period; they are shown at the last and so on. Two conventions are strictly followed while showing the value of the assets to observe the principle of prudence

if the present market price of an asset is higher than the price it was purchased initially a few years ago, then its purchase price is shown as its current value irrespective of the fact that it has risenif the present market price of the asset is lower than the purchase price, then its estimated current market price is shown here

Keeping the above clarifications in view we can read the balance sheet as follows

Cash-checking account/very short term securitiesMarketable Securities-short term investments i.e. CDs(Banks), T-bills (Government), Commercial Papers(MNCs)Account Receivables-goods sold on credit minus bad debtsInventories-Finished goods, work in progress, raw materialTotal Current Assets- Add all the aboveInvestments including Intangible Assets-totally owned subsidiaries, partial equity in other firms, patents, goodwill, copyrights, trademarksFixed (tangible) Assets-more than one-year maturity-land, buildings, machinery, equipment, vehiclesGross book Value-add themAccumulated Depreciation- Accounting purposesNet Book Value-after deducting accumulated depreciationTotal Assets- Current Assets Investment Net book value 

Reading a Balance Sheet-Liabilities

Liabilities show what a firm owes to others, also presented in ascending order, starting with less than one-year maturity

Accounts Payables-normally 30 to 60 days’ creditBank Notes-short term loans from banks/creditorsOther Current Liabilities-result of accruals i.e. unpaid salaries/wages/interest/taxes for the remaining periodCurrent Portion of Long Term Liabilities-Long term debts nearing maturityTotal Current Liabilities-Add all the aboveLong Term Debt-more than one-year maturity-debentures, mortgages, bondsTotal Liabilities-add the current liabilities and the long term debtPreferred Stock-who provided the initial capitalCommon Stock-who bought the sharesRetained Earnings-profits ploughed back increase stockholders’ equityTotal Liabilities and Stock Holders Equity- add the above

How to Interpret a Balance Sheet?

Balance Sheet shows the liquidity position of the firm- its ability to pay off all liabilities if assets have to be sold. For this purpose, we use ratios. Ratios are the quotient of a number or sum of numbers divided by another numerical value. Ratios tell you the relationship among selected items of the financial statement data. Once calculated, we use the results to compare our performance at three levels

Horizontal Performance: We compare these ratios with past ratios of the firm to assess whether we are improving over time, stagnant, or worsening.Comparative Performance: we compare these ratios with our close competitors to find whether we are doing better or worse or equally as compared to our rivals in the field.Vertical/Positional Performance: we compare these ratios with the industry ratios and find out where do you stand in terms of the overall marketplace. Are we at the bottom in terms of operational efficiency or in the top few? Or just average?

Some of the most important ratios used to interpret the Balance Sheet of a firm are Liquidity Ratios and the Solvency Ratios.

Liquidity Ratios

There are two ratios to ascertain the liquidity position of the business firm

Current Ratio

This is calculated by dividing the current assets of the firm by the current liabilities i.e.

Current Assets/Current Liabilities

This ratio measures the short-term liquidity position of the firm in the sense that if the firm has to clear its liabilities in an emergency due to any reason such as a court order, will it be able to do so by disposing of its current assets? Because current assets by definition mean they are very liquid and can be sold/disposed of easily-cash in hand, current account in a bank, short-term government bonds, etc. For example, a firm with a current ratio of 1.5:1 has US$ 1.5 in assets while its liabilities are only one US$. Not bad. However, a firm with a current ratio of 2.5:1 has US$ 2.5 for every one dollar of liability. It is in a more comfortable position

Working Capital

This is calculated by simply deducting the total current liabilities from its total current assets i.e.

Total Current Assets-Total Current Liabilities

Strictly speaking, it is not a ratio in the technical sense, rather a difference but is known as a ratio by the GAAP tradition. It tells you the position of the working capital at the disposal of the firm for running its business operation.

Solvency Ratios

There are three ratios to check the solvency position of the firm

Debt Equity Ratio (Leverage Ratio )

It is calculated by dividing the total liabilities of a firm by its total equity of the shareholders i.e.

Total Liabilities/Total Equity

Also known as the Leverage Ratio, it compares the ratio of the liabilities vis a vis the equity of the shareholders invested in the firm. Obviously, shareholders will like to have as lower debt as possible because, in the case of liquidation of the firm, they will get back whatever is left after paying the debts. Thus a smaller Debt to Equity Ratio is preferable i.e. 0.90:1 is better than 1.2:1

Debt Asset Ratio

It is calculated by dividing the total liabilities of a firm by the total assets it owns and expressed as a percentage by multiplying it with 100.

Total Liabilities/Total Assets x 100

Written as a percentage, it shows the % share of assets owed to lenders says as collateral. A lower percentage is preferred because, in case of liquidation of the firm, the lenders will demand the clearance of their debts from the sale proceeds of the assets and only leftover will be available for distribution among the shareholders.

Equity Asset Ratio

This is calculated by dividing the total equity capital invested by the shareholders by the total assets owned by the firm at the end of the year and expressed as a percentage by multiplying it by 100 i.e.

Total Equity/Total Assets x 100

Expressed as %, it shows the share of owners in the assets. In case these are to be sold and after paying the liabilities, these will be distributed according to their respective share

Limitations of the Balance Sheet

The balance sheet as published does not show the value of a business or what a company’s shares are worth because some assets are not disclosed in a balance sheet, namely internally generated goodwill, and workforce skill. Items are usually valued at their cost when purchased although their prices may have gone up due to inflation/scarcity. For this current cost accounting is more suitable i.e. assets are re-valued regularly and the profit is adjusted accordingly

Balance Sheet-The Take Away

What is our financial health-Are our assets more than our liabilities or are we heading towards short term/long term bankruptcy?Is the owners’ equity safe? In case of termination of business, will they get more or less than they invested?Are our lenders’ capital safe, giving them the confidence to lend us more at market rate or we will be forced to get loans at more than the market rate?Do we have enough working capital or facing cash flow difficulties to run the business?

From the E-book “Finance for Non-finance Managers: A Handbook” by Shahid Hussain Raja, published by Amazon https://www.amazon.com/dp/B07TTNNTC8