What Is A Balance Sheet?
The following section describes the important elements of the balance sheet.
A Balance Sheet indicates the financial strength of the company at any given point of time. It is a snapshot of what a company owns and owes, or gives the details of the assets and liabilities. But to answer the question of exactly what is a balance sheet, we need to look at a few key items that are inside of it.
Assets are resources that are expected to provide a firm with future economic benefits. An item can be recognized as an asset if the firm has acquired rights over it or can quantify future economic benefits that can be derived from that item with a fair degree of accuracy.
These are assets that are expected to produce benefits for more than a year. These are classified as tangible and intangible assets. Tangible non-current assets include land, building, plants and machinery and are reported at net book value, cost price less accumulated depreciation. Intangible non-current assets include items such as patents, copyrights, trademarks, goodwill and are also reported at net book value, gross value less accumulated amortization. Amortization is the allocation of the cost of the intangible asset over the accounting period that benefits from its use.
These are generally made up of financial securities like shares and debentures of other companies, most of which are likely to be associated, and subsidiary companies. These investments are made primarily to generate income from idle cash. Investments made for short-term purposes are recorded under current assets and are carried at cost or market value, whichever is lower. Long-term investments are valued at cost less any decreases in value, which is regarded as permanent.
This consists of cash and other assets that are expected to convert into cash during the next operating cycle of the firm. The major components of current assets are cash, receivables, inventories, and prepaid expenses. While a large amount of current assets may give an impression of good liquidity, it is important to know the structure of the current assets. Large amounts of inventory indicate slow moving, obsolete products or new products which are expected to be sold next year. Similarly, large amounts of receivables might give a false impression of liquidity if the company has poor collection efforts.
Liabilities are debts and obligations that arise during the course of business operations. This section of the balance sheet forms a crucial part as it describes the various financing decisions taken by management to fund the business’s operations. The following section describes some of the important components of the liabilities section of the balance sheet.
Shareholder’s equity is also referred as “Owners Equity” or “Stockholders Equity”. It includes the contribution made by shareholders to the company and retained earnings that the company accumulates over time through its operations. Reserves and surplus are comprised of retained earning, share premium and capital subsidy. Reserves are held in two forms, capital reserves, and revenue reserves. Capital reserves cannot be distributed as dividends to shareholders and include items like share premium, revaluation reserve, and capital redemption reserve. Revenue reserves are the accumulated retained earnings held in the form of investment allowance reserves, dividend equalization reserves, taxation reserves, and general reserves.
Non-current liabilities are the obligations with maturities greater than one year. These include secured loans such as, debentures, term loans, working capital loans, and unsecured loans such as inter-corporate loans and public deposits. Companies carrying large amounts of such long-term liabilities are riskier from the creditor’s point of view since these companies can find themselves overburdened with interest payments during a slow business cycle. The important ratios used by creditors to judge a company’s ability to repay the amount of liabilities it carries are the debt service coverage ratio, the interest coverage ratio, and the cash flow coverage ratio.
Current liabilities represent obligations, or debts that are expected to mature in the next operating cycle. The most common items included are accounts payable, sundry creditors, advanced payments, and interest accrued. They also include provisions made for obligations that are expected to mature the next year such as provisions for taxes, dividends and provident funds.
Key items to be considered while analyzing the Balance Sheet:
A balance sheet is a very crucial statement to evaluate the credit worthiness and the liquidity position of a company. A novice investor should consider the following points while analyzing a balance sheet.
1. It is important to ensure that the amount of the current assets are comfortably more than the current liabilities as this indicates that a company has a healthy short-term liquidity position.
2. The debt to equity ratio can be used to judge the risk of investing in a business. Companies often choose debt as it is a cheaper source of financing, however, the greater the debt to equity ratio, the greater risk to creditors.
3. The asset turnover ratio is used to measure the efficiency of the assets employed by a company. The turnover ratio needs to be considered along with the corresponding proportion of depreciation assigned to the assets, as the value of assets might tend to be low if they are old and substantially depreciated.