For any company to be able to conduct sales, it needs to manufacture the products first, by setting up plants and installing machinery, using certain production technologies, which might be generic or proprietary to the company. As part of its regular business activities, the company may also make investments to support the primary business activities on a continuous basis. These form the Assets of the company.
For all of the above activities, any company needs money or capital which is in the form of debt and equity. Debt relates to the loans and other borrowings undertaken by the company either to make capital expenditure (long-term loans to buy machinery/equipment, construct factories etc.) or to support its working capital requirements (short-term loans to pay for the operations of the company). These are the Liabilities of the company.
The assets of the company need to be balanced with the liabilities (including equity) at any given point in time and hence the term Balance Sheet. Also, unlike the P&L statement which is on a segmented basis (1 quarter, or 1 year), the Balance Sheet is a condensed financial snapshot, continuously accumulated from the time of inception of the company till the present period, highlighting the sources and applications of funds for the company. This helps in understanding the financial health and the Net Worth of the company at any given point in time. Hence, it is also referred to as the Position Statement.
A typical company balance sheet consists of the three sections; assets, liabilities, and equity.
For all accounting purposes, Assets = Liabilities + Equity.
In simple terms, it implies that all the assets of the company are accounted for, through the borrowings and the equity of all shareholders. Balance Sheet shows the financial position in the form of assets, liabilities, and capital (equity).
The Balance Sheet of Prakash Industries Limited (Source) is provided to understand the various items as described in a typical statement.
Assets
Any item of economic significance, that can be utilized by the company to generate value or income is termed as an asset. Assets can be either tangible or intangible in nature. Tangible assets are physical assets like machinery/equipment, plant and property, vehicles etc., while Intangible assets are non-physical in nature represented by goodwill, trademarks, patents etc. In short, assets are items purchased by a company that have financial value, are expected to be useful to the business for generating income, and can be expressed in monetary terms.
There are two types of assets – Non-Current Assets and Current Assets. The sum of current and non-current assets is termed as Total Assets.
Non-Current Assets
Assets that cannot be converted into cash in the short term or in the current financial year are termed as Non-Current Assets. Also termed as long term assets and comprising of tangible and intangible assets, they are held for business operations, and are not expected to be converted to cash immediately.
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Fixed assets comprising equipment, buildings, production plants, and property are categorized as long-term tangible assets. Similarly, intangible fixed assets being non-physical assets include brands, franchises, copyrights, and patents. These assets are without any fixed market value and based on the circumstances, their valuation varies from time to time.
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Capital Work-in-Progress (CWIP) includes the activities under progress for which the capital is being spent, but has not yet been completed. This can include on-going construction of new plants, new machinery installation etc. Upon completion of the necessary activities, the CWIP constituents are reallocated appropriately as fixed assets.
While CWIP is a representation of the capital (progress) related to tangible assets, the Intangible Assets under Development are a similar representation of the capital (progress) related to intangible assets.
Current Assets
Assets that can be easily converted to cash in a short period of time are termed as Current Assets. Investors priority to monitor current assets is higher as the current assets are vital in meeting the financial commitments like interest payments as well as working capital needs. Also, in case of bankruptcy, having a higher portion of current assets helps in liquidation and in faster conversion to cash.
Cash and cash equivalents, inventory, accounts receivables are various current assets listed on the balance sheet. Since, Cash equivalents are generally highly liquid assets like short-term investments and fixed deposits, they can be sold easily.
Accounts receivable is money owed to the company and is considered as an asset on the balance sheet, as it signifies a legal obligation for all the customers to pay the amount.
Total Assets = Non-Current Assets + Current Assets
Equity and Liabilities
In the accounting equation, the balance half of the assets is represented by a combination of Equity and Liabilities. All the accumulated assets of the company are always paid for, with all the liabilities of the company. Only when all the assets and liabilities are accounted for appropriately, can we consider the statement as a Balance Sheet.
Equity
Also referred to as Shareholder’s Equity or Owner’s Equity or simply Equity, it is calculated as the value of a company's assets left over subsequent to deducting the value of its total liabilities. Shareholders' equity is also represented by the total amount of capital invested by the owners, called as Share Capital, and the portion of the net profits that the company reinvests rather than distributing as dividend, called as Retained Earnings.
Thus, shareholder’s equity is a reflection of the business funding through two sources, namely, owners’ initial invested funds, and the funds accumulated over time due to a profitable business. Shareholder’s Equity can be computed in two ways:
Shareholder’s Equity = Total Assets – Total Liabilities
or, Shareholder’s Equity = Share Capital + Retained Earnings – Treasury Shares.
Shareholders' equity represents the Net Value or Book Value of a company or the amount that would be returned to the shareholders upon liquidation of the company assets and repayment of all debts.
Liabilities
The third component of the accounting equation, Liabilities relate to the company's debt arising due to the various operations of the company. Representing the legal obligation of the company to pay other entities at any point in time, they include bank loans, payments to suppliers, employees, utilities, tax etc. The liabilities are categorized as - Non-Current Liabilities and Current Liabilities.
Total Liabilities = Non-Current Liabilities + Current Liabilities
Non-Current Liabilities
Also termed as Long-Term Liabilities, Non-Current Liabilities are the debts expected to be paid over a time period which is greater than a financial year. Non-current liabilities can be paid with assets derived from future earnings or financing transactions. Long-term borrowing, bonds payable, long-term lease obligations and mortgage payments can be categorized as examples of non-current liabilities.
Current Liabilities
Also termed as Short Term Liabilities, Current Liabilities are the debts which are due and expected to be paid during the financial year itself. They include the money owed for taxes, employee wages/salaries, interest payments, accounts payable and notes payable. A company is considered to display good financial strength when the current assets exceed the current liabilities.
Conclusion
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As an investor, it is imperative to understand the pertinent information related to invested capital, asset purchases, the short and long term financial obligations, while evaluating the efficiency of capital usage and the indebtedness of the company.
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A better understanding of these parameters will thereby help in evaluating the company’s potential for future growth through the various investments made by the company and provide clarity on the expected returns. The balance sheet aims to do all of the above, in a snapshot format, providing the financial strength of the company.
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At the same time, investors also need to pay attention to the cash flows of the company – the inflows as well as the outflows, to evaluate the company’s ability to generate cash and its efficiency of usage. The next section deals with the cash flows generated by the company through various activities, related to the core and non-core operations of the company.
Next Chapter
Comments & Discussions in
FYERS Community
Samika commented on April 23rd, 2019 at 12:42 PM
Could you please explain what "Share application money pending allotment" is.
Gopal commented on April 24th, 2019 at 6:48 AM
It is already explained in the 'Primary Market Technology' chapter under the topic 'ASBA' or Application supported by Blocked Amount, which is basically share application money pending allotment.
Manisha commented on May 27th, 2019 at 12:55 PM
Which element in the balance sheet helps us to understand that if we should invest in the company or not?
Gopal commented on May 27th, 2019 at 6:03 PM
Each line item or element of the Balance Sheet, Profit & Loss and even Cash Flow statement is essential in understanding the performance of the Company. Based on all the parameters, inferences can be made, whether to invest or not. Also, considering only 1 year financial statements might not yield sufficient insights. To identify trends across parameters, it is necessary to consider financial statements of at least the last 3 latest years.
Jitendra naik commented on July 20th, 2020 at 6:50 AM
Balance enqary