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March 8th, 2012

Understanding a Company’s Balance Sheet

 

Whether you are a shareholder or merely thinking about investing in a company, a basic understanding of the fundamentals of a company’s financial position is essential. A balance sheet is the “gateway” to assessing a company’s financial strengths and weaknesses. While some people may have a natural aversion to numbers, understanding the balance sheet is not as difficult as it may appear.

The Balance Sheet or statement of financial position is a summary of the financial balances of a business. It is often described as a “snapshot of a company’s financial condition”.

A company’s Balance Sheet has three specific components. The company’s Assets, its Liabilities and Owners Equity information. As the name implies, it is a statement that balances and is based on the formula Assets = Liabilities + Owners Equity.

The Balance Sheet for Demonstration Company Limited (DCL) is provided below as an example.

Assets

Assets represent what the company owns. These items are classified as either “Current Assets” or “Non-current Assets”.

Current Assets are those items that can either be converted to cash or used to pay current liabilities within twelve months. Examples of current assets include Cash at Bank, Investments, Inventory and Accounts Receivable (see Figure 1). The total current assets of DCL amount to $190,000.

Noncurrent assets represent the company’s long-term investments in which the cost of the asset is spread over the number of years for which the asset will be in use. Examples of these are the acquisition of land, building and machinery. Total non-current assets of DCL amount to $570,000, while Total assets amount to $760,000.

The Assets section of the balance sheet helps one to understand what the company owns and what they are trying to do with their business.

Liabilities

The second component of the balance sheet is the liabilities section. This section reports on the company’s debts, loans or upcoming payments. It is subdivided into “Current Liabilities” and “Long Term Liabilities”.

Current Liabilities are those financial obligations that are to be settled, usually within the next twelve months. Typical items in this category are Accounts Payable, which represents bills payable within the period, and the Current portion of long-term loans. Total current liabilities of DCL amount to $195,000.

Long Term Liabilities are those debts that are not due within the next twelve months. They may include such items as building loans, long term bonds or other long term loans. In the case of financial institutions, long liabilities include savings deposits that the Company receives from customers. In the case of DCL, Long Term Liabilities amount to $300,000. This represents the amount outstanding on a bank loan, but excludes the amount due for payment within the current financial period.

Owners Equity

This section reflects the true wealth of the company. Also referred to as shareholders equity, it includes the initial money invested by the shareholders as well the “additional paid-in capital”. Additional paid-in capital captures the increase in the share price beyond the par or book value. Owner’s Equity also includes any retained earnings i.e. Profits accumulated after the payment of annual dividends to shareholders. DCL owners’ equity amounts to $265,000.

Using the Information

Observe that the total assets of DCL amount to $760,000 and is equal to the total of Liabilities and Owners’ Equity in accordance with the balance sheet formula.

The Balance Sheet provides valuable information about what a company owns (assets), what it owes (liabilities) and its value to the shareholders (owners’ equity). In this example the value of the company to its shareholders is $265,000.

The Balance Sheet allows you to determine the company’s ability to meet its short term obligations by computing its net working capital, which is the difference between the company’s current assets and current liabilities. Ideally the current assets should be greater than the current liabilities. You can also determine the company’s liquidity position i.e. its ability to quickly convert an asset into cash without significant loss.

The Balance Sheet allows you to assess trends in a company’s performance by comparing the current year’s statement with that of the previous year or two. If you wish to assess the company’s performance, rank it within the industry. The Balance Sheet is useful for gauging the position of the firm in the industry. Comparing a company’s balance sheet with that of similar firms in the industry allows you to determine the strength of the firm relative to its competitors.

Figure 1

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