Wednesday, August 31, 2011

Balance Sheet

Balance Sheet Tells how wealthy or Poor (about Net Worth) a company is at that moment of time

Balance sheet is a part of any companies annual report.
When we talk about the annual report of a company we are essentially talking about tree distinct financial reporting system:              

1Balance SheetTells how wealthy or Poor (about Net Worth of a company) a company is at that moment of time (say from 1990 to 2008)
Income StatementTells how well or bad the company did last year (say in the year 2008)
3Cash Flow StatementTells from where a company is generating its cash. It also tells how this generated cash is spent on various activities to run its business. (say for the year 2008)

A Balance Sheet Equation is:
Assets – Liabilities = Shareholders Equity (Net Worth)

A balance sheet tells us about the financial position of a company till last financial year. If the report is for year 2008, then that the balance sheet tells the financial well being of the company as on year 2008. When we say balance sheet, as its name suggest, we are trying to balance the companies assets, liabilities and shareholders equity. A Balance sheets shows what a company owns (assets), what a company owes (liabilities), what is left (asset minus liabilities, known as net worth).

Any investor who wants to buy the equity of any company shall see its balance sheet for sure. If the net worth of the company is increasing from year to year it means the company is doing good business. But how to make sure that the companies net worth is always increasing? Key is to maximize assets and minimize the liabilities. In other words, maximize your profit and minimize and do your business with minimum of loan.

AssetIncrease Profit
LiabilitiesMinimize loan
Ideally Company shall generate enough income to finance its business expenditures for the coming year.
1Current AssetsAssets converted into cash within normal operating cycle of a business. Normal operating cycle is the time period between inventory accumulation (raw materials) and sale of finished product. In other words time period between paying cash & receiving cash.examples:
cash, issue able shares (marketable securities), inventories, account receivables, pre-paid expenses, shares of other companies held for less than a year etc
period is less than a year
2Long Term Investmentinvestments in other companies stocks or bonds for a period of more than a year. Shares (securities) are listed in balance sheet as the cost of purchasing it. Purchase price includes market price at the time of buying plus brokerage charges if any.example: shares of other companies held for more than a year.period is more than a year.
3Property, plant, equipment (fixed assets)Fixed assets of a company is used to produce goods and services. All fixed assets have a life greater than one year. They are tangible means you can physically see and touch them. Unlike inventories, fixed assets are not hold with the objective to sell then in near future.examples:
Land, buildings, machinery, automobiles
period is more than a year.
4intangible assetsThese are assets that cannot be physically seen or touched, but they add value to the company. Best example is the brand vale of the company. In this world of extreme brand conscious peoples, establishing a brand name is very important. Once you market and establish your brand name it starts adding vale to your company. In other words just a Name makes money for you. Hence it is an assetexample:
If you open a fast food chain and you want it to McDonalds, you will have to sign a contract and pay huge amounts to the owner to get that brand name working for you.
period is long-term some times for life time and beyond.
5deferred chargesThese charges relates to expenditures that has already been incurred but they are not going to benefit the company this year.example:
a company investing to expand its plant capacity. The project duration is say 3 years. Till 3 years, when the plant is commissioned, no product is generated. Hence no sale, means no earnings.
period is one year or more.
In nut shell you can say, to maximize your assets, increase the account receivable by producing fast and selling fast.

When we say to minimize the Liabilities what we need to control:
1Current LiabilitiesThese can be considered as loans that needs to paid back in less than a year. Current liabilities are paid from current assets.examples: amount owed to creditors, accrued expenses (like salaries)period is one year or less
2Non Current Liabilities
(Long Term Liabilities)
These can be considered as loans that needs to paid back in within period more than a year. The portion of a long term liability that needs to be paid within current financial year (EMI portion of a 5 year loan) shall be booked under current liabilityexample: bonds payable and mortgage payable.period greater than one year
In a nut shell you can say, to minimize your liabilities, pay your vendors as fast as possible, give salaries as fast as possible and be less dependent on long term loans to finance the companies business. > Page3

Now when we have answered that how to maximize the assets and minimize liabilities, we need to understand the correlation between Companies net worth and its benefit to an investor
(Shareholders equity).

A shareholders equity can be classified in the following broad categories

Shareholders Equity
1Capital StockCapital stock = (No. of outstanding shares) X (Face value (par) of each share)example:
Suppose there are 10nos shares out standing in the market (no of shares purchased by investors) with a face value of Rs 10. Then capital stock will be equal to 10Nos X Rs 10 = Rs 100
2Paid-in CapitalIs the amount received by the company over the par value for the stock. This helps to keep a track of the excess over par value that investors have paid for the companies stocks.example:
Suppose there are 10nos shares out standing in the market (no of shares purchased by investors) with a face value of Rs 10. The market value of the stock is Rs 100. Then the paid in capital is equal to 10nos X Rs (100-10) = Rs 90
3retained earningsThis is the accumulated earning of a company since inception. This is calculated after paying the dividends to the stock holders. If the company is making profit there will be surplus in this account. In case of loss a deficit will occur.
When a company is making profit it directly reflects in the companies retained earnings. With companies retained earnings increasing, investors will be ready to pay a higher price (above face value) to buy companies shares. Hence, company will have more money to run its business, means it can invest more to enhance the quality of its product, expand/modernize the production capacity of its plant. All these means, companies product will be sold more, hence more profit.
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