Tuesday, October 1, 2013

Understanding Financial Statements (Part 2) - The Balance Sheet

The balance sheet records the companies assets, liabilities and equity. Assets is what the company owns and liabilities are what it owes. Equity represents the value of money that shareholders have invested in the company and it is calculated by taking Assets minus Liabilities.

The balance sheet is important in our analysis of a company as it reflects the financial position of a company. The levels of debt and the amount of cash the company has can be seen in the balance sheet. Let's go through the various entries in the balance sheet one by one.

The Balance Sheet

You can access a sample of the balance sheet here. This is Singtel's balance sheet which is the company we used to analyse the income statement in part 1 before.

Current Assets
The first portion of the balance sheet list the current assets. These assets are likely to be used up or converted into cash within one business cycle.

Below shows the entries listed as current assets:

Cash and Equivalents
This doesn't just refer to real cash on hand that the company puts in its safe deposits. It includes money market funds which can be liquidated quickly and short term investments like bonds. These are investment that are less than a year.

Accounts Receivables
These are payments the company expects to receive which it hasn't collected yet. In the previous part 1, we discussed on sales which was one of the entries in the income statement. Companies can record as sales even when payment has not been received. Check if accounts receivables is rising faster than sales?  If it is, it may mean that the company is letting more customers take up loan to buy their products or services. There may be a chance that the payments will not be received in full.

Inventory includes raw materials for goods, partially finished products and also finished products that have not been sold. In essence, it includes all the goods from pre production to post production. This is especially important for manufacturing and retail firms. If there are too many goods stored at the warehouse, it may be difficult to sell when recession comes. The firm will suffer heavy a heavy loss as a result. We have to see what goods the company produce. For construction firms, raw materials like steel and aluminium can be kept for a long time and sold for cash in the future. However, for retail firms, the clothing that is stored in the warehouse may not be able to sell at a high price as the fashion trend has already changed after some time.

Non Current Assets
Next is the non current assets. Sometimes they are called fixed assets. These are long term assets which is not expected to be converted to cash within one year or one reporting period.

Below shows the entries in the non current asset rows:

Property, Plant and Equipment
These are the assets which the firms has which includes buildings, factories, furnitures, equipment etc.

Long term Investments
These are investment in longer term bonds or stocks of other companies. The value recorded might worth less or more than the actual market value. Look into the notes to financial statements and see what investments are in this account. After knowing what are the exact investments, you can then decide how to view the amount recorded.

Goodwill/Intangible Assets
Goodwill is used in mergers and acquisitions. If a company pays more than the book value to acquire another company, the difference is recorded as goodwill. This amount can change significantly at times. It does not reflect the actual physical assets in the firm.

Current Liabilities
Liabilities are what the company owes. Current liabilities are what the company is expected to pay within a year.

Below shows the entries under current liabilities:

Accounts Payable
These are what the company owes to others which are expected to be paid within a year.

Short Term Borrowings
These are loans the company take which have to be repaid within a year. It could be short term loans from the bank. It could also be long term debt which is due within the next year.

Non Current Liabilities
Non Current liabilities are debts which are owed for more than a year. There are different entries inside but the most important one is long term debt. These are money the company has borrowed usually by issuing bonds or sometimes from a bank.

Stockholder's Equity
It is also called common equity as recorded in the balance sheet. This is the total assets minus the total liabilities. It represents part of the company owned by shareholders.

Retained Earnings
This is the most important in the stockholder's equity entry. This is the amount of capital the company has generated over its lifetime, minus dividends and stock buybacks. Each year the company makes a profit and doesn't pay it all out in dividends, retained earnings will increase. If a company has lost money overtime, retained earnings can turn negative and renamed as accumulated deficit on the balance sheet.

Why is the balance sheet important?
Companies which have lots of cash and little debt can be more resilient during a crisis than companies who have little cash. Do watch out for companies who have high levels of debt as they can crumble down in an instant when trouble arises.

When looking at current assets and current liabilities, it is generally better for companies who have more current assets than current liabilities. Current liabilities are what a company needs to repay within a year. If there is not enough current assets to cover the amount of liabilities, a company may not be able to continue its operations in the next financial year. This is also known as the current ratio which is current assets divided by current liabilities. A current ratio of more than 1 indicates that the company is healthy. A value of less than 1 is not a good sign and most of the time auditors will flag it out.

We have completed the 2nd of the 3 financial statements found in a company's financial report. In the first part, the income statement shows us how much money the company has made. In the balance sheet, it shows us what is the value of the company in terms of its equity. In the last and final statement, which is the cashflow statement, it records the cash that is flowing in the company. It is a more accurate statement than the income statement as it removes the unnecessary non cash items like depreciation and records the real cash items. We'll look into it in the next part.

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  1. Hi,

    Very Informative, I am sure readers will find it extremely useful.

    As you mentioned, the trend between account receivables and sales is very important, If the firm is booking a large amount of revenue that haven't been paid for, this can be a sign of trouble.

    Lastly, i will just add on that : "Something is wrong if one cannot understand how a dollar flow through a business. Either the company business model is too complex or we need do more digging before we commit the money".

    1. Hi Solace,

      Yes, we should invest in a business that we can understand. There are some red flags that we can see in a financial statement too. However, some companies can cover it up very well. That's why there are still accounting scandals going on.