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How to read a balance sheet

September 22, 2009 12:49 IST

Henry R Luce, founder Time magazine, once observed, "There are men who can write poetry, and there are men who can read balance sheets. The men who can read balance sheets cannot write."

For many, the balance sheet is like a jigsaw puzzle - just when you feel that you are close to piecing the jigsaw puzzle together and see the picture it reveals, the puzzle throws up a new challenge.

You discover that one piece has been incorrectly placed , you don't know which one is it, you just know that the picture cannot be completed unless you unscramble the puzzle and do it all over again.

The importance of the balance sheet

The balance sheet is a statement of the company's assets and liabilities. Simply stated, the balance sheet is a record of what the company owes to others and what the company already has, and what others owe to the company.

Once you know how to read it, you will then be able to understand whether the company really has enough money to support its ambitious expansion plans or whether it will have to take loans (debt) in order to grow, or if the company has a lot of its money blocked in inventories. For example, if a company deals in readymade garments. The garments are a part of the inventory of the company.

Assets are a chief component of a balance sheet

Assets and Liabilities are the key components of a balance sheet. 'Assets' can be termed as resources that a company owns and uses to generate cash flows. In simpler words, assets are the total funds that the company owns.

Assets can be further divided into fixed assets, current assets and investments.

'Fixed assets' are assets that help companies reap economic benefits over a period of time. Fixed assets are essential in generating revenues and running the business of the company. A company is not very different from an individual. It faces the same concerns that we do, but on a larger scale. We try to cut down our expenses to save more.

Companies do the same thing only it is called as 'cost cutting'. We use our skills and abilities to earn a livelihood, similarly companies use fixed assets, such as land, building, plant and machinery, to generate revenues.

Next in line are current assets. Compare them with you own lifestyle. We as individuals keep aside some cash, which is an asset for us for meeting our day to day expenses.

Also, there could be times when your friend may need some money urgently and you may lend it to her. Because she has to repay it at a later date it becomes an asset for you as it is your right to receive that money.

Similarly a company has 'current assets' on its books that include cash, inventories, debtors and loans and advances. Every company needs to have sufficient cash on its books which it can draw upon for expanding its business or which acts as a buffer when business environment is weak.

'Debtors' tell you how much repayment is due from parties to whom a company has sold its products. Further, all the products of a company may not be sold during any year. So it will have some products lying in its warehouse which have a value attached to them and this is reflected as 'inventory' under current assets.

To easily understand 'investments' compare them with your salary or monthly income. What do you do with your salary? Do you spend the entire amount? Save it entirely or do you invest the whole amount?

Most of us would divide the salary into two parts - savings and invest some part, while spending the rest on things like grocery, clothes, gifts etc. The companies also follow a similar principle. Any surplus cash that companies have after investing into their business is likely to be invested in mutual funds, government bonds or acquiring stakes in other companies.

Liabilities are a chief component of a balance sheet

Liabilities are what the company owes and needs to pay to various people or entities like creditors, bankers, shareholders etc. Liabilities can be further classified as borrowings, shareholders fund, current liabilities, etc.

Say tomorrow, you have your own company and it is doing well. What would be your next step then? You would want to grow your business further. However, what if you don't have the money to do so? Will you be content with what you have or try to borrow money from friends, family or banks in order to expand your business? Companies too face a similar dilemma and the decisions that they take are reflected in the balance sheet.

If the company decides to borrow money, the amount that it borrows from banks or other lenders gets reflected as 'borrowings'in the balance sheet.

Next in line are 'current liabilities'. Current liabilities are payments that are short term in nature and are due within a period of one year. Sundry creditors and provisions constitute a part of current liabilities.

And lastly we discuss the 'Shareholders' funds'. It is that portion of the balance sheet which purely belongs to the shareholders. It consists of equity (funds raised by issuing shares) and reserves and surplus (the accumulated profits that a company has earned and retained overtime).

Balance sheet as a key to understand the company

Just like in a puzzle, it is essential to never lose sight of the bigger picture, so things automatically fall into place. A similar principle applies to the Balance Sheet too.

Rather than just understanding the various terminologies of the balance sheet, it is important to understand what they are trying to convey- the financial state of the company, its ability or inability to grow, take more loans.

To understand whether the company you want to invest in is worth your money or not, you must understand the balance sheet in order to get a grasp of the bigger picture.

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