Monday, 19 April 2010

Financial Statements: The Balance Sheet - 1

In the two previous posts, we looked at a typical Income Statement and its analysis. In the next few posts, we will look at the balance sheet and its analysis.

Whereas the income statement is a report on the operating performance of a company during the entire report period, the balance sheet is a financial position statement as at a period-ending date.

A published balance sheet that conforms to Generally Accepted Accounting Principles (GAAP) in the U.S. is shown alongside. Let us look at the balance sheet line by line. (You can click on the image at right to bring up a larger, readable view in a separate window.)

The first line is the heading that indicates the dates of the balance sheets. Balance sheet is primarily as at 28-June-2009 with amounts for corresponding date in previous year being also included in the statement.

The balance sheet reports the Assets, Liabilities and Stockholder Funds as on the particular dates, viz. June 28, 2009 and corresponding previous year date of June 29, 2008.

Assets are subdivided into current assets and non-current (long-term) assets and there is a similar subdivision of liabilities into current and long-term liabilities.

Current Assets

Current Assets are assets that are "turned over" in the course of day-to-day operations.

  • Inventories are used to make products which are sold and get converted either into cash or receivables, viz. debtors for credit sales
  • Receivables are paid in due time and gets converted into cash
  • Cash is used to replenish inventories and also to meet day-to-day expenses of operating the business.

The above cycle gets repeated and is reflected as the major constituents of current assets, Inventories, Receivables and Cash. Some minor items, such as deferred taxes and prepayments of some expenses are also included under current assets, as these too are short term in nature.

Long-Term Assets

Unlike current assets, long-term assets are not turned over in the course of business. Instead, these are held to facilitate day-to-day operations. For example, property, plant and equipment are used to produce and store products, and also to accommodate the company's employees and various facilities such as workstations.

Any other assets, such as deferred income taxes that will not be consumed in the next one year are also included under long term assets.

Long-term assets also include "intangibles." Intangible assets are items that have value but have no physical form to see and touch. For example, patents and trademarks can have great value for a business but have no tangible form. An intangible asset that is often of dubious value is Goodwill.

Goodwill represents the excess price paid when one company takes over another company. Where the net value of assets minus liabilities of the taken-over company is less than the price paid, the excess payment is accounted as a "Goodwill" asset in the acquiring-company's accounts. If the taken-over company is highly profitable, this goodwill can indeed have some value. Otherwise, it really becomes a "fictitious" asset of no real value.

Current Liabilities

Just like current assets, current liabilties are also mainly items that are turned over in the course of the day-to-day operations of the company. For example, the item Accounts Payable mainly represents dues to suppliers of raw materials and merchandise. Accrued expenses include unpaid salaries to employees and other operational expenses that have become due but have not yet been paid.

Current liabilities also include the current portion of long-term liabilities. "Current portion" means the part, such as mortgage installments, that will be payable within one year.

Working Capital

Working capital is a key measure that can gauge the financial health of a business. Working capital is computed by deducting Current Liabilities from Current Assets. The idea is that a company should be able to meet its maturing short-term obligations with the cash realized through conversion of short-term assets.

If the short-term (current) assets are too low compared to current liabilities, or if the current assets consist mainly of items such as inventories that take too long to get converted into cash, the company's working capital position is generally considered not healthy.

We have used tentative terms like "generally considered" because actually, working capital requirements vary from industry to industry. In businesses like retailers, who do their business mainly for cash, meeting current liabilities from current cash inflows is not usually a problem. On the other hand, heavy industries like machinery manufacturers who typically need months to execute an order and to collect the cash will need considerable working capital to meet day-to-day payments.

We will look at the techniques of judging the adequacy of working capital in the post on balance sheet analysis.

In the second part of this post, we will focus on long-term liabilities and stockholder "equity".

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