The Abcs Of Understanding Financial Statements Part 2 Of 4 Battling The Balance Sheet
Jun 18, 2010
As discussed in the first of the 4 articles (The ABC's of Understanding Financial Statements-Part 1 of 4), there are always three main components to every financial statement. They are:
- Balance Sheet
- Statement of Income
- Statement of Cash Flows
This article will focus on the Balance Sheet. Articles 3 and 4 will address the other reports.
The Balance Sheet is different from the other two statements in that it represents the financial condition as of a specific point in time (i.e. as of December 31) as opposed to measuring activity for a longer and defined period of time (i.e. 1 year, quarter, month, etc). It represents a snapshot of the company’s financial position as of that date. While many business executives focus on the Statements of Income and Cash Flow, the Balance Sheet is the primary report that measures the financial health of the entity at that point in time. That is why every financial analyst (bankers, investment brokers, credit reporting agencies, etc) will monitor key metrics from the Balance Sheet to understand the financial health of that business. It is unfortunate that too many small business owners ignore this report when examining their own business opportunities.
There are three major sections within the Balance Sheet.
- Assets – the initial cost of everything the company owns and uses in their business.
- Liabilities – debts owed to lenders and creditors.
- Equity – represents ownership of the shareholders.
Below is an example of a simple Balance Sheet. You will notice a few key elements that will appear on every report. First of all, the name of the Company will always be at the top of the report. It will also always be identified as the Balance Sheet and give the specific date in which the numbers were reported.
The assets of the business will be the first section reported. Sometimes they will appear in the left column (as in this example), other times they will appear at the top of the report. Assets will be allocated between current, fixed assets and long-term (none are shown in this example).
Current assets are those that will be utilized within the next 12 months of the operating cycle. They will include cash, accounts receivable, inventory and sometimes other prepaid expenses.
Fixed assets are those items that are used in the production of the company’s products and/or services and include machinery, equipment (both production and office), office furniture, land, buildings, vehicles, etc. Since fixed assets have a defined useful life, they are depreciated over that useful life. The annual depreciation expense is reflected on the Statement of Income but the accumulation(s) of the annual depreciation is recorded as a reduction of the fixed asset and is known as accumulated depreciation on the Balance Sheet. Once the accumulated depreciation for an asset equals the initial cost of that asset, there will be no more depreciation expense incurred. However, the fixed asset will remain on the Balance Sheet with a net cost of zero.
Long-term assets are (as you suspected) those that will be not be utilized within the next 12 months and have a useful life over the next several years. Items that typically will be classified as long-term assets are goodwill, security deposits, prepayments on multi-year contracts, etc.
The liability section of the Balance Sheet will either be on the right side of the page or just below the asset section. Similar to assets, liabilities will be allocated between current and long-term.
Current liabilities will include accounts payable and accrued expenses that are due to vendors within the next year and the portion of bank debt that is due within the next 12 months. Since many bank loans extend beyond a 12 month period, the outstanding balance will be allocated to both current and long-term liabilities based upon the repayment schedule.
Long-term liabilities will be any other debt which is due to be paid after the one year period. Again, this would include bank loans and certain long-term leases
Equity is that portion of the balance sheet that reflects shareholder investment. It IS NOT an indicator of the current value of the business. It represents the initial investment of the shareholders (Contributed Capital) plus the accumulation of profits and losses for all the years the company has been in business (Retained Earnings). Equity will always be the difference between total assets less total liabilities (ASSETS – LIABILITIES = EQUITY). In the event that Equity is a negative number that means the company’s liabilities exceed the assets. This is also known as “insolvency”. Insolvent businesses are not necessarily out of business, it means that they do not have sufficient assets to pay off all of their debts. As long as the lenders and suppliers do not require immediate payment, the company can continue to do business. However, it is important to note that companies that are insolvent should be monitored carefully and frequently if you plan to do business with them!
In summary, the Balance Sheet is a useful tool for the business owner in understanding the overall financial strength of their company. Since most suppliers and all lenders rely on the Balance Sheet to make decisions on credit worthiness, it is imperative for the business owner to also understand the criteria and metrics that are being used.
Next month we’ll address the Statement of Income and how it should be used in measuring and evaluating performance over a period of time.