What exactly is a balance sheet?
A balance sheet is a snapshot of a company’s financial position at a particular point of time in contrast to an income statement, which measures income over a period of time.
Balance sheet is usually calculated as at 31 December, last day of the financial year. A financial year starts on January 1 and ends on December 31. The period between January 1, 2008 and December 31, 2008 will complete a financial year.
A balance sheet measures three kinds of variables: assets, liabilities and shareholder’s equity.
Assets are things like plants/factories and machinery that the company uses to create value for its clients/customers.
Liabilities are what the company owes to outside parties, say to its vendors.
And equity is the money initially invested by shareholders plus the retained earnings over the years.
These three variables are linked by the relationship: Assets = Liabilities + Shareholder’s equity.
Both assets and liabilities are further classified based on their liquidity, that is, how easily they can be converted into cash.
Current assets are assets, which can be converted into cash in less than a year. Examples include cash, inventories and money owed by customers (accounts receivables).
Current liabilities are liabilities that are due within a year and include interest payments, dividend payments and accounts payable.
Long-term assets include fixed assets like land and factories as well as intangible assets like goodwill and brands. Finally, long-term liabilities are basically debt with maturity of more than a year.
Questions and Answers: To answer various questions about a company, two or more entries in a balance sheet are often combined in the form of financial ratios.
There are many such ratios but let’s look at three of them along with the questions that they help answer:
- Current ratio is the ratio of current assets to current liabilities. This tells how well the company can meet its short-run obligations since current assets are those which can most quickly be converted into cash to meet short-run liabilities.
- A current ratio less of than 1 indicates that current liabilities exceed current assets and that may be a dangerous sign for an investor.
- Debt/ Equity ratio: This is the ratio of long-term debt (loans for instance) to shareholder’s equity. A high ratio indicates a greater reliance on debt on the part of the company and may indicate long-term solvency (Any company’s ability to meet its long-term debt) problems.
Finally, the sales-to-fixed assets ratio tells us how efficiently a company is using its fixed assets (such as factories/plants and real estate) to generate sales and revenues. A low ratio may indicate that the company has excess capacity or possibly problems in the supply of raw materials that reduce production.
Compare: It’s important not to look at financial ratios in segregation. They should be compared with the same ratios in previous years in order to get a sense of how the company’s financial position has changed over time.
They should also be compared with the ratios of similar companies in the industry because different industries have different financial norms and debt/equity ratios that might look alarming in one industry but may be normal in another.
Limitations: It’s also important to keep in mind the limits of balance sheet information.
Most obviously since the balance sheet is a snapshot at a particular point of time, it may become less relevant particularly in a fast-moving industry or if the company makes a dramatic decision like a take-over.
Balance sheets are also less useful in evaluating a company with a lot of intangible assets like brands and knowledge since accounting methods can only offer rough estimates of the value of such assets. This is especially a problem in evaluating companies in the Information Technology (IT) sector.
Finally assets are often valued according to their original cost minus depreciation (the fall in value of an asset; like the value of your car goes on decreasing year after year and more so if your car is damaged in an accident) rather at their current market value.
Bottom line: Despite these problems balance sheets are still an invaluable tool. They may not provide the final answer in figuring out how much a company is worth yet they are always a first step in the right direction.