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In this tutorial, we will learn the importance of balance sheets to you as an investor. We will cover what they represent, how to understand them and how they are presented. We will also provide some useful equations and an example of a balance sheet.
The tutorial will cover the following topics:
UNDERSTANDING THE BALANCE SHEET
In order to make an informed investment decision, you should review a company's balance sheet. Let's look at what a balance sheet entails.
The balance sheet is one of the most important financial statements of a company. It is reported to investors at least once per year. It may also be presented quarterly, semiannually or monthly. The balance sheet provides information on what the company owns (its assets), what it owes (its liabilities), and the value of the business to its stockholders (the shareholders' equity). The name balance sheet is derived from the fact that these accounts must always be in balance. Assets must always equal the sum of liabilities and shareholders' equity.
WHY SHOULD THE BALANCE SHEET BE IMPORTANT TO YOU?
The balance sheet is the fundamental report of a company's possessions, debts and capital invested. Before investing in any company, an investor can use the balance sheet to examine the following:
- Can the firm meet its financial obligations?
- How much money has already been invested in this company?
- Is the company overly indebted?
- What kind of assets has the company purchased with its financing?
These are just a few of the many relevant questions you can answer by studying the balance sheet. The balance sheet provides a diligent investor with many clues to a firm's future performance. In this tutorial, you will learn the basic building blocks necessary to do such analysis. Once you completely understand the balance sheet, making informed investment decisions should be much easier for you.
Read below to start understanding the basic concept behind the balance sheet.
THE
BASIC CONCEPT BEHIND A BALANCE SHEET
The concept behind the balance sheet is very simple. In order
to acquire assets, a firm must pay for them with either debt (Liabilities)
or with the owners' capital (Shareholders' Equity). Therefore, the
following equation must hold true:
Assets = Liabilities + Shareholders' Equity
| Total Liabilities |
$30,000 |
| Shareholders' Equity |
$50,000 |
| Total Assets |
$80,000 |
WHAT
ARE ASSETS?
Assets are economic resources that are expected to produce
economic benefits for its owners. Assets can be buildings and machinery
used to manufacture products. They can be patents or copyrights
that provide financial advantages for their holder. Let us begin
with a look at a few of the important types of assets that exist.
Current assets are assets that are usually converted to
cash within one year. Bondholders and other creditors closely monitor
a firm's current assets since interest payments are generally made
from current assets. They include several forms of current assets:
- Cash is known and loved by all. It is the most basic
current asset. In addition to currency, bank accounts without
restrictions, checks and drafts are also considered cash due to
the ease in which one can turn these instruments into currency.
- Cash equivalents are not cash but can be converted into
cash so easily that they are considered equal to cash. Cash equivalents
are generally highly liquid, short-term investments such as U.S.
Government securities and money market funds.
- Accounts receivable represent money customers owe to
the firm. As more and more business is being done today with credit
instead of cash, this item is a significant component of the balance
sheet.
- A firm's Inventory is the stock of materials used to
manufacture their products and the products themselves before
they are sold. A manufacturing entity will often have three different
types of inventory: raw materials, works-in-process, and finished
goods. A retail firm's inventory generally will consist only of
products purchased that have not been sold yet.
Now that we have looked at some of the most important short-term
assets, let us move forward to examine long-term assets.
LONG-TERM ASSETS
Long-term assets are grouped into several categories. The following
are some of the common terms you will:
Fixed assets are those tangible assets with a useful life
greater than one year. Generally, fixed assets refer to items such
as equipment, buildings, production plants and property. On the
balance sheet, these are valued at their cost. Depreciation is subtracted
from all except land. Fixed assets are very important to a company
because they represent long-term illiquid investments that a company
expects will help it generate profits.
Depreciation is the process of allocating the original
purchase price of a fixed asset over the course of its useful life.
It appears in the balance sheet as a deduction from the original
value of the fixed assets.
Intangible assets are non-physical assets such as copyrights,
franchises and patents. To estimate their value is very difficult
because they are intangible. Often there is no ready market for
them. Nevertheless, for some companies, an intangible asset can
be the most valuable asset it possesses.
Remember that every company will have different assets depending
on its industry. However, it is important to know and understand
the major accounts that will appear on most balance sheets. Now,
we will talk about what the company owes to others: its liabilities.
WHAT ARE LIABILITIES?
Liabilities are obligations a company owes to outside parties.
They represent rights of others to money or services of the company.
Examples include bank loans, debts to suppliers and debts to its
employees. On the balance sheet, liabilities are generally broken
down into Current Liabilities and Long-Term Liabilities.
Both bond and stock investors scrutinize liabilities. A company
that has too many financial obligations may be in danger of going
bankrupt. In this case, both bond and stock investors usually lose.
Bond investors also must examine the type of debt that the company
has issued. If a bankruptcy does occur, there is a hierarchy of
debtors. An investor will want to ensure that he/she is high on
the list to be paid before the money runs out. Let us start our
analysis of liabilities with current liabilities.
Current liabilities are those obligations that are usually
paid within the year, such as Accounts
payable, interest on long-term debts, taxes payable, and dividends
payable. Because current liabilities are usually paid with current
assets, as an investor it is important to examine the degree to
which current assets exceed current liabilities.
The most pervasive item in the current liability section of the
balance sheet is Accounts payable. Accounts
payable are debts owed to suppliers for the purchase of
goods and services on an open account. Almost all firms buy some
or all of their goods on account. Therefore, you will often see
Accounts payable on most balance sheets.
Long-term debt is a liability of a period greater than
one year. It usually refers to loans a company takes out. These
debts are often paid in installments. If this is the case, the portion
to be paid off in the current year is considered a current liability.
That wraps up our short review of liabilities. You only have one
piece left of the balance sheet left to learn - Shareholders' Equity.
Remember that Assets minus Liabilities equal Shareholders' Equity.
WHAT
IS SHAREHOLDERS' EQUITY?
Shareholders' equity is the value of a business to its
owners after all of its obligations have been met. This net worth
belongs to the owners. Shareholders' equity generally reflects the
amount of capital the owners invested plus any profits that the
company generates that are subsequently reinvested in the company.
This reinvested income is called Retained Earnings.
Now that we understand the major components, let us move forward
to examine a sample balance sheet.
EXAMPLE
OF A BALANCE SHEET
Below you will see an example of a balance sheet and the various
components that you have been studying earlier. The most important
lesson to learn in viewing this example is that the basic balance
sheet equation holds true.
Assets = Liabilities + Shareholders' Equity
The following balance sheet is arranged vertically starting with
assets and then proceeding to detail liabilities and shareholders'
equity. Note that the balance sheet gives a snapshot of the assets,
liabilities and equity for a given day. In our case, that is December
31. Often a balance sheet shows information for two successive periods
as the one below. This gives the investor a better perspective of
the company's operations by showing areas of growth.
Pete's Potato
& Pasta, Inc.
Balance Sheet Ending December 31st |
|
1998 |
1999 |
| ASSETS |
|
|
| Current Assets |
|
|
| Cash and cash equivalents |
$ 10,000 |
10,000 |
| Accounts
receivable |
35,000 |
30,000 |
| Inventory |
25,000 |
20,000 |
| Total Current Assets |
70,000 |
60,000 |
| Fixed Assets |
|
|
| Plant and machinery |
20,000 |
20,000 |
| Less depreciation |
-12,000 |
-10,000 |
| Land |
8,000 |
8,000 |
| Intangible Assets |
2,000 |
1,5000 |
| TOTAL ASSETS |
$ 88,000 |
79,500 |
| LIABILITIES
AND SHAREHOLDERS' EQUITY |
| Liabilities |
|
|
| Accounts
payable |
$ 20,000 |
15,500 |
| Taxes payable |
5,000 |
4,000 |
| Long-term bonds issued |
15,000 |
10,000 |
| TOTAL LIABILITIES |
40,000 |
29,500 |
| SHAREHOLDERS'
EQUITY |
| Common Stock |
40,000 |
40,000 |
| Retained Earnings |
8,000 |
10,000 |
| TOTAL SHREHOLDERS' EQUITY |
48,000 |
50,000 |
| LIABILITIES & SHAREHOLDERS'
EQUITY |
$ 88,000 |
79,500 |
As you can see, total liabilities and shareholders' equity equals
total assets.
TYING
IT ALL TOGETHER
You have now learned the basic construction of a balance sheet
and should have a clearer understanding of its importance. The basic
financial statement reveals what a company owns, what a company
owes to others, and the investments its owners made. It details
how a company finances its operations and what assets the company
has acquired with this financing.
The key to understanding the balance sheet is in the most basic
and fundamental of all accounting equations: Assets must equal liabilities
plus shareholders' equity. All of our further balance sheet analysis
will be based upon that building block.
This concludes our introductory tutorial on the balance sheet.
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