Part 1: The Income Statement
Part 3: Cash Flow Statement
Part 4: Financial Ratios
This is the second part of Understanding Financial Statements, this part would cover the balance sheet segment of the financial statements, which shows the assets that the company currently owns as well as the liabilities it has. There are 5 key segments of a balance sheet: Current Assets, Non-Current Assets, Current Liabilities, Non-Current Liabilities and Equity.
Assets of a company
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Current Assets
This category comprises assets that are expected to be sold, used up or able to be liquidated within a year or within an operating cycle for a company, which is the amount of time needed for a company to purchase raw materials, process them, sell them and receive the payment.
Cash and Cash Equivalents
As the name goes, this includes the cash and assets that can be easily converted to cash that the company holds. This includes cash on hand, fixed deposits, short-term government bonds and money market funds. Usually companies need a buffer of cash in case creditors come knocking on the door before their clients are able to pay for their products, however, too large a cash reserve (cash hoarding) is not a good sign as 1) it shows the management's unwillingness to pay dividends and 2) the company would make a good target for an unfriendly takeover. Unless the management has clear plans for the cash, a large cash reserve is usually an alarm bell due to the low returns that cash and cash equivalents are able to generate.
Trade Receivables
This item is made up of amounts due to the company by its clients for the products or services that it has supplied. In a more real-life and individual example, when you work for your company and get your paycheck at the end of the month, you are actually receiving receivables from the company as you have provided the service and the company legally owes you your wages. In the perspective of a company, trade receivables are created when companies sell services on credit.
Trade receivables provide some insight into the business as well. If trade receivables are increasing at a rate faster than revenue is growing, the company is giving more liberal credit terms for its customers or distributors, which is usually a sign of deteriorating business and vice-versa.
Inventory
This as it implies is the inventory that the company has on hand. This is an important item in some companies, where products are devalued quickly, such as fashion and computer hardware. Large inventories without sufficient revenue to support them would result in the company having to write down the value of its inventory at a later date when it is forced to dispose of them or sell them at a lower price.
Non-Current Assets
This category refers to assets that would take longer than a year or an operating cycle to be used up and also includes non-tangible assets (goodwill)
Property, Plant and Equipment (PP&E)
This is made up of the land, the buildings, the machinery, software, etc, that the company owns. Some industries may require more, such as manufacturing, construction, etc, while other industries would require less, eg service industries.
Investment in Companies
Usually this is shown as "Investment in associated companies", "Investment in Joint Venture", "Investment in Subsidiary", but they refer to the same basic idea that this is the value that the company has placed on its share of companies that it owns. Just for extra info, the difference between a subsidary and an associated company is that subsidaries are majority (50% or more) owned by the company while associated companies only mean that the company has significant voting rights (usually 20-50%)
Goodwill
This is one of the segments that you would like to focus on in the balance sheet. This is made up of intangible assets, added when there is a discrepancy between the purchase price of a company and its tangible (physical) assets. When looking at the balance sheet, usually I like to remove the goodwill portion of the equity as it is intangible and is based purely on the purchase price of the companies set by the management of the company.
Liability burdens
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Current Liabilities
Directly in contrast with current assets, these make up the amount of money that the company is likely to have to pay within one operating cycle or one year.
Trade Payables
These make up the value of the products or services that the company has obtained on credit. Opposite of trade receivables, the faster this grows relative to revenue (of course not overwhelmingly so), the better as the company is able to get better payment terms with its suppliers and is hence able to hold on to money for a longer period of time, reducing its short-term borrowing costs.
Borrowings
This refers to the short-term borrowings or long term notes or borrowings that are due to mature within the operating cycle or one year. A large amount of borrowings in current liabilities with little current assets is not a good sign as the company has liquidity risk, the risk of not being able to meet its short-term obligations.
Non-Current Liabilties
Borrowings
This shows the long-term borrowings that the company has. Having too much of this is not good as it increases financing costs for the company (unless they are able to earn a high rate of return on it)
Equity
This is not the end-all-be-all of the financial statement but is an important part of the information that you can gather from it. This shows the net assets that a company has and after deducting minority interests, represents the net value of assets that belong to shareholders of the company
Share Capital
This shows the amount that the company has gathered by issuing shares.
Reserves
Some of these are due to legal restrictions on the cash of the company or as an allowance for bad debts. Their specific purpose is covered in the Notes to the Financial Statements of the company
Retained Earnings
This is the amount of money that the company has generated for shareholders in excess of the share capital, which was provided to the company.
Current Assets + Non-Current Assets - Current Liabilities -
Non-Current Liabilties = Total Equity
Total Equity - Minority Interests = Equity attributable to owners of company
Summary
This concludes this part on the balance sheet segment of the financial statements, the next part, the cash flow statement would cover the cash flow of the company.
For the next part on this topic:
Part 3: Cash Flow Statement
For the other parts on this topic:
Part 1: The Income Statement
Part 4: Financial Ratios
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