Tuesday, August 19, 2008

Understanding a balance sheet

While studying in secondary level, I was never interested to learn accounting. Even though mathematics is one of my favourite subjects, I thought balance sheet is a difficult concept to understand at first. After dwelling into stocks recently, I am slowly starting to appreciate looking at a company’s balance sheet.

Balance sheet is one of the three important financial statements that summarises a company Total Assets, Total Liabilities and Total Equity at a particular point of time. This point of time can be the last day of the financial year or quarter (ie 31 Dec 2007).

The fundamental balance sheet equation which consists of Total Assets, Total Liabilities and Total Equity can be expressed in the following equation:

Total Assets = Total Liabilities + Total Equity

For example if you have $500k worth of assets and out of which $200k is borrowed from the bank, therefore your asset is $500k and your liability is $200k. Total equity or your net worth in this example becomes $300k.

To elaborate further, the variables in the above equation can be broken down in the following expressions.

Total Assets = Current Assets + Non-Current Assets
Total Liabilities = Current Liabilities + Non-Current Liabilities

In the new expressions, current and non-current variables are added into the picture. Just note that current assets have a life span of one year or less. They include cash or anything that can be converted into cash easily. On the other hand, non-current assets are those that cannot be converted into cash within a year. They may also include intangible assets like goodwill and patents.

As for the liabilities portion, the same life span is applied to the variables. Current liabilities are those financial debts or repayments that need to be settled within a year while non-current liabilities are considered longer term debts that can be settled after one year.

Now let us relate the new equations to the earlier example. Lets assume that your loan of $200k is taken from separate banks and half of the loan need to be repaid within a year while the other half after one year. Assume that $400k of property value and $100k of cash make up your total assets. The balance sheet of this example may look like the following table:

Sample balance sheet in Excel

What you see in the table above is a simplified example of a balance sheet. They may look similar if you see an actual balance sheet. I suggest that you look at Vicom’s balance sheet. It is one of the cleanest balance sheets that I can think of. For a start, if possible try to avoid balance sheets of financial companies. They may confuse you with their long list of debts and complicated structures.

After looking more into a company’s balance sheet, my confidence level and understanding improves further. There are many things that you can pick up from the balance sheet of a company but I think those concept requires a separate topic to explain.

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