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Balance Sheet Deciphered in Simple Layman Language

 What is a Balance Sheet and how to make money reading it?

If an individual has reached a point in their life when he/ she starts thinking about investing his/ her money, chances are they have definitely heard the term ‘balance sheet’ being used at least one in their lifetime. So, what is a balance sheet and what does it signify? By the end of this article, we shall explain everything that a balance sheet implies, its use and its importance while making an investment. So, keep reading.

The first question that needs to be answered is, what is a balance sheet? A company’s accounts can be divided into three important statements buried right in the middle of a hundred-page document we call the set of accounts. There are a profit and loss account, a balance sheet, and a cash flow statement. As the name suggests, the profit and loss account gives away the net profit of an organisation during a given period and the cash flow statement shows us where the stream of cash is coming in from and where is it being spent.

Today we are mainly focussing on the balance sheet. Every twelve months, the directors will prepare a balance sheet and if I have to explain it to a layman, I would say that as such it represents you freezing the business and taking almost a photograph of where it's at right now. It shows the company’s assets, liabilities, and owner’s equity at a specific point in time. Basically, a balance sheet shows what a company owns (i.e. assets), what it owes (i.e. liabilities), and how much owners and shareholders have invested (i.e. equity). A company always has to pay for everything they own (i.e. assets) and they do this by either borrowing money (i.e. liabilities) or getting money from owners and investors (i.e. equity). And so, it always has to balance sheet always has to balance (assets= liabilities+ equity) – hence the name ‘balance sheet’. The balance sheet gives us a snapshot of all the assets, liabilities, debt and equity a company has at a given point of time. And so, the companies publish their balance sheets at the beginning for the financial year and the end, and by accessing the difference between the two it shows us how the company performed during the year.

Now that I have used the terms- assets, liabilities, equity and debt multiple times, its time for me to explain what they actually mean.

Assets are essentially the resources owned by the organisation with the help of which it creates value. In simpler terms, assets are anything that can be used in the production of a good or a service thereby creating economic value (i.e. generating income) for the organisation. For example, for a newspaper company, the printing press would be considered as their assets.

They can be classified into current assets and non-current assets. Current assets are the assets that can be liquidated within 12 months or 1 financial year for example – debtors, stock in the inventory, cash, etc. Non-current assets on the other hand are used for the long term in the production of goods for example vehicles, machines, furniture etc.

Liabilities, as the name suggests, are the obligations an organisation owes to either outside parties or even the owners. For example, a loan taken for business operations, creditors, etc. Liabilities can be classified into three, current, non-current, and shareholders’ funds (i.e. equity).

Current liabilities are the ones that need to be paid by the business within the financial year like creditors. And non-current liabilities are to be paid over a longer period of time say- 5-10 years for example- a loan that needs to pay over a period of 15 years. Equity is basically what the organisation owes its owners/ shareholders and these include the profits as well.

IMPORTANCE OF BALANCE SHEETS

Not only is a balance sheet important for the organisation, but it is also important for all the other stakeholders of the organisation like the shareholder, employees, the government, the community etc. It gives the interested parties a clear picture of how the financial health of the business is or how is it performing compared to the previous year.

Firstly, it is helpful for the management of the organisation. Managements need to make decisions regarding the organisations all the time and to do so they need to access the situation of the organisation before. They generally require details like the Company’s debt funding status, liquidity situation assessment, trade receivables status, cash flow availability, the investment made in other assets, and fund availability to plan their future expansions. Therefore, the balance sheet helps the management in calling shots based on the status of the organisation.

Another important use for the balance sheet if to the organisations’ investors. They use the balance sheet and the other financial statements to analyse the organisation’s financial soundness. They do this by analysing various ratios to understand the future growth potential and the current returns it has been generating. Based on these numbers investors or potential investors decide if they want to be kept their investment of increase/ decrease it in the organisation.

The balance sheet is also assessed by the banks or financial institutions to decide if they want to lend money to the organisation. As the balance sheet shows the current composition of debt and equity as well as assets and liabilities, it helps them come to a conclusion that is the organisation already over-borrowed or if it still has some scope of borrowing.

Another important stakeholder of organisations is the government. Not only does the government need the balance sheet for tax calculation purposes, but they also need to look out for any malpractices or fraudulent activities taking place in the organisation. Similarly, the stock market regulator, SEBI needs to look out for its investors and needs to make sure that their interests are being safeguarded and no misdeeds are being done.

Sometimes, the clients of the organisation also may need to look the balance sheet to see if the company can provide a steady supply and not go bust anytime soon in the future. 

HOW TO READ BALANCE SHEETS

Reading about the financial strength of an organisation just from a balance sheet generally requires a particular amount of study and comparison, also access to the supplementary financial report, the income report.

This analysis is known as the Financial Ratio and analysis. By comparing this period's calculated ratios with prior periods and industry benchmarks, allows us to spot healthy/unhealthy trends within the financial strength of the organisation in reference to its past and therefore the industry as a whole. Whether the returns from the business are competitive with other investment options, whether the corporate is becoming more or less profitable, more or less hooked on to external funders, better or less ready to meet its financial obligations once they become due or more or less efficient at managing the assets of the corporate. There are various sorts of financial ratios but they're generally grouped into 4: Leverage Ratios, Liquidity or Solvency ratios, Operational Ratios, and Profitability ratios.

Leverage Ratios are the ratios which calculate the extent to which the corporate uses external debt in its capital structure instead of equity funders. Over-reliance on external debt makes a company's profitability susceptible to the rate of interest raises and is more susceptible to liquidation actions by creditors during a downturn. The foremost common leverage ratio is that the debt to equity ratio.

Liquidity/Solvency Ratios are the ratios which calculate the company's ability to pay its debts as they become due. Some companies might be profitable but yet unable to pay critical payments like staff, loan repayments or rent because their money is tied up in debtors (money owed to the company by customers) or inventory. The most common Liquidity/Solvency Ratio is the Quick ratio.

Operational Ratios are the ratios which calculate the efficiency of a company's management in its operations and use of assets. Typical efficiencies affect stock turn and debtor days which measures respectively, the quantity of stock required to realize sales targets and the way many days it takes to urge paid by customers. Generally, you'd not want to overstock and you'd want your debtors to pay within the shortest possible time.

Profitability Ratios are the ones which calculate the return on sales and capital employed. These ratios are usually expressed as a percentage and monitored over time periods to spot healthy/unhealthy trends.

In conclusion, by comparing these ratios with previous periods, commonly agreed safe operating levels and industry benchmarks help us read about the changing financial strength/health of a company from the Balance Sheet report.

RED FLAGS TO LOOK OUT FOR

It is common for a business to expand its line, which increases inventory. However, if inventory goes up, but nothing has changed within a company's offerings, it's going to mean items aren't selling. In many industries, the longer a product remains shelved, the larger the danger it's of becoming obsolete or spoiling. It is simple to identify this problem by examining the record. it's important to calculate inventory for the year by using the ending inventory number from the previous year's record. This amount is split by the present year's sales. If the amount is quite it's been in previous years, something must be done to urge products moving at a swifter pace.

Although a hefty account receivable figure could seem good, it's only profitable if it is often collected. within the business world, the longer an account goes without being paid, the more unlikely it's that the company will see compensation. When receivables begin to mount, it's going to be necessary to regulate the company’s collections process and become stricter together with your credit policies.

It is acceptable to sell old equipment that's not being utilized or that has stopped performing effectively. However, the proceeds should never be wont to pay down debt or be put toward short-term expenses. When this happens, it's going to cause problems for the company's future operating expenses. to form sure gains, losses, and disposals are getting used correctly, it's knowing to examine the companys income and balance sheets.

Even though a business shows a profit on paper, it's going to still be cash poor. When cash doesn't flow into the business, investors may start to stress receivables aren't being collected properly, revenue is being exaggerated, otherwise, they are struggling to pay your loans. If net income is consistently low, they'll suffer a cash crunch. When this happens, it's essential to spot the cause. repeatedly, it's going to flow from to a slow month or similar circumstances. However, if it's thanks to poor collections efforts, it's advisable to speak together with the customers and push for payment.

After identifying the basis of the crunch, one will have a far better understanding of when cash will flow better. It means you'll be required to regulate your payment schedule.

It always looks good when the company shows consistent income from continuing operations. Investors are often leery of seeing income from the sale of fixed assets, an outsized one-time sale, or the sale of investments. Operating income is listed separately from non-operating income on your earnings report. If there is a particular increase from year to year, it's going to be necessary to focus on sources of revenue that are solid and steady.

Many companies have "other" expenses that are very small or inconsistent. it's normal and is reflected within the record and income statements. However, when these things have high values, it's a particular red flag and wishes to be checked. In many cases, a number of these expenses are often reclassified. Other times, the high value could also be a one-time occurrence.

Delving into a company's financial statements will give investors great insight into its overall performance and future. Knowing the essential red flags will assist the investors to identify problems. 

An investor should be vigilant about investigating anything during a company’s earnings report that raises a red flag. Both revenues and expenses are susceptible to manipulation. Company management often has incentive to interact in manipulation and auditors don't always catch on. Reading the earnings report and management’s discussion of its business (together with the record and footnotes, also because the income statement) provides clues for vigilant investors.

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