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Balance sheet 101

A very simple financial statement, the balance sheet gives information about three things - the money available, outstanding loans and the difference between these two.

Balance sheet 101: Introduction

The balance sheet is one of the most important financial statements for an investor to take into consideration. Although this accounting statement may seem difficult to comprehend at the first glance, it is actually a very simple statement if you know what you're looking for. Before we start discussing how to read a balance sheet, we should first know what exactly a balance sheet is.

So, what is a balance sheet?
A balance sheet is a very simple financial statement designed to give readers information about three things - the money available to the company, outstanding loans and the difference between these two.

Let's look at a simple balance sheet of an imaginary company - ABC Limited:

Bank balance = Rs 10,000; money borrowed from a friend = Rs 2500 and the difference between these two numbers is Rs.7,500.

This simple balance sheet tells us that the company ABC Limited has Rs 10,000 but has to repay Rs 2500 to its friend and therefore, has a net amount of Rs 7,500.

Sounds simple? That's all about the balance sheet. Investors should remember that though complicated terms, such as assets (which refers to Rs 10,000 here), liabilities (Rs 2,500 owed to the friend) and shareholder's equity (the difference between these two numbers) are used, the core mathematical principle is that assets = liabilities + shareholder's equity. And if that seems like stating the obvious, it definitely is

The format of a balance sheet:

Assets Liabilities Shareholder's Equity
(A)(B)(C) = (A) - (B)
Rs.10,000Rs.2,500Rs.7,500

In fact, the word balance in the balance sheet has been derived from the requirement that the left side of the equation (assets) should be equal to the right side of the equation (liabilities + shareholders' equity).

Characteristics of a balance sheet:
An important characteristic of a balance sheet is that it gives financial information of a particular moment. It's very similar to a photograph - it only reflects things as of that instant. And that's why a balance sheet is a 'snapshot in time'. And since the quantum of assets and liabilities can vary on a day-to-day basis (or even a minute to minute basis), it is important to keep in mind the date of preparing the balance sheet.

Another important feature of a balance sheet is that most transactions will not affect just one side. This feature is actually the characteristic of the current accounting system and can be best explained with an example. If a company purchases an asset for Rs 100, it cannot be the case that only the assets of the company increased. If that were the case, it would have violated the basic equation.

To ensure that the equation is balanced, we need to see the source of that asset (worth Rs 100). Broadly, there are only two ways through which the company could acquire the money to purchase that asset. The first method is through debt (which means the money needs to be repaid at some point in the future). The company may have taken a bank loan. In that case, the right-hand side of the equation - i.e liabilities - would also increase by Rs 100, thereby maintaining the balance. The second is through the company's own funds. Perhaps, it has made a profit of Rs 100 or shareholders have given extra money to the company. In either case, the right-hand side would still increase but this time, the shareholders' equity would increase, too.

The only exception is a case wherein the company used money from its own cash reserve to purchase the asset. In such a scenario, the amount of cash with the company would go down to the same extent as the increase in asset size. This transaction would not affect the liabilities and shareholder's equity portions i.e the right-hand side of the balance sheet. This is because only the left-hand side is modified to the extent of redistribution among different asset classes.

Interpretation
Since the principle of balance is maintained, one look at a balance sheet should broadly tell you two things - how big the company is (which can be ascertained by looking at the assets) and how indebted a company is, which is in terms of the size of its liabilities. This information is also given on Value Research's website under the 'Financial' tab. In most cases, the size of the assets will be greater than the size of liabilities, but when a company goes through difficult times, it is possible that the size of liabilities exceeds the asset size, thereby having negative net-worth. A case in point is SpiceJet. As a rule of thumb, it is better to stay away from companies that have negative net worth, as these companies are likely to go through bankruptcy (in that case, shareholders are likely to lose all their money).

More articles in this series:

Balance sheet 101: Understanding assets

Balance sheet 101: Understanding liabilities

Balance sheet 101: Understanding equity