Every entity running business activities in India must prepare financial statements for every financial year the business exists. Irrespective of whether the motive of the entity is to earn profits or is a not for profit organisation, the preparation of financial statements provides innumerable benefits to the organisation. Understanding a balance sheet is vital for the shareholders and the board of directors of the company.
Constituents of a financial statement
Before we can understand what a balance sheet is and how to read a balance sheet, we must learn the constituents of financial statements. A company usually prepares the following statements of accounts:
1) Profit and Loss Account
2) Balance Sheet
3) Cash Flow Statement
A listed company releases these financial statements for the general public to read and comprehend.
The Profit & Loss Account is a financial statement prepared for the entire financial year. It contains a summary of all the incomes and expenses of the entity during the period under consideration. After comparing the incomes with the expenses, the resulting figure is either the net profit or the net loss taken forward to the balance sheet.
The Balance Sheet is always prepared on a particular date. If the financials are being prepared for the entire year, the balance sheet ends on 31st March. 31st March is the year-end in India – in any other country, the laws could be different. However, if a listed company is releasing its quarterly limited review statements, the balance sheet would be prepared as on the last date of that quarter. The balance sheet pictures the position of the company on a particular date only.
As per the regulatory requirements in India, a company is also required to prepare a Cash Flow Statement. The Statement divides the cash flows of the company into three categories-
1) Operating Cash Flows
2) Financing Cash Flows
3) Investing Cash Flows
Accordingly, the cash movements of the company are reconciled to show the resulting cash and bank balance available with the company as at the year-end.
Is reading a balance sheet difficult?
Understanding a balance sheet is relatively straightforward. Now, a balance sheet is just a statement of all the assets and liabilities of a company. But what are assets and liabilities?
1) Asset –
An asset is a resource with financial benefits, owned and controlled by an entity acquired due to a past event. The resource has the potential to generate future economic benefits for the entity. The past event could be a purchase transaction, swap or even a merger – any event that gives the entity ownership over the asset. It is necessary to note that there are broadly two categories of assets – current and non-current. Let’s understand these in detail.
a) Current Assets
Current assets are those that the entity believes will be sold, consumed or exhausted within one year. Common current assets are inventory, cash and cash equivalent, trade receivables or debtors and bills receivables. Other liquid assets can also be included. Current assets are shown as a separate sub-head within the heading of assets and are the lifeline of any business. As current assets can be converted by the business owners into cash relatively quickly, it is used to fund business running expenses.
b) Non-current assets
These are the long-term investments of a company. The company does not intend to sell or completely exhaust these items in one year. Non-current assets are required for the consistent growth and expansion of a business unit.
Liabilities are the obligations of a business unit – what the entity owes to the others. Similar to the classification of assets, liabilities, too, can be current and non-current.
a) Current Liabilities
Current Liabilities are the liabilities that the company has to pay off or settle within one year. These typically include business purchases made on credit, short-term borrowings and short-term tax obligations.
b) Non-current liabilities
These liabilities are the ones that are required to be paid off after one year. So there is no immediate financial obligation on the company when it comes to non-current liabilities. Long-term loans, debt raised from the public and preference share capital are examples of non-current liabilities. An easy way of identifying these is to see whether there is a fixed interest payout commitment.
3) Shareholder’s funds
The third type of element found in a balance sheet is share capital or equity. Capital is the money raised from the owners of the business. Equity is different from liability because the company is not obliged to make a fixed payment to the owners – any future payment is discretionary and is the company’s choice.
Understanding a balance sheet
Now that you are well-versed with all the balance sheet terminologies, it is time to decipher meaningful information by reading a balance sheet.
You can use the above data to calculate meaningful financial ratios. Leverage, solvency, efficiency, profitability and dividend ratios are the most common ratios used by corporates. A company’s balance sheet plays a crucial role in understanding the company’s financial soundness and forecasting its growth prospects. Since all the listed companies are required to prepare their financials as per the Indian Accounting Standards (Ind AS), a comparison of the financial standing of different companies within the same industry becomes possible.
Practical application of the readings
If you are an investor in the stock market, you must know how to read and understand a company’s financials. With this ability, you will be able to fundamentally analyse a stock and judge the valuation of a company. This knowledge will help you take entry and exit positions and give you control over your finances.
Reading a balance sheet is not only for Chartered Accountants and finance graduates. If you have the determination to do better in the stock market, or if you hold a passion for understanding financials, you should go ahead and do your research. Don’t limit your knowledge to degrees – all the information is readily available on the web. Receive expert guidance if needed, and make financial freedom a reality.