How do I understand a balance sheet?

Balance sheet

A balance sheet, also known as a statement of financial position, reveals a companys assets, liabilities and owners equity (net worth).

The balance sheet, together with the income statement and cash flow statement, make up the cornerstone of any companys financial statements.

If you are a shareholder of a company, it is important that you understand how the balance sheet is structured, how to analyze it and how to read it.

,1.

The Balance Sheet EquationThe main formula behind balance sheets is: Assets = Liabilities + Shareholders EquityThis means that assets, or the means used to operate the company, are balanced by a companys financial obligations along with the equity investment brought into the company and its retained earnings.

The total assets must equal the liabilities plus the equity of the company.

,2.

Know The Current AssetsCurrent assets have a life span of one year or less, meaning they can be converted easily into cash.

Such assets classes include cash and cash equivalents, accounts receivable and inventory.

Cash, the most fundamental of current assets, also includes non-restricted bank accounts and checks.

Cash equivalents are very safe assets that can be readily converted into cash; U.

S.

Treasuries are one such example.

Accounts receivables consist of the short-term obligations owed to the company by its clients.

Companies often sell products or services to customers on credit; these obligations are held in the current assets account until they are paid off by the clients.

,3.

Know The Non-Current AssetsNon-current assets are assets that are not turned into cash easily, are expected to be turned into cash within a year and/or have a life-span of more than a year.

They can refer to tangible assets such as machinery, computers, buildings and land.

Non-current assets also can be intangible assets, such as goodwill, patents or copyright.

While these assets are not physical in nature, they are often the resources that can make or break a company - the value of a brand name, for instance, should not be underestimated.

Depreciation is calculated and deducted from most of these assets, which represents the economic cost of the asset over its useful life.

,4.

Learn The Different LiabilitiesOn the other side of the balance sheet are the liabilities.

These are the financial obligations a company owes to outside parties.

Like assets, they can be both current and long-term.

Long-term liabilities are debts and other non-debt financial obligations, which are due after a period of at least one year from the date of the balance sheet.

Current liabilities are the companys liabilities which will come due, or must be paid, within one year.

This is includes both shorter term borrowings, such as accounts payables, along with the current portion of longer term borrowing, such as the latest interest payment on a 10-year loan.

,5.

Learn about Shareholders EquityShareholders equity is the initial amount of money invested into a business.

If, at the end of the fiscal year, a company decides to reinvest its net earnings into the company (after taxes), these retained earnings will be transferred from the income statement onto the balance sheet into the shareholders equity account.

This account represents a companys total net worth.

In order for the balance sheet to balance, total assets on one side have to equal total liabilities plus shareholders equity on the other.

,6.

Analyze With RatiosFinancial ratio analysis uses formulas to gain insight into the company and its operations.

For the balance sheet, using financial ratios (like the debt-to-equity ratio) can show you a better idea of the companys financial condition along with its operational efficiency.

It is important to note that some ratios will need information from more than one financial statement, such as from the balance sheet and the income statement.

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Types of financial statements

A financial statement is a statement that is mainly prepared to show the financial PERFORMANCE of an entity for a certain period of time, or to show the financial POSITION of an entity at a particular date.

They are 4 main financial statements.

,The Statement of Profit or Loss and other Comprehensive Income.

This shows the performance of an entity regarding whether it has made a profit or a loss, and how much.

,The Statement of Financial POSITION.

This shows the financial position of an entity at a particular date, usually the financial reporting date.

It shows the balances of the entitys assets, liabilities and equity.

,The Statement of Changes in Equity.

This shows the movements that have occurred, which affect the overall equity balances at the financial reporting date.

It shows items such as issue of new shares, revaluation of assets, issuance of dividends etc.

,The Statement of Cash Flows.

This shows the movement of the businessu2019 cash and cash equivalents during a financial period.

Cash flow statement

Cash flow statement is one of the basic financial statement required to be prepared by companies.

Before understanding Cash Flow Statement first we should understand What is Cash and Cash Flow.

Cash does not mean only hard cash we have in hand.

Here it means Cash and Cash Equivalent.

Cash Equivalent means those assets which can be converted in cash very easily and quickly without bearing any loss.

It include cash at bank and marketable securities.

Marketable securities means investment traded on daily basis and can be encashed anytime.

It also include bullion( but not ornaments because for encashing ornaments we have to bear loss.

,Cash Flow means any activities because of which there is a change in quantum of cash.

Becuase of any activity if there is an increase in cash it will be called Cash Inflow and if because of an activity there is decrease in cash it is called Cash Outflow.

Cash Flow Statement is a statement which give a complete picture of the inflow and outflow of cash of a company.

It discribe where where we are getting the funds and where we are utlising the funds.

For cash flow statement we divide the whole business activities in three categories:,1 Operating ActivitiesIt is the basic function of a business.

It represents in normal business activities whether we are earning and getting losses on cash basis.

Here cash basis means amount recieved from and paid for normal business activities.

If it is positive means we are earning.

,2.

Investing ActivitiesIt include the activities related to Fixed Assets and Long Term Investments.

It should be negative.

If it is positive means we are selling our assets and if it is positive it means we are buying assets which means our business is growing.

Income recieved from Investment is added in Investing activities.

One important point to be noted is trading investment whether long term or short term are not recorded in this category.

It is recorded in operating activities because it would be the part of our routine business activities.

3.

Financing ActivitiesIt include the change in capital and ling term liabilities of the business like Equity Share Capital ,Preference Share Capital, Debentures and Long Term Loans.

Inflow include issue of securities and raising loans.

Outflow includes refumption ans buyback of secuities and repayment of loans plus interest and dividend paid.

Normally it is negative bacause of payment of dividend and interest.

It being positive means we are arranging funds for development which would be a good sign.

,Sum total of these three activities are equal to the change in Opening and Closing Balance of Cash and Cash Equivalent

Statement of financial position

The reason is described at length in Basis of Conclusions of IAS 1 para BC14 - BC21.

In summary, IASB views that the new title better reflects the function of the financial statement.

The old title pretty much describes the structure of the statement not so about the function.

The board is also in opinion that the new title is more consistent with the references made in the IFRS Framework and what people use to describe on the objective of the statement which is no other than to present the financial position of an entity.

,The relevant excerpts from the standards are as follows for your convenience.

Hope this helps.

,Titles of financial statements.

,[BC14] The exposure draft of 2006 proposed changes to the titles of some of the financial statementsu2014from balance sheet to statement of financial position, from income statement to statement of profit or loss and from cash flow statement to statement of cash flows.

In addition, the exposure draft proposed a statement of recognised income and expense and that all owner changes in equity should be included in a statement of changes in equity.

The Board did not propose to make any of these changes of nomenclature mandatory.

n,[BC15] Many respondents opposed the proposed changes, pointing out that the existing titles had a long tradition and were well understood.

However, the Board reaffirmed its view that the proposed new titles better reflect the function of each financial statement, and pointed out that an entity could choose to use other titles in its financial report.

n,[BC16]tThe Board reaffirmed its conclusion that the title statement of financial position not only better reflects the function of the statement but is consistent with the Framework for the Preparation and Presentation of Financial Statements, which contains several references to financial position.

Paragraph 12 of the Framework states that the objective of financial statements is to provide information about the financial position, performance and changes in financial position of an entity; paragraph 19 of the Framework states that information about financial position is primarily provided in a balance sheet.

In the Boards view, the title balance sheet simply reflects that double entry bookkeeping requires debits to equal credits.

It does not identify the content or purpose of the statement.

The Board also noted that financial position is a well-known and accepted term, as it has been used in auditors opinions internationally for more than 20 years to describe what the balance sheet presents.

The Board decided that aligning the statements title with its content and the opinion rendered by the auditor would help the users of financial statements.

n,[BC17]tAs to the other statements, respondents suggested that renaming the balance sheet the statement of financial position implied that the cash flow statement and the statement of recognised income and expense do not also reflect an entitys financial position.

The Board observed that although the latter statements reflect changes in an entitys financial position, neither can be called a statement of changes in financial position, as this would not depict their true function and objective (ie to present cash flows and performance, respectively).

The Board acknowledged that the titles income statement and statement of profit or loss are similar in meaning and could be used interchangeably, and decided to retain the title income statement as this is more commonly used.

n,[BC18]tThe title of the proposed new statement, the statement of recognised income and expense, reflects a broader content than the former income statement.

The statement encompasses both income and expenses recognised in profit or loss and income and expenses recognised outside profit or loss.

n,[BC19]tMany respondents opposed the title statement of recognised income and expense, objecting particularly to the use of the term recognised.

The Board acknowledged that the term recognised could also be used to describe the content of other primary statements as recognition, explained in paragraph 82 of the Framework, is the process of incorporating in the balance sheet or income statement an item that meets the definition of an element and satisfies the criteria for recognition set out in paragraph 83.

Many respondents suggested the term statement of comprehensive income instead.

n,[BC20]tIn response to respondents concerns and to converge with SFAS 130, the Board decided to rename the new statement a statement of comprehensive income.

The term comprehensive income is not defined in the Framework but is used in IAS 1 to describe the change in equity of an entity during a period from transactions, events and circumstances other than those resulting from transactions with owners in their capacity as owners.

Although the term comprehensive income is used to describe the aggregate of all components of comprehensive income, including profit or loss, the term other comprehensive income refers to income and expenses that under IFRSs are included in comprehensive income but excluded from profit or loss.

n,[BC20A]tIn May 2010 the Board published the exposure draft Presentation of Items of Other Comprehensive Income (proposed amendments to IAS 1) relating to the presentation of items of other comprehensive income (OCI).

One of the proposals in the exposure draft related to the title of the statement containing profit or loss and other comprehensive income.

The Board proposed this change so that it would be clear that the statement had two components: profit or loss and other comprehensive income.

A majority of the respondents to the exposure draft supported the change and therefore the Board confirmed the proposal in June 2011.

IAS 1 allows preparers to use other titles for the statement that reflect the nature of their activities.

n,[BC20B]tSeveral other IFRSs refer to the statement of comprehensive income.

The Board considered whether it should change all such references to statement of profit or loss and other comprehensive income.

The Board noted that the terminology used in IAS 1 is not mandatory and that statement of comprehensive income is one of the examples used in the standard.

The Board decided that there was little benefit in replacing the title statement of comprehensive income in other IFRSs or income statement with the statement of profit or loss.

However, the Board did change the terminology when an IFRS made reference to the two-statement option.

n

Income statement and balance sheet

Some of these may be slightly subjective and are my opinion and what I look for.

Remember, these financial statements do have limitations as they can be a snapshot in time, there can be timing differences, and accounting rules not reflecting economic reality and value.

These are indications that a company will thrive and stay in business, though they can only reflect economic conditions up to a certain point.

This is a simple list - there are of course many other relationships to explore between the statements.

,Income statement:,High margins: gross, operating, and net profit margins,Low G&A: one factor that can reveal the ability to scale.

More sales would then result in higher operating and net profits,Consistency over time - ideally things trending in the right direction - more sales, higher margins, consistent gross margins,Net income and cash flow being similar when appropriately compared/adjusted.

You donu2019t want to see lots of net profit with no cash flow - or at least not without understanding what is driving the difference.

,Balance sheet:,High liquidity such as cash and receivables,Plenty of working capital (current assets - current liabilities).

You may even want to adjust certain accounts such as tax assets, inventory, etc.

depending on the purpose of the analysis eg liquidation,Conservative leverage: low debt relative to equity and cash flow.

Some will use EBITDA.

EBITDA and cash flow have differences that are worth learning about in more depth, but not in this post.

,Limited convertible and dilutive securities (assuming an equity holder perspective),(Added) I do not like an underfunded pension (a pension liability).

It can (and often) reduce cash and future earnings for the pension to again have a surplus or at least not be significantly underfunded.

Income statement is also known as

In the 500 years since the codification of the double-entry bookkeeping and accounting system, the names of its components have changed many times with different names being used by different accounting standards throughout the world.

,As far as the income statement is concerned, it has at times been also known as the:n,Earnings Statement,Statement of Earnings,Profit and Loss Statement,Operating Statement,Statement of Operations,Statement of Expenditures and Revenues,In line with the international accounting standards, Australian reporting entities today use the name - Statement of Financial Performance.

Financial statements examples

Part 1 of 4:Organizing Your Information1.

Determine which holdings to report as subsidiaries.

For the purpose of consolidated statements, a company is only considered a subsidiary if the parent company holds a controlling interest in that company.

Generally, this means that the parent company owns over 50% of the shares of the subsidiary.

This is because this share value would give them majority voting power in the subsidiary.

However, there are situations where a company can be considered a subsidiary even when the parents owns a smaller percentage of their shares, such as:,The parent has majority voting rights by agreement with the subsidiarys board.

,The parent has power to govern the policies of the subsidiary under agreement or law.

,The parent has the ability to remove and replace the majority of the subsidiarys board.

,The parent has the ability to cast the majority of votes during a meeting of the subsidiarys board of directors.

,In contrast, a parent may own more than 50% of a subsidiarys shares and not retain control.

In this case, they are known as an unconsolidated subsidiary and not shown on consolidated statement.

,2.

Gather your paperwork together from all the companies.

When you consolidate financial statements, youll need all of the financial information for each company being considered.

This will include information for the parent company as well.

Specifically, youll need access to the books (the record of all transactions) for each company, as books are not kept for the consolidated entity.

,Its easiest to start with the financial statements of the companies being considered if these have already been prepared.

This will allow you to simply combine larger line items and go back through the books only to eliminate duplicate items.

,3.

Coordinate fiscal periods.

In order to consolidate financial statements, youll need to be sure that all companies financial reports refer to the same fiscal period.

Generally, if there is a mismatch in fiscal periods, you should modify subsidiarys timeline match that of the parent.

This should either be done at acquisition or can be done through an adjustment to the subsidiarys financial statements.

,For example, if a subsidiary considers August 31 as its year end and the parent companys year end is December 31, then prepare financial statements for the first subsidiary running from January 1 through December 31.

This may involve significant adjustment.

,Part 2 of 4:Setting Up a Worksheet1.

Set up a spreadsheet.

This should in a program that you can easily manipulate, like Microsoft Excel.

Be sure to create separate pages for each combined financial statement you plan to create.

At this point, just start by creating one for the consolidated balance sheet and one for the consolidated income statement.

,2.

Add financial information for each company side-by-side.

Set up your spreadsheet so that you can see where youll be adding the information from different companies together.

This will help you organize your information later.

Youll also want to label the rows with what type of financial information you plan to input there.

,For example, for the consolidated balance sheet, label your rows with common titles such as u201cCashu201d or u201cAccounts Payableu201d and u201cInventory.

u201d,3.

Leave every third and fourth column blank for credit or debit consolidation adjustments.

Youll need an area to record adjustments from duplicate transactions as you move forward with the process.

Simply be sure to label these columns individually as credit and debit as you would in bookkeeping and label them collectively as duplicate adjustments or something similar.

,For one subsidiary and one parent, simply fill the first two columns with their financial information and leave the next two blank for these adjustments.

Leave the fifth column blank too for the eventual calculations of the final, adjusted values.

,For multiple subsidiaries, follow this same pattern but separate the subsidiaries.

In this case your spreadsheet columns should be laid out as follows:,1.

Parent financial information,2.

Subsidiary 1 financial information,3.

Adjustments (subsidiary 1)-debit,4.

Adjustments (subsidiary 1)-credit,5.

Consolidated financial information after subsidiary 1 adjustments,5.

Subsidiary 2 financial information,6.

(and on) repeat of process for other subsidiaries,Part 3 of 4:Combining Financial Statements1.

Check your financial statements again.

Before combining them its best to check the financial statements you will be using to ensure that they are for the same fiscal period.

If not, youll want to adjust them now.

Going back and adjusting for this later will be much more work.

In addition, check your financial statements for any missing information and seek to correct this before beginning to consolidate them.

,2.

Create a consolidated balance sheet.

Consolidate financial statements by creating a balance sheet that reflects a sum of net worth, assets and liabilities.

This is done by simply adding together the separate values from the balance sheets of the parent company and the subsidiaries.

The balance sheet will include assets like cash, receivables, and land, as well as liabilities like payable accounts and loans.

,For example, if the parent has $30,000 in cash and the subsidiary has $15,000 in cash, the consolidated balance sheet would show $45,000 in cash.

,3.

Create a consolidated income statement.

This document will include all revenues earned and expenses incurred by the parent company and its subsidiaries.

Like the consolidated balance sheet, this is done by simply adding the values from the companies independent income statements together.

Included values are measures of money earned, including sales and net income, and also measures of expenses like cost of goods sold and wage expense.

,For example, if the parent company incurred $45,000 in income expense and the subsidiary incurred $20,000 in income expense, the consolidated income statement would show $65,000 in interest expense.

,Part 4 of 4:Eliminating Duplicate Values1.

Review the consolidated statements for duplicate values.

After the statements have been consolidated, youll need to check for instances that dont make financial sense.

These situations arise when, for example, when money or assets have flowed between the parent and the subsidiary, or when the part of the value of the subsidiary is now reported twice by the parent.

In general, the consolidated report should read like the financial statements of one company.

Check for the following problems:,The consolidated company owning parts of itself (intercorporate stockholdings),The company owing itself money (intercorporate receivables and payables),The company selling items to itself for profit (intercorporate sales),2.

Eliminate intercorporate stockholdings.

Intercorporate stockholdings refer to the situation where stock in the subsidiary is owned by the parent and is therefore not reportable as stock outstanding in the consolidated statement.

Note that this is not true for subsidiary stock held by parties outside of the parent corporation or subsidiary.

,Adjustments are made on the consolidated balance sheet by debiting the subsidiarys common stock, additional paid in capital, and retained earnings and crediting the consolidate stock of subsidiary account for the book value of the intercorporate shares.

,3.

Account for intercorporate receivables and payables.

These refer to situations where, after consolidation, a company can appear to owe itself money.

This arises from situations where a parent company owes money to or receives money from a subsidiary for products or services.

This results in unnecessarily high values for some of the combined accounts.

,Adjustments for this situation are made on the balance sheet by debiting consolidated accounts payable or crediting consolidated accounts receivable by the book value of the duplicated entry.

,4.

Delete any intercorporate sales.

By transferring inventory between parents and subsidiaries, either party may technically realize a profit, even though no sale has been made.

This results in overstated inventory, net income, and retained earnings for the consolidated company.

,Correct this imbalance on the balance sheet by debiting retained earnings of the consolidated entry and crediting consolidated ending inventory by the amount of the sales.