Stockwire 28-Dec-2020

Balance sheet 101: Introduction

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

is 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? at'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

e format of a balance sheet:

Assets Liabilities Shareholder's Equity

(A) (B) (C) = (A) - (B)

Rs.10,000 Rs.2,500 Rs.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. is 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. e first
method is through debt (which means the money needs to be repaid at
some point in the future). e 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. e 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.
e 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. is transaction would not affect the liabilities and
shareholder's equity portions i.e the right-hand side of the balance sheet.
is 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. is 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).

We hope that this article has helped you understand the basics of a
balance sheet. We are coming up with more articles on individual balance
sheet items, including assets, liabilities and shareholder's equity.

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