The Balance Sheet tells a great deal about the financial position and management of the company. To understand what a balance sheet tells you, you should know how to analyze it. Analysis of balance sheets is not very complicated. However, you should have a clear idea of how to approach the analysis.
First of all, you should know what each item in a typical published balance sheet means. In this article, we look at the items you will find in a typical balance sheet and briefly outline what each of them signifies. Part one of the article looks at current assets and liabilities and part two looks at long term assets and liabilities.
Meanings of Balance Sheet Items
Cash and Short Term Investments: Bank balances and money market funds are examples of cash and its equivalents. These can be immediately used for making payments, but earn no income for the company. Short-term investments include investments in bonds and such instruments that earn some income, and can be sold and converted into cash quickly when needed
Receivables: Businesses typically allow customers to pay for their purchases after a credit period of 30/60/90 days. Receivables represent the unpaid amounts due from customers. Such credit helps to increase the volumes of their sales in a competitive market. However, if the customer becomes unable or unwilling to pay, the receivable amount might not be recovered in full. Companies typically make a provision for such bad debts.
Inventory: Companies that sell physical goods typically stock merchandise (or raw materials to produce the merchandise). Inventory represents the stocks so held, and helps ensure that no orders are lost because merchandise was not available. While inventory helps business in this way, it also requires space to store, equipment and manpower to manage and involves considerable time to be converted into cash. If inventories are not sold quickly, they can become obsolete or even get physically spoilt. Inventories should thus be minimized to the extent possible.
Prepaid Expenses: Businesses typically have to make certain payments in advance. For example, they might have to pay rent, utility payments and taxes in advance. These prepayments are subsequently adjusted as expense when the amounts become due, and remain under the head Prepaid Expenses till that time.
Other Current Assets: Any other amounts that are receivable within one year are included as other current assets. This can include Notes Receivable, which are short term debts owed to the company.
Total Current Assets: The amounts against the items listed above are totaled to arrive at the total current assets, which are assets that get converted into cash during the day-to-day operations of the business.
After current assets come the current liabilities, which are amounts the company must pay within a year.
Accounts Payable: Just as the company extends credit to its customers, the company’s suppliers will also extend credit to the company. Accounts payable represents the bills for goods and services that the company has already received but which have not been paid for yet.
Accrued Expenses: These are expenses like staff salaries and bonuses that have become due but have not yet been paid.
Notes Payable: These are debts payable by the company in less than a year.
Current Portion of Long Term Debt: Long term debt is typically paid off over a number of years in installments. The installments due within one year are included under current liabilities.
Other Current Liabilities: Any other amounts payable within one year will be shown under this heading.
Total Current Liabilities: The total of the liability items outlined above constitute this total.
Working Capital: If you deduct the Total Current Liabilities from the Total Current Assets, you get the working capital employed by the company. It is working capital that finances day-to-day operations and its inadequacy can bring operations to a halt. We will look at this critical item in more detail in the article on balance sheet analysis.
Next come the long term assets held by the company. Unlike current assets, these are not converted into cash during regular operations. Instead they are used during their useful lifetime to facilitate day-to-day operations. We look at these in part two of the article.
