Reading a balance sheet
A balance sheet (or statement of financial position) is an accounting report that provides a snapshot of a business’s position at a given point in time, including its assets, its liabilities and its total or net worth (assets less liabilities). “A balance sheet does not aim to depict ongoing company activities,” wrote Joseph Simini in Balance Sheet Basics for Nonfinancial Managers. “It is not a movie but a freeze-frame. Its purpose is to depict the dollar value of various components of a business at a moment in time.”
Balance sheets are typically presented in a vertical report form. Asset accounts are listed first, with the liability and owners’ equity accounts listed in sequential order directly below the assets. The term “balance sheet” originates from the the fact that the balance sheet is a representation of the accounting equation (assets=liabilities + capital), thus the two totals should balance.
Contents of a balance sheet
Most of the contents of a business’s balance sheet are classified under one of three categories: assets, liabilities, and (owners) equity.
Assets
Assets are items owned by the business, whether fully paid for or not. These items can range from cash to inventories, equipment, patents, and deposits held by other businesses. Assets are further categorized into current assets and non-current assets.
Current assets include cash, accounts receivable, inventories, prepaid expenses, and any other item that could be converted to cash in the normal course of business within one year.
Non-current assets include property,equipment (from office equipment to heavy operating machinery), vehicles, fixtures, and other assets that can reasonably be assumed to have a life expectancy of several years. In practice most non-current assets—excluding land—will lose value over time. This is reflected in accounts through a a process called depreciation. Non-current assets are reported net of depreciation in the balance sheet.
Non-current assets also include intangibles like the value of trademarks, copyrights, and a difficult category known as “goodwill.” When someone buys a company and pays more for it than the worth of its assets, the difference is written into the books of the acquired entity as “goodwill.”
Liabilities
Liabilities are the business’s obligations to other entities as a result of past transactions. Liabilities may be due to employees (salaries), investors ( for loans) or to other companies (who have supplied goods or services). Liabilities are typically divided into two categories: current liabilities and non-current liabilities.
Current Liabilities are due to be paid within a year. These include payments to suppliers, payable taxes and accrued expenses (like wages and salaries). Current liabilities also include the “current” portion of long-term debt payable within the coming year. Non-current liabilities are amounts owed to lenders, mortgage holders, and other creditors payable over more than one year
Equity
Once a business has determined its assets and liabilities, it can then determine (owners’) equity i.e. the book value of the business. Owners’ equity, Or shareholders equity in the case of a limited company, is in essence the company’s net worth.
A balance sheet, if studied closely, can tell the any business owner much about the enterprise’s health. In Balance Sheet for Nonfinancial Managers, for instance, Simini points out that “in a well-run company current assets should be approximately double current liabilities.” He goes on: “By analyzing a succession of balance sheets and income statements, managers and owners can spot both problems and opportunities. Could the company make more profitable use of its assets? Does inventory turnover indicate the most efficient possible use of inventory in sales? How does the company’s administrative expense compare to that of its competition? For the experienced and well-informed reader, then, the balance sheet can be an immensely useful aid in an analysis of the company’s overall financial picture.”
(Some of the material in this post has been adapted from inc.com, the original post can be found here http://www.inc.com/guides/2010/06/how-to-read-a-balance-sheet.html)
Reading an income statement
This is the first of three posts which give you a quick guide to reading the three key financial statements – the income statement, balance sheet and statement of cash flows. This post deals with the income statement, with the other two coming over the next few weeks.
The Income Statement
An income statement presents the results of a company’s operations for a given period—usually a year. The income statement presents a summary of the revenues, expenses, profit or loss of an entity for the period. This statement is similar to a moving picture of the entity’s operations during the time period specified. Along with the balance sheet and the statement of cash flows, the income statement is one of the primary means of reporting financial performance. The key item listed on the income statement is the profit or loss.
Within the income statement there’s a good bit of information. If you’re knowledgeable about reading financial statements, in a company’s income statement you’ll find information about return on investment, risk, financial flexibility, and operating capabilities.
The current view of the income statement (in line with International Financial Reporting Standards (IFRS)) is that income should reflect all items of profit and loss recognised during the accounting period. The following summary income statement illustrates the format under IAS 1 – Presentation of Financial Statements (image from http://www.accaglobal.com):
This example above is fairly typical of the income statement of a large public company. I’ll explain some items below.
Some terms on the income statement explained
Revenue
According to the IASB’s IAS 18, revenue is defined as “the gross inflow of economic benefits (cash, receivables, other assets) arising from the ordinary operating activities of an entity (such as sales of goods, sales of services, interest, royalties, and dividends)”. This means that revenue is typically the figure for sales of goods or provision of services for the period of the income statement.
Cost of sales.
The cost of sales figure includes all expenses incurred in buying to making the product or service which generates revenue.
Other Income
This is income from sources like interest or investment income.
Expenses
Expenses are classified as either distribution cost, administrative expenses, other expenses or finance costs. No further detail is needed.
Share of profit of associates
This figure is the share of the profits made in an associate company – one where 20-49% is owned by the company (or group of companies) the income statement is prepared for.
The final item in the example above represents a loss made in a section of a business which is discontinued. This separate disclosure is required by accounting standards. Additionally, IAS1 also requires a short statement of comprehensive income, which shows unrealised gains (like unrealised asset revaluations, or currency gains/loses on translation). I don’t include it here, but it is usually no more than a few lines.
Self financing your business
Here’s an article from inc.com (7 Easy Steps to Bootstrapping Success) which give some good ideas on self-financing a business venture. Some useful advice seen as banks are not too generous with start-up financing at present.
Routine activities – a source of waste and additional cost?
I don’t write too much on my blog about my research interests, but this one I just have to share. To be honest, I have been putting it off for a while too. Brian Plowman (a consultant specialising in productivity management) wrote a short, but to me really inspiring piece in Financial Management in May of this year (pp. 29-30 if you have access to a copy).
Institutional and organisational theory would define a routine along the lines of; a routine is a repetitive, recognisable patter of interdependent actions involving multiple actors (see an article by Feldman & Pentland 2003, in Administrative Science Quarterly). The article from Financial Management takes a more practical approach to routines. It mentions the term “interfacing activities” which become routine. These interfacing activities are links between the tasks carried out by individuals in organisations. In themselves, these interfacing activities are not a problem, but what tends to happen is that lots of informal interfacing activities creep into organisations. These may be quite wasteful. For example, the article mentions a hospital worker looking for a particular piece of equipment. It is not where it should be or where a computer systems says it should be. So the employee has developed a whole series of interfacing activities to find it. This is turn have become so common place that they are now a routine and accepted activity. Wasteful? Yes of course it is. The article proposed that up to 50% of an organisations interfacing activities may in fact be wasteful (as in the hospital example). Can this be remedied. Finding these informal and potentially wasteful activities is difficult, but it could reap huge benefits.
Another over-budget ERP
For some of my students, take a look at this news item re cost over-runs in an ERP implementation. The item gives some very typical reasons for cost over-runs in implementation projects.
Investors call for clearer business reporting
CIMA commented recently (see here) on an IFAC report which suggests that financial reports have become too complex with the result that the underlying financial performance of a business is hidden. Add to this the increasingly complex nature of businesses and you get some idea if the problems in compiling clear concise and meaningful reports. The IFAC report quotes Tanya Branwhite, executive director of strategy research at Macquarie Securities in Australia: ‘If financial accounts are not prepared with the users in mind, then we risk a whole area of unaudited “shadow reporting” being provided directly to investors that doesn’t go through the rigorous financial accounting process,’ she warns.
I remember from my early accounting lectures that a ‘knowledgeable’ investor in seen as the defining user of accounting reports. If you are prepared to stick your money where your mouth is, you’ll want to know all the detail. But the problem is that financial statements just can’t provide this, or as the IFAC report highlights, are too complex. According to the IFAC report, business reporting suffers from a number of significant issues at present: information overload, fair value accounting, operational performance, convergence of accounting standards, real time reporting, management commentary and sustainability reporting. The big questions is how can financial reporting help solve these? One simple answer suggested is that investors might become more actively involved in the standard setting process (i.e. IFRS) and discussions about the presentation and content of financial reports.
Economic progress reaches the roof of the world
This caught my eye the other day in the Economist :Nepalese telcoms: High-fi | The Economist.
New business ideas: renting a car by the hour
I read this article in The Economist recently about businesses renting out cars by the hour. It’s a good story from many angles – threatening car manufacturers; reducing emissions; new business ideas. Have a read and see what you think.
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