A balance sheet is essentially a statement of all assets and liabilities of any commercial organization, shown in a tabular form, at the end of the financial year in the annual report. In this statement, the assets and liabilities must be equal, as otherwise something is wrong in the entries. It is always accompanied by a profit and loss statement. All companies give the previous year's figures for comparison purposes. Now what are the items that are considered as assets and liabilities ? They are:
Assets
Fixed assets - Items like land, buildings, furniture, plant and machinery are considered as fixed assets. They are subject to yearly depreciation as per local IT laws. Other pre-paid expenses, patents, goodwill are also considered as assets and shown separately. Any changes in assets, like a sale of any land or machinery must be shown. Items that are subject to depreciation must reflect it in the statement.
Current Assets: This should be more than current liabilities to remain healthy. Please see my article titled 'Why cash flow is so very important ?' It consists of the following items:
Cash in hand and bank - This is obvious and does not need much explanation.
Debtors, also known as 'Bills Receivables' - This is the outstanding money that is to be collected from customers. It is important that this is collected in time. Unfortunately, many company's sales personnel and management's ignore this area. A sale is not complete unless the money is collected.
Inventories - This is the stocks of raw materials, finished goods and work in progress. The opening and closing stocks of raw materials and finished goods are to be shown. They are to be checked physically. It should be noted that the work in progress should reflect the difference between the opening and closing stock of raw materials. Since it is difficult to physically check WIP, especially in processing companies, many companies hide their inefficiencies under this head.
Liabilities
Creditors, also known as 'Bills Payables' - This is the money that is to be paid to the suppliers. Many companies do not pay their suppliers in time, even after collecting their money from their customers. This will result in this amount ballooning. It is not a good sign. A stage will come when the company will not have sufficient current assets to meet this current liability. This is often called the 'acid test' or the 'current ratio'. Then the company becomes technically insolvent. This is a common problem with most SMEs.
Loans and Advances - This is self explanatory. When you borrow money, it has to be repaid within a stipulated period and hence it is a liability.
Accrued liabilities - The items are tax dues, employee dues, if any and interest obligations which may have to be paid after some time and not necessarily in the same financial year for which the balance sheet is drawn up. It is better to show this separately, so that the focus is not lost in meeting this obligation.
Long term debt - Often, financing agencies give long term loans and many companies pay the interest but do not pay part of the principal due. Certain period of moratorium is always allowed by most financing agencies. Good and well managed companies keep track of such liabilities and keep them under control.
Profit and Loss Statement
This is part of the annual report and shows whether the company made profit. This can be revealing when bulk of the profits come from other income like investments rather than operations. This is a danger sign.
Cash Flow
This is a very important part of a balance sheet. It reflects how the company managed its cash flow. In many countries it is mandatory for the company to show this statement in the annual report. A careful analysis of this statement can be very enlightening.
Analysis of balance sheets
Many ratios based on the information furnished in the annual reports are used for analysis of balance sheets. It is beyond the scope of this paper to cover them. Analysis of balance sheet, profit and loss and cash flow statements of companies is a very important activity for bankers, financing agencies, investors and analysts.
Unfortunately, many companies adopt some illegal practices and window dress their accounts and balance sheets. The company auditors are supposed to verify the veracity of the statements and certify them as correct. We all know what happened to Enron and their auditors Arthur Anderson. There are many more such examples. While this kind of activity has become fairly common all over the world, we cannot assume that all companies do this. This is widely prevalent mainly because the compensation of TMT is linked to the stock market prices on a quarterly basis. It is not possible to audit giant companies in a short time. Just like law, where everyone is deemed innocent unless proven guilty, we have to take the declared performance and balance sheets as true, factual and correct. With the courts viewing such acts as serious white collar crimes, it is prudent to follow ethical practices and show the correct figures, because the consequences of any illegal acts can be disastrous, as and when found. Any fudging of figures is not only cheating the stakeholders, it is also fooling oneself.
© Copyright, August 08, 2008. Without prejudice. All rights reserved
What is a Balance Sheet - To learn more about this author, visit Madhavan T Gopalachary's Website.
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Madhavan T Gopalachary
(Visit Madhavan's Website)
Madhavan Gopalachary, nick name "madgopes"
(g pronounced as in go) given by IIT
classmates, is a Mechanical Engineer and
an alumnus of Indian Institute of
Technology, Madras having passed out
specializing in IC Engines &
Thermodynamics.
He has nearly 35 years of experience in
the Corporate World. He started off as a
trainee and handled sales, marketing,
manufacturing, product management, profit
center management, strategic planning and
corporate development including R & D in
various organizations and at various
levels before becoming a CEO. His last two
professional assignments were at CEO level
before embarking to start management
consultancy business on January 01, 1998.
He has worked for British, Swedish MNCs as
well as very large Indian business houses.
He has spent a large portion of his time
from June 1998 till date in East African
Countries practicing as an independent
Management Consultant.
More details can be obtained at the
following web sites:
mmg.name
/mtg.html;
mmgconsu
lting.biz/
Madhavan's articles can be accessed at www.madgopes.com
.
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