The balance sheet provides users, such as creditors and investors, with information regarding the sources of finance available for projects and infrastructure. At the same time, it normally provides information about the future earnings capacity of a company's assets as well as an indication of cash flow implicit in the receivables and inventories.
The balance sheet has many limitations, especially relating to the measurement of assets and liabilities. The lack of timely recognition of liabilities and, sometimes, assets, coupled with historical costs as opposed to fair value accounting for all items on the balance sheet, implies that the financial analyst must make numerous adjustments to determine the economic net worth of the company.
The analyst must understand the components, structure, and format of the balance sheet in order to evaluate the liquidity, solvency, and overall financial position of a company.
Balance Sheet Format
Balance sheet accounts are classified so that similar items are grouped together to arrive at significant subtotals. Furthermore, the material is arranged so that important relationships are shown.
The table below indicates the general format of balance sheet presentation:
This format is referred to as the account format, which follows the pattern of the traditional general ledger accounts, with assets at the left and liabilities and equity at the right of a central dividing line. A report format balance sheet lists assets, liabilities, and equity in a single column.
Balance Sheet Components
These are cash and other assets expected to be converted into cash, sold, or consumed either in one year or in the operating cycle, whichever is longer. The operating cycle is the average time between the acquisition of materials and supplies and the realization of cash through sales of the product for which the materials and supplies were acquired. The cycle operates from cash through inventory, production, and receivables back to cash. Where there are several operating cycles within one year, the one-year period is used. If the operating cycle is more than one year, the longer period is used.
Often referred to simply as investments, these are to be held for many years and are not acquired with the intention of disposing of them in the near future.
Property, Plant, and Equipment
These are properties of a durable nature used in the regular operations of the business. With the exception of land, most assets are either depreciable (such as a building) or consumable.
These lack physical substance and usually have a high degree of uncertainty concerning their future benefits. They include patents, copyrights, franchises, goodwill, trademarks, trade names, secret processes, and organization costs.
These vary widely in practice. Examples include deferred charges (long-term pre-paid expenses), non-current receivables, intangible assets, assets in special funds, and advances to subsidiaries.
These are obligations that are reasonably expected to be liquidated either through the use of current assets or the creation of other current liabilities within one year or within the operating cycle, whichever is longer.
The excess of total current assets over total current liabilities is referred to as working capital. It represents the net amount of a company's relatively liquid resources; that is, it is the liquid buffer, or margin of safety, available to meet the financial demands of the operating cycle.
These are obligations that are not reasonably expected to be liquidated within the normal operating cycle but instead at some date beyond that time. Bonds payable, notes payable, deferred income taxes, lease obligations, and pension obligations are the most common long-term liabilities. Generally they are of three types:
The complexity of capital stock agreements and the various restrictions on residual equity imposed by state corporation laws, liability agreements, and boards of directors make the owner's equity section one of the most difficult sections to prepare and understand. This section is usually divided into three parts:
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