- Part 3: Understanding the Balance Sheet - June 12, 2016
- Part 2: How well you performed – The Income Statement - May 15, 2016
- Part 1: Your quick guide to financial statements - April 27, 2016
In our last 2 posts, we got a brief overview about the the different financial statements companies produce in their annual reports and got an in-depth understanding about the income statement.
So now that we’ve gained an understanding about how company performance is analysed (through the income statement), we need to understand the financial health of the company.
A quick overview of the different financial statements
To give context to financial statements, imagine that company analysis is similar to how you judge the success of a person:
- The Income Statement is equivalent to the financial performance of a person – how much he/she earns in a given year demonstrates how well he has performed in his/her job
- The Balance Sheet indicates the financial health of a person – whether he/she is in good shape, whether he/she has any housing or personal debt outstanding
- The Statement of Cashflows indicates how much cash a person has on hand – financial performance and health does not mean anything if a person does not have cash! Cash is the life and blood of companies
In this series, we proceed to understand the Balance Sheet. What does the Balance Sheet tell us in terms of a company’s financial health?
Understanding the accounting equation
In order to have a good grasp of the balance sheet, we need to understand something fundamental to accounting – The Accounting Equation:
In the Balance Sheet, the accounting equation always holds – Assets = Liabilities + Equity.
It’s simple: If imagine you invest $1,000 to buy a shop that costs $2,000 to start a business. The accounting equation appears as such:
As we can see in the simple example, you truly own $1,000 of the house because you paid $1,000 of it. The rest is owed by the bank. Owner’s equity represents this $1,000 ownership.
Throughout the balance sheet, every asset, liability and equity is representing and appropriately balanced by a corresponding account
Types of Assets and Liabilities
This part can get a little technical so bear with me, but it is absolutely essential to know!
Assets are expected to provide an inflow of future economic benefit to the company
- Current Assets are expected to provide economic benefit for up to a year. Examples: Inventory, trade receivables, cash at bank
- Non-current assets are expected to provide economic benefit for more than one year. Examples: Building, land, equipment
- Intangible assets are expected to provide economic benefit but does not take a physical form. Examples: Brand name, customer relationships
Liabilities are expected to cause an outflow of resources in the future for the company
- Current Liabilities are expected to cause an outflow of resources within the next one year. Examples: Money owing to suppliers
- Non-current liabilities are expected to cause an outflow of resources beyond the next one year. Examples: Bonds payable, Bank loans
The understanding of balance sheets is crucial to start investing! Many investors begin their analysis of companies with the balance sheet because the balance sheet gives many more clues that an income statement.
Follow me on this series, Accounting Principles, as we delve deep into understanding a company’s financials.