A company’s balance sheet is essentially a statement of its wealth (assets) and what it owes to others (liabilities) at a particular point in time. The assets could be fixed assets like land, buildings plant and machinery. They could be movables like cars or computers. They could also be liquid assets in the form of cash reserves or receivables payments due to the company from those it has goods to, for instance, or repayments on loans given. Liabilities are anything the company has to pay to others. Thus, they would include payments due to its suppliers. Loans taken from others as well as interest due on those loans would also be part of the liabilities. What is owed to the shareholders would also fall in this category.
However, balance sheets present this information not explicitly under the heads assets and liabilities, but rather as a statement that gives sources of funds on top application of funds below. All sources of funds effectively constitute liabilities. Share capital and reserves and surpluses form liabilities owed to the share holder, while loans are liabilities towards others. The application of fund segment is a listing of assets, except for one entry, which is current liabilities and provisions. The gross value of assets, minus the current liabilities, gives the figure for net current assets. Net current assets must be equal in total figure at the end of the sources of funds segment. This also means that net assets and net liabilities are always equal, hence the term balance sheet.
Application of funds includes value of fixed assets of current assets (like receivables or inventories) as well as investment. Entries in the balance sheet are explained in more detail in annexed schedule. In fact to make the most of a balance sheet, it is important to look at these schedules closely.
If a balance sheet is always balanced how does it indicate financial health?
To begin with, a balance sheet in itself cannot adequately tell us whether a company is in sound financial health or not. For that we must also look at balance sheets for earlier years as well as profit and loss accounts of the company. This is because while a balance sheet presents the picture of the company’s finances at a particular point in time, the profit and loss account tells us how the company has performed over a period of time – a quarter half year or full year. Thus, a company may have considerable assets but that may be a result of good performance in past years. While it may be doing badly at present or it may have accumulated liabilities from bad performances in the past, but may have turned the corner and started doing very well. Looking at the situation at one specific date will not tell us which of these is true. Looking at the current position (balance sheet) and the performance over a year (P&L account) will obviously tell us more. Subject to those caveats, a balance sheet itself can give significant pointers to the financial health of a company. For instance, while assets and liabilities will match in every balance sheet, a company whose liabilities are primarily to its shareholders is clearly better placed than one which owes a lot to the rest of the world.
The P&L account details the income and expenditure of the company over a quarter, half year or year. Unlike a balance sheet income and expenditure of course need not be balanced. Where income exceeds expenditure the account will show a profit, where the reverse is true, we have a loss. Expenditure includes not just operating cost like inputs and wages but also provisions that the company has to make for depreciation of its fixed assets, for interest on loans, dividend payable to shareholders and tax.
Thus, we have several different figures for profit. The first stage is operating profit that tells us whether the company is able to sell its products at higher than cost and by how much. Then, we have profit after depreciation or profit before tax (PBT).
While depreciation does not actually involve any cash outgo, the reason it is counted as if it an expenditure is because depreciating assets ultimately have to be replaced. Companies are happy to have high depreciation rates, since its saves tem tax the profit that is taxable is profit after deprecation. Next comes the provision for tax, giving us the profit after tax (PAT), which is also normally known as net profit, though in some cases there might be some other extraordinary provisions which give a lower figure for net profit.
Not necessarily. They might indicate a company that has not very bright prospects in future. Normally a highly profitable company that sees the prospect of future growth would be using its reserves to invest in expansion rather than letting cash idle in bank accounts However, this is only a thumb rule, since investment tends to be lumpy. So it could be that cash reserves are huge at the moment because the company is building up to a big investment some time soon.