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Mar 1, 2012

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Guide Through the Balance Sheet & Its Key Terms

The Balance Sheet (BS) is a financial statement which gives a snapshot of the companies assets and the funds that are related to those assets at an instant in time.

*Note: I will use a two column layout as it is easier to understand.
We can split the BS in two mayor blocks: Assets and Liabilities/Funds:

                       Assets           Liabilities/Funds
Things owned
the business
Amounts owed
the business

The blue block, assets, representing the company uses has given its resources. In other how the company spent the money. The green block, Liabilities, represents the sources of that money. Whether through the contribution of partners or debt, the whole block can be considered as liabilities, because the company is a legal entity independent of its owners.

As you may have noticed there is a balance between the two blocks. this occurs given that all the resources that a company obtains, either through loans or contributions of partners are used in assets.

Total Assets ($1000)  =   Total Liabilities/Funds ($1000)

The Balance Sheet Structure:

We can divide our balance in 5 mayor blocks. Lets start by the Assets:

Total Assets = Current Assets (CA) + Fixed Assets (FA)

1.Current Assets (CA)
             Assets       Liabilities/Funds

This block includes all short-term assets. Short-term means they can be converted quickly and easily into cash. 
  • Inventories: Raw materials, work in progress, finished goods...
  • Accounts receivables: generally, they represent amounts due from customers.
  • Cash and cash equivalents: bank accounts, cash
  • Miscellaneous: other short-term assets, like pre-payments

2.Fixed Assets (FA)
          Assets       Liabilities/Funds   

The second mayor block represents the long investments of the company.
  • Intangibles: They do not have a physical presence, like the Goodwill, patents and licenses. Nevertheless, they have a great impact in the balance sheet and the value of a company. For example, check the image below, which represents the market value of a coca-cola's outstanding shares (the market cap) in 2007, with and without including the brand value.
  • Net fixed assets: these are those physical items required for operations.(Lands and Buildings, office equipment, machinery...)
  • Long-term investments / other assets: generally, it refers to shares in other companies. It is the market value of a company's outstanding shares.
*Note: the BS does not pretend to reflect the market value of the company or its assets.

Total Liabilities = Current Liabilities (CL) + Long-term loans (LTL) + Owner Funds (OF)

Total Assets = Total Liabilities therefore  

Total Assets = Current Liabilities (CL) + Long-term loans (LTL) + Owner Funds (OF)

3.Current Liabilities (CL) 

       Assets          Liabilities/Funds

All short-term assets (To be paid within one year). The accounts we can find in this block counterbalance the current assets,  and their relation is reflected in the cash position of the company.
  •     Accounts payable: Amounts due to suppliers,
  •     Short-term loans: Bank overdraft, interest on short-term debt.
  •     Miscellaneous: bank accounts
4. Long-term Liabilities (CL) 

         Assets          Liabilities/Funds

All mortgages, term loans, bonds, etc., to be paid in a period longer than a year. You can also classify them in medium (3-5 years) and long debt (from 5 to 20 years).

5. Owner Funds (OF) 

 All claims by the owners of the business:

            Assets            Liabilities/Funds
  • Issued common stock: nominal value or book value is the price used to bring owners of capital into the business. It differs from the market value which fluctuates.
  • Capital reserves: By the law in some countries is a statutory reserve. This account covers all surpluses accruing to the common stockholders that did not arise from trading. Example: the revaluation of fixed assets, the premiums on shares, currency gains, etc.
  • Revenue reserves: are amounts retained in the company from normal trade. Example: revenue reserves, general reserve, retained earnings.
Finally, let's give some numbers to our balance sheet, and learn 4 key terms you will need to master, in order to analyse the performance of a company.

                   Assets                     Liabilities/Funds
1.Fixed Assets
2.Current Assets
5.Owners Funds
4.Long Term L
3.Current Liabilities

1. Total Assets = $700 ( FA)+ 300 (CA)
Total Assets = $450( FA)+ $350(CA) + $200 (CL)

2. Capital employed (CE) = fixed assets + investments + inventory + accounts receivable + cash – accounts payable and short terms loans.

In other words CE =  Total assets - Current liabilities. or  CE = Owners Funds + Long Term liabilities

Capital Employed = ($700 + $300) - $200 or CE = $450 + $350

Why is it important? Because it represents the long term foundation funds of the company.

3. Net worth:

Net worth =  $700 (FA) + $300 (CA) –  $200 (CL) –  $350 (LTL)

The value of the company is determinate by the value of the total assets less external liabilities. In other words, once a company  pays all debts the remaining belongs to the owners of the company.

4. Working capital (WC)

It is a measure of liquidity (cash availability). It is the ability of the company to meet the day a day cash demand. There are companies rich in assets, but short in liquidity. 

Known as WC = Current Assets  – Current Liabilities ,  WC = $300 - $200

It can also be defined as the difference between the long term funds and the fixed assets.

WC = OF + LTL – FA,                                           WC = $450 + $350 - $700

WC = Capital employed (CE) – FA                         WC = $750 - $700

Which means that those long terms funds that are not linked to fixed assets determine the working capital.