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Understanding a company's balance sheet

October 29, 2009 13:44 IST
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Any investor wanting to invest in a company should first find out the financial health of the company. A financially strong company would mean that investing your money would ensure its safety and growth.

But how do you determine if a company is financially strong? A company's balance sheet can give you the answer.

Balance sheet is one of the most important and elemental financial statements found in a company's annual report and in other such filings. Here we will understand the fundamentals of the balance sheet, its components in assets, liabilities, equity and their sub-categories.

What is a balance sheet?

Simply put, the balance sheet of a company would give a clear idea to the investors on the company's health as of the date given in it. The balance sheet is a financial statement that basically tells you how much a company owns in the form of assets and how much a company owes in the form of liabilities.

You will also see the different terms in the balance sheet such as net assets, liabilities, stockholders' equity or net worth. The net worth is the difference between what the company owns and what it owes, or simply its equity.

If a company has more assets relative to its liabilities then the company can be considered to be in a good position and as an investor you can invest your money. However, if the company has more liabilities than its assets then as an investor you should carefully analyze the company's current position and future prospects before investing in it.

There are three parts to a balance sheet: assets, liabilities, and equity. Let us briefly see the meaning of these parts.

What are assets?

Assets are the things, tangible and intangible that the company owns and which could give benefits in the future. Broadly speaking, there are two types of assets: current and non-current assets.

There are many sub-categories within these two types of assets. Current assets are divided into cash and cash equivalents, short-term investments, account receivables, inventories and prepaid expenses among others.

Non-current assets are long-term investments, property, plant and equipment, goodwill and other intangible assets among others.

Current assets are those assets of the company that are likely to be exhausted or renewed into cash within one business cycle that is within one year. For instance, the groceries arranged in a supermarket for sales purposes can be called as current assets as these will be sold within the next year.

Non-current assets are all those that are not current assets. As in the above example, the refrigerators used at the supermarket to store groceries can be called as non-current assets as neither they will be exhausted nor converted into cash within a year.

What are liabilities?

As said already, liabilities are obligations owed by the company to its lenders. Like assets, liabilities also fall under two broad categories: current and non-current liabilities.

Current liabilities are the legal obligations which the company is expected to settle within the current year. The supermarket, for example, will get regular supplies of groceries from the wholesaler but might settle the amount only the next month. This is an example for current liabilities.

Non-current liabilities are the money the company will settle in the future or pay over a number of years. For example, the bank loan for a period of time taken by the supermarket developing the business.

What is equity?

From the investor's perspective, equity is the shares owned by the shareholders of the company, hence the name shareholders' equity. But how do you arrive at equity? Equity is the difference between the total assets and total liabilities. Like assets and liabilities, equity is also subdivided into several categories. However, the two biggest of them all are the paid-in capital and retained earnings.

When the stocks of the company was first offered to the public in the form of say initial public offering, the money paid by the shareholders for buying their share of shares is called the paid-in capital. In other words, the paid-in capital is the total amount received by the company on the sale of its shares.

Retained earnings, on the other hand is the total profits made by the company from its operations after deducting dividends paid to the shareholders. It is a cumulative number that is money earned or lost over time. Retained earnings can also be negative to be called 'accumulated deficit' if the company has made a loss over a period of time.

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