A Beginner’s guide to The Balance Sheet – A simple analogy

READ THIS: This is a continuation of A Beginner’s guide to The Income Statement – A simple analogy in part of Fundamental Analysis. Do read that article first if you haven’t done so as the same analogy is being used below.

The Balance Sheet is easily found together with the Income Statement (and of course, the Cash Flow Statement) in a typical annual report of a listed company. It has very useful information to understand the financial situation of the company at that particular moment. Many key financial ratios (e.g. Current ratio, Debt/Equity ratio) can be derived using the Balance Sheet. We can also use it to compare it with other companies in the same industry as every company will have their own way of managing their finances.

The Balance Sheet consists of three main components – Assets, Liabilities and Equity. To put it very simply…

Assets are what a company owns,

Liabilities are what a company owes,

and lastly, Equity is the amount invested by the shareholders.

The relationship between the three of them is as follows:

Assets = Liabilities + Equity

Try looking at a few annual reports from different companies and you will realize that the total assets as tabulated in the Balance Sheet will always have the same value as total liabilities plus total equity.

Within assets and liabilities, you might find that they are categorized further into “current” and “non-current”. These are measures of liquidity. If an asset is considered to be “current”, it means that it can be converted into cash within one year. Likewise, a current liability means that it would be due within one year.

You might also want to note that majority of the time, current assets are listed as accordingly to their order of liquidity and current liabilities in the order that they are due.

Here’s a simple diagram for better visualization:

balancesheet.JPG

Note: Non-current is sometimes also known as Long-term or fixed. 

Christopher and his Chicken Rice Stall

Let’s bring back the analogy of the Hainanese Chicken Rice stall set up by your friend, Christopher.

We know that at the end of the second year of business, he has rented two chicken rice stalls and you became an investor (and shareholder) of his company. He has made a reputation for himself and he sees a lot of potential to accumulate more earnings in the long run. He has decided to buy over an entire Kopitiam and make it the main branch of his shop while still running his other stalls.

Let us assume that he bought the Kopitiam at $100,000. He took a bank loan with a period of 10 years. A yearly installment would amount to be $10,300 at a simple interest rate of 3% (Take note that I have used simple interest here to simplify the calculations. In reality, the interest rate should be compounding).

This is how his Balance Sheet would probably look like:

Current assets

Plates and Utensils $500
Equipment (e.g. Rice Cooker) $2,025
Furniture $3,700
Cash (Total revenue) $75,000
Total $81,225

Non-current assets

Property (Kopitiam) $100,000

Total assets = Current assets + Non-current assets = $81,225 + $100,000 = $181,225

Current liabilities

Bank borrowings $10,000
Bank interest $300
Staff salary $14,400
Rental $24,000
Dividends payable $2,410
Total $51,110

Non-current liabilities

Bank borrowings $89,700
Bank interest $2,700
Total $92,400

Total liabilities =Current liabilities + Non-current liabilities = $51,110 + $92,400 = $143,510

Equity

Shareholder investment $10,000
Retained earnings (Net income – Dividends) $21,690
Equity attributable to owners (25% ownership stake) $6,025
Total $37,715

Total liabilities + Total Equity = $143,510 + $37,715 = $181,225

We can observe the following from the above analogy:

1) Asset value

The value of the Kopitiam stays at $100,000 in non-current assets despite having an interest rate of 3% tied to its purchase price. The interest rate is also present in both current and non-current liabilities.

2) Debt to Equity Ratio

He has taken up a lot of debt because of the Kopitiam that he has purchased. In this case, his total debt would be $103,000, both current and non-current liabilities combined. Comparing it to the total amount of Equity he has, his Debt/Equity ratio is at $103,000 over $37,715 which is 2.73 times. What this signifies is that for every dollar of equity that he receives from you (and other shareholders in future), he needs to fork out another $1.73 himself through the company’s earnings to fund for the debt. In such a situation, this may not be as ideal to you as he is leveraging very much on debt. It should be in his and your best interests to make sure that the total debt decreases over time.

3) Current Ratio

His Current Ratio (which is equal to current assets over current liabilities) is at $81,225 over $51,110 which is roughly 1.59 times. This is mainly due to the cash that he has collected from his total revenue. This is an assuring number as he should not have any worries of not being able to pay off any liabilities for this year alone, and having leftover money to continue his business operations.

There are many other financial ratios apart from Debt/Equity ratio and Current ratios that we can derive from the Balance Sheet. The above points are the main things that I would look out for. You may have your own way of analyzing the Balance Sheet too. Please share them in the comments below! I would love to hear them.

I hope this article has benefited you, and that it was easy enough to understand. Stay tuned for the Cash Flow Statement next!

Thanks for reading!

Miss Niao xoxo

Author: missniao

Hello! I blog about financial matters and things that average people can do to have a better retirement. I want to inspire people to take control of their money and have a better understanding about it. If you are interested to know more, follow me @ missniao.wordpress.com! :)

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