What a balance sheet tells an Investor
The financial position of a company as a going concern is never stationary and is in the process of continuous change. Raw materials are purchased and converted into finished goods which, in turn, are sold. Money constantly flows in as sales are effected and customer pay their dues. On the other hand, cash gets regularly depleted as wages and other expenses incidental to the business are paid, purchases are raw materials and essential supplies are made, and suppliers’ bills are settled on due dates. The book value of money of the assets and liabilities as shown on the balance sheet, thus, undergoes a constant change.
To portray these changes as they take place, it becomes necessary to maintain a continuous record of the financial truncations as they take place. To ascertain the financial position of a company as at a particular point of time, the process of recording has to temporarily halt. A balance sheet, then, is the picture which emerges when the process of recording financial transactions is so arrested.
This does not mean that to get a static snapshot of its financial position as on a particular day, the company has to temporarily halt all its operations as is done by some large retailers when they down their shutters for a couple of days for the purpose of the annual stock-taking. All that the company need do is to maintain separate books of account for individual years and stop making further entries in the books pertaining to the year that has just ended unless the transactions specifically relate to that year. Once all the entries are completed, the books can be closed and balances struck which then can be transferred to the balance sheet to show the financial standing of the company as on the last day of the year.
A balance sheet can be prepared after the passage of any predetermined length of time. For example, balance sheet can be drawn up at the end of each month, quarter, six-months or a year. The law leaves companies free to decide how frequently they would like to prepare their balance sheets and only requires that the so-called ‘financial year’, which may be less or more than a calendar year, shall not exceed fifteen months.
Since however, it is both expensive and inconvenient to prepare balance sheets at frequent short intervals, companies invariably prefer to prepare balance sheets at the end of each period of twelve months. The yearly balance sheet is, thus, the one most commonly met with and has the advantage that it covers all of the seasons of the years.
A balance sheet in its traditional form is a columnar statement of the financial position or status of a company. The statement is prepared by listing liabilities on the left-hand side and assets on the right hand side. Balance sheets to prepared break down naturally into four firm divisions –two on the liabilities side and two on the assets sides.
The first division on the liabilities side comprises all ‘permanent’ liabilities in the nature of the share capital and accumulated reserves. The second division covers all temporary liabilities and can be further split into two sub- divisions. The first sub-division includes all long – term or ‘non-current’ liabilities such as debenture bonds, long-term loans from banks or financial institutions, and miscellaneous deferred liabilities.
The second sub-division is made up of current liabilities, that is, obligations which must be met, by convention, within one year from the date of the balance sheet. Such obligations or accounts consist of trade creditors, bank overdrafts or cash credits, deposits from clients against goods to be supplied or from the public as short-term loans, accrued interest, salaries and wages, rates and taxes, unclaimed dividends and such.
The two divisions on the assets-side consist of ‘current’ and ‘non-current’ assets. The distinction between current and non-current assets is relative and depends on the ease and frequency with which an asset can be converted into cash.
[Excerpts from: Balance sheets: Contents, Analysis & Interpretation by Hemant R. Dani]