Applying Common Sense to Financial Statements – Part 2

At any point of time, an individual may want to check his financial position; his assets or borrowings, if any. He may have petty cash stashed away in bank accounts, investments in bank deposits, stocks or bonds, a home, vehicle, loans and so on. If he decides to record them in an accounting format, he has to draw a personal balance sheet.

If you zoom out of the individual picture into a larger entity, a corporate body, you come across the balance sheet of a company. The financial statement has pretty much the same concepts of assets and borrowings with a few exceptions that incorporate the inherent nature of a large corporation. The concept of owner’s equity is one such example. Secondly, the easy-to-understand terms are replaced with high sounding technical and professional terminologies. For example, borrowings are termed as liabilities to denote a larger sense of what a business owes to its shareholders. Sometimes, the meaning or two or three technical terms may denote the same thing. For example, both capital and funds denote money.

No business operates entirely in cash. Payments in businesses are not instant. Companies purchase land and equipment and build up inventories for production. These assets cannot be liquidated for each business calendar year. Similarly, businesses owe money to creditors, suppliers and tax authorities. Owners do not withdraw their original capital or profits at the end of the business calendar year. Thus, businesses have liabilities. A balance sheet is the statement of summary that presents what a business owns and what it owes at a specific period of time. In other words, the balance sheet summarizes the financial balances of a business. It presents the business’s assets and liabilities at a specific date in a business calendar year. Owner’s equity, that forms part of liabilities, is simply the owner’s money that partly finances the business. To understand better, you need to visualize a business or a company as an entity that uses the owners’ and creditors’ money to purchase fixed or liquid assets that facilitate production.

A balance sheet has three parts: assets, liabilities and owner’s equity. Usually, it is presented in two sections with assets in one section and liabilities and owner’s equity (also called net worth) in another section.

Assets

The asset section is organized into two major categories based on their liquidity. They are current assets and fixed assets. Current assets comprise cash, inventories, receivables and prepaid expenses. These are liquid in nature. Cash is the most liquid asset. Inventories and receivables can be turned quickly into cash than fixed assets like land and building. Receivables denote money that has been accounted for but not received yet. Debtors pay businesses in a payment cycle; a monthly, bi-monthly or a three-month cycle. Prepaid expenses involve expenses paid in advance for future services. Fixed assets include property, factory and equipments, intangible assets and financial assets (long-term investments).

Liabilities

Liabilities include short-term loans such as accounts payable, provisions and long-term loans and corporate bonds. Accounts payable is an account with the supplier of the business. Just like account receivables, the payables too has a payment cycle. Provisions are provided in the statement for warrants or court decisions or taxes. A business raises extensive capital through long-term borrowings as longer the term, lower the interest rate. Owner’s equity comprises the total value of issued shares and reserves. The revenue earned by the business is accounted in the retained earnings part of owner’s equity section.