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Resources - Applied Finance / Chapter 10

The Balance Sheet

Balance sheet

Overview

The final chapter in this module talks about the balance sheet, along with what it means its significance & components.

Balance Sheet - General Summary

The balance sheet summarizes and reports the entity’s assets and liabilities as of the date of the report. It allows stakeholders to understand the nature of assets owned by the organization as well as what amounts are due to whom. 

Further in this article, we will be using the balance sheet of Tata Steel Limited (TSL) for the years 2021-22 to explain the different components of the balance sheet. You can access the balance sheet from the annual report (page no. 292) provided on the tata steel website.

Uses & Importance

The balance sheet is important for both internal and external stakeholders of the company.

  • The investors and the creditors of the company use the balance sheet to understand how the capital that they have supplied is being employed by the company and to determine the likelihood that they will be repaid.
  • The internal stakeholders of the company use information from the balance sheet to understand when and how much the company owes its suppliers and creditors and to ensure that they have sufficient liquidity (usually in the form of cash and/or account balances) to meet those needs.
  •  The balance sheet also communicates the leverage position of the firm, that is, the share of debt in the funding mix which is of interest to both internal and external stakeholders.
  • Last but not the least, the information from the balance sheet, when put together with the information from the income statement can be used to compute several efficiency ratios (Several of these efficiency ratios will be introduced in later modules, but may be understood as the ability of the firm to generate profits or other outcomes from different forms of assets or capital employed) which can be used to evaluate the performance of the company which is of interest to both the internal and external stakeholders of the firm.

The components of the Balance Sheet

All items on the balance sheet may be classified into one of three categories, assets, liabilities and owner’s equity. There exists a relationship between the three with the assets always being equal to the sum of the liabilities and the owner’s claims or equity. Several sub-classifications within these three categories are typically made to better communicate the firm’s financial position.

  • Assets

    Assets are economic resources in which a company has invested in expectation that they will either help the company in its functions (for example, a piece of machinery which helps in the manufacturing process or a building in which services can be delivered) or can be resold at a profit.

    Only monetary assets appear on the balance sheet. For instance, while employees may be a very important asset for a service company, they will not appear on the balance sheet of the company. Additionally, it is important to note that assets are typically listed at the lower cost of acquisition and the market price to satisfy the conservatism accounting convention. Thus, the value of assets on the balance sheet is usually lower than their market value. 

    Assets are further classified into current and non-current assets based on whether the assets will be used up (or exchanged for cash) within the year. Thus, current assets are assets that the firm expects to use up within the year. Common types of current assets include

    • Cash and bank balances - (Items II(b)(iii & iv) in TSL balance sheet)
    • Short-term financial investments – Such as in treasury bills (Items II(b)(v, vi & vii) in TSL balance sheet)
    • Receivables – Value of services/goods sold in credit for which cash is yet to be received (Item II(b)(ii) in TSL balance sheet)
    • Inventories – Inventories may be further classified into raw material inventory, work in process (raw materials which have been processed, but, have yet to be transformed into final goods) and final goods inventory (Item II(a) in TSL balance sheet)

    Non-current assets are assets such as buildings, machinery, software, copyrights etc. which are expected to benefit the firm over a long period of time. Some of the important non-current assets include

    • Property, plant and equipment – comprises buildings, machinery and other equipment (Item I(a) in TSL balance sheet). Such assets except land are depreciated over the expected life, the purchase cost is usually given as gross block and the carrying value net of accumulated depreciation is reported as net block.
    • Capital Work in Progress (CWIP) – Long term tangible assets under construction (Item I(b) in TSL balance sheet)
    • Intangible assets – Assets such as softwares, copyrights and patents (Item I(d) in TSL balance sheet)
    • Long term investments – Long term investments made in other companies, financial assets, loans provided etc. (Items I(f,g) in TSL balance sheet)
  • Liabilities

    Liabilities are dues payable by the entity to external parties either towards repayment of debt or towards goods/services supplied, but not yet paid for. As with assets, liabilities are typically classified into current and non-current. Current liabilities are those that are due within a year and common current liabilities include:

    • Short-term borrowings – loans which fall due within a year (Item VI(a)(i) in TSL balance sheet)
    • Trade payables – Payments due towards goods/services supplied, but not yet paid for (Item VI(a)(iii) in TSL balance sheet)
    • Provisions – Provisions are predicted costs which are expected to be incurred towards goods sold, but, not yet known (Item VI(b) in TSL balance sheet). For instance, a manufacturer may expect costs to be incurred towards replacing defective products under a guarantee period. While it is not possible to know the exact cost to be incurred based on prior data, a cost may be predicted and expensed. Such expenses are also recognized in the balance sheet as liabilities and any real expenses as and when incurred are adjusted against such provisions

    Similarly, common long-term liabilities include

    • Long-term borrowings (Item V(a)(i) in TSL balance sheet)
    • Long-term provisions (Item V(b) in TSL balance sheet)
    • Other liabilities – such as financial, lease and tax liabilities
  • Equity

    As shareholders are the residual owners of the company, the value of the assets of the company less the dues owed to other stakeholders belongs to them. The equity/shareholders equity records such amounts due to the shareholders. The equity is further divided into:

    • Common stock – comprises the investment by the shareholders into the business (Item IV(a) in TSL balance sheet)
    • Retained earnings – comprises the share of profits retained for use in the business (Item IV(c) in TSL balance sheet)

Closing summary

All the aforementioned cover the main components of the income statement. However, the exact terminologies used will vary across different companies based on their operational characteristics and accounting choices. Now that we have covered the preparation and interpretation of the income statement, as an exercise, you can compare the financial statements of a few service companies and companies that manufacture goods to see how they vary from each other.