Sunday, 15 July 2012

Balance Sheet Analysis

Balance Sheet:

A Balance sheet, is known as a "statement of financial position", reveals a company's assets, liabilities and owners' equity (net worth).
This means that assets, or the means used to operate the company, are balanced by a company's financial obligations along with the equity investment brought into the company and its retained earnings.
Assets are what a company uses to operate its business, while its liabilities and equity are two sources that support these assets. Owners' equity, referred to as shareholders' equity in a publicly traded company, is the amount of money initially invested into the company plus any retained earnings, and it represents a source of funding for the business.
It is important to note, that a balance sheet is a snapshot of the company's financial position at a single point in time.
Balance Sheet Accounts:
The Chart of Accounts is normally arranged or grouped by the Major Types of Accounts. The Balance Sheet Accounts (Assets, Liabilities, & Equity) are presented first, followed by the Income Statement Accounts (Revenues & Expenses).
Here we're going to discuss the Balance Sheet Portion of the Chart Of Accounts and how it's organized.
While most balance sheet accounts that need to be set up are common to all businesses, some depend on the type of business. Inventory accounts are needed for those businesses that produce and sell goods or "inventoriable" services as well as those that just buy and resell the goods.

The Assets, Liabilities, and Equity are presented in separate sections of a Balance Sheet in order that important relationships and subtotals and totals can be presented.

Note: This USA Order may vary depending on your country.
General Components of a Balance Sheet:
Assets :
Formal Definition:The properties used in the operation or investment activities of a business.
Informal Definition:All the good stuff a business has (anything with value). The goodies.
Additional Explanation: The good stuff includes tangible and intangible stuff. Tangible stuff you can physical see and touch such as vehicles, equipment and buildings. Intangible stuff is like pieces of paper (sales invoices) representing loans to your customers where they promise to pay you later for your services or product.
Assets are generally assigned to sub-categories or sub-groups. Similar types of assets are grouped together. The groups are based on the asset's purpose or use and liquidity (availability of the asset for paying debts).

The order that the Assets are presented are based on the following guidelines:
  1. List the Items that are cash.
  2. List the Items that are held primarily for converting into cash and list them in the order of their expected conversion into cash (beginning with the fastest and moving toward the slowest).
  3. List the Items used in operations that could be converted into cash listed in the order of their expected conversion into cash (beginning with the fastest and moving toward the slowest).
  4. List the Items whose cost provide future benefits or can not be converted into cash.

  • Current Assets:
    Current Assets include Cash and Assets that will be converted into cash or consumed in a relatively short period of time, usually within a year or the business's operating cycle. Prepaid Expenses and Supplies (already paid for or a liability incurred) are included because they will normally be used or consumed within the operating cycle.
    • Cash and Cash Equivalents 
      Anything accepted by a bank for deposit is considered as Cash or Cash Equivalents. Cash in the form of coins and currency, undeposited checks, money orders, deposits in banks are examples. The cash must be available for immediate use and not restricted in any manner.
      • Cash On Hand
        • Cash Register Drawer(s) Funds
        • Undeposited Cash
      • Petty Cash
      • Bank Checking Accounts
        • General
        • Payroll
      • Savings Accounts
      • Money Market Accounts
    • Short-Term Investments 
      Short-Term Investments include readily marketable securities that can easily be sold and converted back into cash. These type of investments normally result from a business in the lucky position of having excess cash available. The invested should be temporary in nature and not made to exercise control over another business or satisfy any other requirements and/or agreements. Reported at current market value by using an allowance for unrealized market gains and losses.

      • Certificates of Deposit
      • Stocks
      • Bonds
      • Other Short Term Investments
      • Valuation Allowance for Market Value Fluctuations
    • Receivables 
      Included in this category are Accounts Receivable (open account customer balances resulting from sales) and customer Notes (principal and interest resulting from sales) that are formalized agreements and evidenced in writing. Short term temporary loans and advances are also included. An allowance for estimated uncollectible amounts is also provided.

      • Accounts Receivable
        This account will normally have a sub ledger that contains a record for each customer or client.
      • Allowance For Bad Debts (Contra Account)
        Used to record customer accounts that may not be collected.
      • Trade Notes Receivable - Current principal portion
      • Interest Receivable
      • Other Receivables
        • Short Term Owner Loans and Advances
        • Short Term Employee Loans & Advances
        • Short Term Travel and Expense Advances
    • Inventory 
      The accounts set up in the inventory section depend on the type of business. Is the business a service, retailer, wholesaler or manufacturer ? For retailers and wholesalers an inventory sub ledger is usually maintained to keep track of each individual product. Manufacturing types of businesses usually and Service types of businesses occasionally maintain sub legers for projects, jobs, and processes.

      • Manufacturer
        • Raw Materials
        • Manufacturing Supplies
        • Work In Process
          • Direct Labor
          • Direct Material
          • Manufacturing Costs
            • Direct Labor
            • Direct Material
            • Manufacturing Overhead - Actual
              • Indirect Labor
              • Supervision Salaries
              • Fringe Benefits
              • Manufacturing Supplies
              • Small Parts
              • Perishable Tools
              • Utilities
              • Depreciation
              • Rent
              • Leases
              • Repairs & Maintenance
              • Insurance
              • Property Taxes
            • Overhead Costs Applied
          • Finished Goods
        • Retailer or Wholesaler
          • Merchandise Inventory
          • Store Supplies
        • Service
          • Work In Process - Projects / Jobs
          • Completed / Unbilled Projects / Jobs
        • Common To All
          • Office Supplies
      • Prepaid Expenses
        Prepaid Expenses are assets created by the early payment of cash or assuming a liability. They expire and are charged to expenses based on the passage of time, usage, or other factors. All Prepaid Expenses could be recorded in a single account or separate accounts could be used for each different type.

        • Prepaid Insurance
        • Prepaid Rent
        • Prepaid Advertising
        • Prepaid Interest
        • Other Prepaid Expenses
      • Other Current Assets
        This category includes other current assets that do not neatly fit into any of the other categories. The amounts must be deemed collectible in a relatively short period of time (operating cycle).
        • Notes Receivable - Current principal portion of Long-term Notes
        • Other Current Assets
    • Long-Term Investments
      Investments that are intended to be held and not converted into cash for an extended period of time (longer than the operating cycle). Reported at current market value by using an allowance for unrealized market gains and losses.
      • Stocks
      • Bonds
      • Other Long Term Investments
      • Valuation Allowance for Market Value Fluctuations
    • Property, Plant, and Equipment
      Assets of a durable nature that are used to provide current and future economic benefits to the business.These accounts will normally have a sub ledger that contains a record for each parcel of land, building, or piece of machinery and equipment along with depreciation calculations and amounts.

      • Land
      • Buildings
      • Accumulated Depreciation - Buildings (Contra Account)
      • Building Improvements
      • Accumulated Depreciation - Building Improvements (Contra Account)
      • Machinery and Equipment
      • Accumulated Depreciation - Machinery and Equipment (Contra Account)
      • Office Equipment
      • Accumulated Depreciation - Office Equipment (Contra Account)
      • Computer Equipment
      • Accumulated Depreciation - Computer Equipment (Contra Account)
      • Vehicles
      • Accumulated Depreciation - Vehicles (Contra Account)
      • Furniture and Fixtures
      • Accumulated Depreciation - Furniture and Fixtures (Contra Account)
      • Leasehold Improvements
      • Accumulated Amortization - Leasehold Improvements (Contra Account)
      • Computer Software
      • Accumulated Amortization - Computer Software (Contra Account)
      • Other Property, Plant, or Equipment
      • Accumulated Depreciation - Other Property, Plant, or Equipment
    • Other Noncurrent Assets
      All assets that are noncurrent and that do not fit neatly into any of the other categories.
      • Long Term Owner Loans & Advances
      • Long Term Employee Loans & Advances
      • Notes Receivable - Long-term principal portion of Long-term Notes
      • Security Deposits
      • Intangible Assets
        • Patents
        • Organization Costs
        • Goodwill
        • Accumulated Amortization (Contra Account)
  • Liabilities :
    Formal Definition:Claims by creditors to the property (assets) of a business until they are paid.Informal Definition:Other's claims to the business's stuff. Amounts the business owes to others.
    Additional Explanation: Usually one of a business's biggest liabilities (hopefully they are not past due) is to suppliers where they have bought goods and services and charged them.
    Liabilities are listed in the order of their expected payment date (maturity). In other words, how soon they must be repaid. Liability accounts are separated into current (short-term) liabilities and long-term liabilities. Short-Term Liabilities generally are debts that must be repaid within 1 year from the date of the balance sheet. Long-Term Liabilities are debts that must be paid more than 1 year from the date of the balance sheet.
    • Current Liabilities
      Current liabilities are the portion of obligations (amounts owed) due to be paid within the current operating cycle (normally a year) and that normally require the use of existing current assets to satisfy the debt.
      • Short Term Notes (Demand Notes)
      • Accounts Payable Trade
        A sub ledger is normally maintained in order to keep up with and track amounts owed to individual suppliers.
      • Accounts Payable Other
      • Payroll Liabilities
        • Accrued Salaries and Wages Payable
        • Employee Payroll Withholdings (Deductions)
          • Employee U.S. Federal Income Tax Withheld
          • Employee State Income Tax Withheld
          • Employee Local Income Tax Withheld
          • Employee FICA Withheld
          • Employee Medicare Withheld
          • Employee Garnishments Withheld
          • Employee Benefits
            • Employee Insurance Deduction Withheld
            • 401 K Deduction Withheld
            • IRA Deduction Withheld
          • Other Payroll Withholdings
        • Employer Provided Benefits
          • Mandatory
            • Employer FICA Contribution Payable
            • Employer Medicare Contribution Payable
            • Employer Federal Unemployment Payable
            • Employer State Unemployment Payable
            • Employer Workmen's Compensation Insurance Payable
          • Optional
            • Employer Provided Health Insurance Payable
            • Employer Provided Life Insurance Payable
            • Employer Provided 401 K Contributions Payable
            • Employer Provided IRA Contributions Payable
      • Sales Tax Payable
      • Unearned Revenues
      • Customer Advances and Deposits Payable
      • Interest Payable
      • Bank Loans (Notes Payable) - Current principal portion of Long-Term Notes
      • Notes Payable (other than bank notes) - Current principal portion of Long-Term Notes
      • Accrued and Estimated Liabilities
        • Accrued / Estimated Taxes Payable
          • Accrued Real Estate and Property Taxes Payable
          • Accrued Income and Franchise Taxes Payable
            • Accrued Federal Taxes Payable
            • Accrued State Taxes Payable
            • Accrued Local Taxes Payable
        • Other Accruals Payable
      • Other Current Liabilities
    • Long-Term Liabilities
      Long term liability accounts are the portions of debts with due dates greater than a year or the operating cycle. These are obligations that are not expected to be paid within the current operating cycle.
      • Bank Loans (Notes Payable) - Long Term principal portion
      • Notes Payable (other than bank notes) - Long Term principal portion
      • Other Long-Term Liabilities
  • Equity (Capital):
    Formal Definition: The owner's rights or claims to the property (assets) of the business.
    Informal Definition: What the business owes the owner(s). The good stuff left for the owner(s) assuming all liabilities (amounts owed) have been paid.
    The accounts set up in this section will depend on the legal structure of your business. These accounts report the Owner's Capital Invested and the Accumulated Profits or Losses for the business since it began. Owner sub ledgers may also be maintained to keep up with and track shares and interests and amounts owed individual owners.
    • Sole Proprietorship
      • Owner's Capital
      • Owner's Drawing
    • Partnership or Limited Liability Company
      • Partner's or Member's Capital
      • Partner's or Member's Drawing
    • Corporation
      • Capital Stock
        • Common Stock
          • Common Stock Par or Stated Value
          • Premium Paid on Common Stock
        • Preferred Stock
          • Preferred Stock Par or Stated Value
          • Premium Paid on Preferred Stock
      • Retained Earnings

    Sample Balance Sheet:

    Example Company
    Balance Sheet
    December 31, 2011

    Current AssetsCurrent Liabilities
    Cash$   2,100 Notes Payable$   5,000 
    Petty Cash100 Accounts Payable35,900 
    Temporary Investments10,000 Wages Payable8,500 
    Accounts Receivable - net40,500 Interest Payable2,900 
    Inventory31,000 Taxes Payable6,100 
    Supplies3,800 Warranty Liability1,100 
    Prepaid Insurance     1,500 Unearned Revenues     1,500 
    Total Current Assets   89,000 Total Current Liabilities   61,000 
    Investments   36,000 Long-term Liabilities
    Notes Payable20,000 
    Property, Plant & EquipmentBonds Payable  400,000 
    Land5,500 Total Long-term Liabilities  420,000 
    Land Improvements 6,500 
    Equipment201,000 Total Liabilities  481,000 
    Less: Accum Depreciation   (56,000)
    Prop, Plant & Equip - net  337,000 
    Intangible AssetsSTOCKHOLDERS' EQUITY
    Goodwill105,000 Common Stock110,000 
    Trade Names  200,000 Retained Earnings229,000 
    Total Intangible Assets  305,000 Less: Treasury Stock   (50,000)
    Total Stockholders' Equity  289,000 
    Other Assets     3,000 
    Total Assets$770,000 Total Liab. & Stockholders' Equity$770,000 

     The notes to the sample balance sheet have been omitted.

    Analysis of a Balance Sheet:

    Since balance sheets present the health of a company as of one point in time, valuable information will be lost if managers do not take the opportunity to compare the progress and trend of a business by regularly evaluating and comparing balance sheets of past time periods. Information is power. The information that can be gleaned from the preparation and analysis of a balance sheet is one financial management tool that may mean the difference between success and failure.

    For analyzing and better understanding of your company's liquidity and leverage position you can calculate liquidity and leverage ratios using data from your balance sheet, 

    These financial ratios turn the raw financial data from the balance sheet into information that will help you manage your business and make knowledgeable decisions.

    A ratio shows the relationship between two numbers. It is defined as the relative size of two quantities expressed as the quotient of one divided by the other. Financial ratio analysis is important because it is one method loan officers use  to evaluate the credit worthiness of potential borrowers. Ratio analysis is a tool to uncover trends in a business as well as allow the comparison between one business and another. 

    In the following section, four financial ratios that can be computed from a balance sheet are examined: 
    • Current Ratio 
    • Quick Ratio 
    • Working Capital 
    • Debt/Worth Ratio

    Current Ratio :
    The current ratio (or liquidity ratio) is a measure of financial strength. The number of times 
    current assets exceed current liabilities is a valuable expression of a business’ solvency. 

    Here is the formula to compute the current ratio: 

    Current Ratio =     Total Current Assets/Total Current Liabilities

    The current ratio answers the question, “Does my business have enough current assets to meet the payment schedule of current liabilities with a margin of safety?” A rule-of-thumb puts a strong current ratio at 2

    Of course, the adequacy of a current ratio will depend on the nature of the small business 
    and the character of the current assets and current liabilities. While there is usually little doubt about debts that are due, there can be considerable doubt about the quality of accounts receivable or the cash value of inventory. 

    A current ratio can be improved by either increasing current assets or decreasing current liabilities. 
    This can take the form of the following: 
    • Paying down debt. 
    • Acquiring a loan (payable in more than one year’s time). 
    • Selling a fixed asset. 
    • Putting profits back into the business. 

    A high current ratio may mean that cash is not being utilized in an optimal way. That is, the cash might better be invested in equipment. 

    Quick Ratio: 
    The quick ratio is also called the “acid test” ratio. It is a measure of a company’s liquidity. The quick ratio looks only at a company’s most liquid assets and divides them by current liabilities. 

    Here is the formula for the quick ratio: 

    Quick Ratio =     (Current Assets - inventory)/ Current Liabilities 

    The assets considered to be “quick” assets are cash, stocks and bonds, and accounts receivable (all of the current assets on the balance sheet, except inventory). The quick ratio is an acid test of whether or not a business can meet its obligations if adverse conditions occur. Generally, quick ratios between 0.5 and 1 are considered satisfactory as long as the collection of receivables is not expected to slow. 

    Working Capital Working capital should always be a positive number. It is used by lenders to evaluate a company’s ability to weather hard times. Often, loan agreements specify a level of working capital that the borrower must maintain. 

    Working Capital = Total Current Assets - Total Current Liabilities 

    The current ratio, quick ratio and working capital are all measures of a company’s liquidity. In general, the higher these ratios are, the better for the business and the higher degree of liquidity. 

    Debt/Worth Ratio /Leverage Ratio:
    The debt/worth ratio (or leverage ratio) is an indicator of a business’ solvency. It is a measure of 
    how dependent a company is on debt financing (or borrowings) as compared to owner’s equity. It 
    shows how much of a business is owned and how much is owed. 

    The debt/worth ratio is computed as follows: 

    Debt/Worth Ratio =     Total Liabilities/ Net Worth 
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