So, now we have covered the cash flow statement, we understand the cash movements due to operating, investing and financial activities. Now, let us move to the Balance Sheet.
The balance sheet, which also referred to as 'Statement of Financial Position', gives you an idea about what the company owns and how it financed them.
The balance sheet is divided into three parts – Assets, Liabilities and Equity which are related as below
ASSETS = LIABILITIES + EQUITY
Assets are something which is either cash or can generate positive cash flow in the future.
An asset which is either in cash form or can be converted to cash quickly (such as accounts receivable, short term investments, inventories) – are called Current Assets. An asset which takes longer to liquidate is called Non-Current Asset which includes long term investments, Fixed Assets (plants and machinery) and Goodwill.
The value of the non-current assets is generally calculated based on the cost of acquisition adjusted for the depreciation calculated using prevailing accounting rules.
Note: Any entrepreneur can see the problem here. The value of an asset for a going concern is not dependent on the procurement cost but the economic value it can create. Consider that business bought two similar (but not identical) machines at the same time for the same cost. They produce similar parts with a slight difference. Given both machines are similar, the depreciated value for the both will be same (or very similar) say after two years if calculated the written down value method which is prevalent in India or straight-line method.
Now, consider for some reason, the part produced by the first machine is highly popular and the utilisation of the machine is very hight. Whereas, the second machine is rarely used. These trends are not expected to change in the foreseeable future.
Are both the machines of the same value?
From an economic consideration, the first machine is much more valuable because the expected cash-flow it generates in future is much higher than the second one.
Even the liquidation value of the assets are not expected to match the book value. The point is that the value of an asset depends on the expected economic benefit irrespective of what the book value is.
Liabilities tell you about the debt issued by the company – in form of financial debt such as bank loans, bonds & debentures issued, commercial papers issued etc. or operational debt in the form of accounts payable or unearned revenue.
Practically, this section tells you about the contractually obligated future cash outflows with some ideas about the expected timeline. The contractual cash outflows which are expected to happen in the current financial year are grouped together as the current liabilities and the rest in non-current liabilities.
As mentioned, debt is contractual and missing debt payments have significant implication for your company. Depending on debt contract creditors can take hold of pledged assets, start legal action or, in extreme cases, force the liquidation of the company.
So, as an entrepreneur, your priority is to arrange cash for the debt payments in a timely fashion because default can put your business at risk.
This part of the Balance Sheet, also known as Net-Worth, shows the ownership interest or capital invested in the business. The Equity value (book value) shows a theoretical value which the shareholders (also knows as owners and members) of the company receive if the company is liquidated.
EQUITY = ASSETS – LIABLITIES
As per the definition by Companies Act 2013, the net-worth is defined as
“ the aggregate value of the paid-up share capital and all reserves created out of the profits and securities premium account, after deducting the aggregate value of the accumulated losses, deferred expenditure and miscellaneous expenditure not written off, as per the audited balance sheet, but does not include reserves created out of revaluation of assets, write-back of depreciation and amalgamation”
So, let us discuss some terms here
1. Paid-Up share capital
Share Capital is the amount that the company has raised by issuing shares. Do not confuse this with the market value of shares.
There are two types of Share Capital – Equity Share Capital for shares with voting rights and Preference Share Capital for the issuance of preference shares.
Paid-Up Share Capital means the amount the company has already received for the issuance of shares.
2. Securities premium account
If a company issues shares at a higher issue price than the par value, the excess amount acquired in reported in this account.
3. Retained earnings and accumulated loss
When a company makes a profit, part of the profit gets invested back in the company. Same way, if a company makes a loss, it is accumulated in a loss account. If the aggregate amount of income and losses from the inception is positive, it is called retained earnings and a negative value is called accumulated loss or accumulated deficit.
For an entrepreneur, retained earnings or the accumulated losses are an important indication for raising of outside capital. A company which has been profitable and has increasing retained earnings may not need to raise equity capital. The accumulated deficit, which is often experienced by early-stage companies, is not necessarily a bad thing as long as the company is successfully implementing its strategy – product development and customer acquisition. But, it gives an indication about the future capital requirements.