Section 2(40) of the Companies Act, 2013 defines the term financial statement to include:
- Balance Sheet as at the end of the financial year;
- Profit and loss account for the financial year;
- Cash flow statement for the financial year;
- Statement of change in equity, if applicable, and
- Any explanatory note forming part of the above statements.
Note: For one person company, small company and dormant company, financial statements may not include the cash flow statement.
A glance of the balance sheet gives the reader an insight of the financial strength of the company. Balance Sheet is the summary of assets and liabilities of the company, at a given point of time. The given point of time here implies end of a financial period, a quarter, half-year or a financial year.
Components of a balance sheet
- Assets (resources or valuables that are owned by a company). There are two types of Assets:
- Current Assets include:
- Current assets have a life span of one year or less, meaning they can be converted easily into cash. Such assets classes include cash and cash equivalents, accounts receivable and inventory;
- Cash, the most fundamental of current assets, also includes non-restricted bank accounts and checks;
- Cash equivalents are very safe assets that can be readily converted into cash, example: Reserve Bank of India Bonds;
- Accounts receivables consist of the short-term obligations owed to the company by its clients. Companies often sell products or services to customers on credit; these obligations are held in the current assets account until they are paid off by the clients;
- Inventory represents the raw materials, work-in-progress goods and the company’s finished goods. Depending on the nature of company, the exact makeup of the inventory account will differ. For example, a manufacturing firm will carry a large amount of raw materials, while a retail firm caries none. The makeup of a retailer’s inventory typically consists of goods purchased from manufacturers and wholesalers.
- Non-current assets
- Non-current assets are assets that are not turned into cash easily, are expected to be turned into cash within a year and/or have a life-span of more than a year;
- They can refer to tangible assets such as machinery, computers, buildings and land;
- Non-current assets also can be intangible assets, such as goodwill, patents or copyright. While these assets are not physical in nature, they are often the resources that can make or break a company – the value of a brand name, for instance, should not be underestimated.
Note: Depreciation and assets go hand in hand. Depreciation depicts the true economic cost of asset over its useful life.
- Liabilities includes shareholders’ equity (resources or valuables that are owed to a company). There are two types of liabilities:
- Long-term liabilities are debts and other non-debt financial obligations, which are due after a period of at least one year from the date of the balance sheet;
- Current liabilities are the company’s liabilities which will come due, or must be paid, within one year and includes both shorter term borrowings, such as accounts payables, along with the current portion of longer term borrowing, such as the latest interest payment on a 10-year loan;
- Shareholders’ equity: is the initial amount of money invested into a business. If, at the end of the financial year, a company decides to reinvest its net earnings into the company (after taxes), these retained earnings will be transferred from the income statement onto the balance sheet into the shareholder’s equity account. This account represents a company’s total net worth. In order for the balance sheet to balance, total assets on one side have to equal total liabilities plus shareholders’ equity on the other.
Important aspects of a balance sheet
Share capital: comprises of the authorised capital, issued capital and paid-up capital of a company. The authorised capital is the maximum amount of share capital for which shares can be issued by a company. The issued capital is that part of the authorised capital which is offered for subscription. The part of the issued capital which is paid by the subscribers is called the paid-up capital.
Further we can say that issued capital reflects the equity and preference share capital of a company and the share capital being high compared to debt is a sign of growth. A share capital comprises of equity and preference share capital and a high share capital is a measure of the company’s ability to fund its growth and expansion.
Further, how frequently a company changes its equity base is an important factor to consider while analysing the company. The increase in equity capital might increase the number of shares but it shall have a negative impact on the earning per share which is calculated as net profit divided by number of equity shareholders. This shall result in low earnings for a shareholder or investor.
We have already discussed about the reserves of a company in our earlier blog which can be read here https://indianlawblog.com/2019/05/30/reserves-vs-surplus-analysis-under-the-companies-act-2013. Generally, reserves are a part of the shareholder’s equity. Generally, reserves are used for distributing dividends to the shareholders of company. However, sometimes the company might not distribute dividends and use the reserve amount for further development of the company. Also, companies create revaluation reserves to inflate the net worth of the company. Net worth is determined by share capital and reserves. Also, the Return on Investment(RoI) is a ratio of net income after taxes to net worth (excluding taxes). If the return on investment is positive, the company is making profits.
Debt or Debtors (Asset side of balance sheet)
Debt is the amount due to the company. While studying the balance sheet, one should see the debt turnover ratio which a ratio of outstanding debtors to income is and is expressed in number of days. Basically, the debt turnover ratio is an indicator of the time taken by company to recover the debt owed. An efficient company strives to keep its debtors’ days as few as possible.
Current Liabilities are short term debts of the company which should be paid within a year. The credit turnover ratio is the ratio of creditors at the end of the period to income and is expressed in number of days. It determines the ability of the company (expressed in number of days) to pay off its debts to the creditors.