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Introduction to balance sheets

Jul 7, 2009

A lot of emphasis was given on companies' revenues and profits during the high growth phase (FY04 to FY08) as virtually every company was growing at a strong pace. However, with the events that occurred in the past 18 months, the focus on the relatively ignored part of the annual report, the balance sheet, has increased. And in the process it has made many investors realise the need of a good balance sheet. In the past few articles of this series, we discussed about the various aspects of a profit and loss account, right from the topline till the appropriation items. In the next few articles, we will touch upon few of the key constituents of a balance sheet.

What is a balance sheet?
A balance sheet gives a snapshot of a company's financial strength. The statement shows what a company owns or controls (assets) and what it owes (liabilities plus equity). The balance sheet is broken into two parts - 'Sources of funds' and 'Application of funds' - as they are called in accounting terminology. We shall first look into the key constituents of the head 'sources of funds', after which we will cover the head 'application of funds'.

Sources of Funds

'Sources of funds' indicates the total financing that a company has done. In simple terms it shows how a company has got the funds which it has used to purchase its assets. As such, Total assets = Shareholders' equity + total liabilities It may be noted that in the above ratio, total liabilities includes loans and current liabilities. As current liabilities are found on the lower side of the balance sheet, we will touch up on this topic in the next few articles.

Shareholders equity - To put in the simplest form, equity is that portion of the balance sheet which purely belongs to the shareholders. An easy way to calculate it is by using the above formula.

Shareholder's equity = Total assets - total liabilities

Shareholder's equity represents the total capital received from investors, plus the accumulated earnings which are displayed in the form of reserves and surplus.

As such, Shareholders' equity = Share capital + reserves and surplus

Share capital represents the funds that are raised by issuing shares. On multiplying the face value of a share by the number of issued, subscribed and fully paid, we get the value of share capital. The reason a company's share capital remains constant for years is on account of non-issuance of additional shares. When a company issues more number of shares, the effect needs to be seen in the share capital.

The picture displayed below will help us understand this better.

Sourced from Nestle's CY08 annual report

Reserves and surplus, as the name suggests, are the accumulated profits that a company has earned and retained overtime. Retained profits are the profits that are left after paying the dividends to the shareholders. When a company reinvests money back into itself, the reserves and surplus account will expand. Its complementary effect will be seen in the assets side.

The reserves and surplus account is made up of different reserves such as 'General Reserve', 'Profit and loss reserve', amongst others. This also includes a reserve which is called the 'Share premium account'.

When a company issues shares, the instrument would have to carry a denomination, called as the face value. For example, let us assume that the face value of a company's shares is Rs 10 per share. It fixes the issue price at Rs 100 per share. Now, out of each share that is issued, Rs 10 will go in the share capital account (as explained above) and the balance Rs 90 will go to the 'Share premium account'.

Loans and borrowings is the other major component of the 'Sources of funds' side. When a company is in need of capital (for any purpose), but is not able to generate enough internally, it would look to borrow funds. These could vary from meeting capital expenditure requirements to meeting working capital requirement, amongst others.

Loans can be of various types. They could be short term (working capital loans) or long term (term loans) in nature. You would also find terms such as 'secured loans' and 'unsecured loans' in companies' annual reports. Secured loans are loans that are secured by collateral to reduce the risk associated with lending.

In the next article of this series, we will take a look at the key constituents of the 'Application of funds' head.

Investing: Back to Basics Article Series - Previous article | Investing: Back to Basics Article Series | Next article


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