Reading a Balance Sheet

Reading furnishes the mind only with materials of knowledge. It is thinking that makes what we read ours

John Locke

1. Read the following text and answer the questions: Who and what is the balance sheet relevant for? What would be the main difference between accounts payable and accounts

receivable? What financial ratios can be calculated by reading a balance sheet?

2. Match the following terms with their correspondent explanations: inventory, fixed assets, current liabilities, retained earnings, current assets, accounts receivable, owner’s equity, intangible assets, accounts payable They have a life span of one year or less, meaning they can easily be converted into

cash. They are typically paid within one year or less and are therefore paid with current

assets. Because current assets pay for them, the ratio between the two is important: a company should have enough of the former to cover the latter.

They have a life span of over one year. Depreciation is calculated and deducted from these types of assets.

The initial amount of money invested into a business. They are the short-term obligations owed to the company from clients. It represents

the amount of materials currently available for production. What the company owes to suppliers for buying raw materials or retail products on

credit. While these assets are not physical in nature, they are often the resources that can

make or break a company. The percentage of net earnings not paid out as dividends, but kept by the company to

be reinvested in its core business or to pay debt. It is recorded under shareholders’ equity on the balance sheet.

A balance sheet reveals a company’s assets, liabilities and owner’s equity, also called net worth. The balance sheet provides all the necessary information to shareholders, those people who contribute with their money to the internal financing of a company, in exchange for dividends. The balance sheet is divided into two parts:

assets = liabilities + owners’ equityAssets are what a company uses for its production process, while liabilities are

obligations to be paid to outside parties. Owners’ equity, referred to as shareholders’ equity in a PLC, is the amount of money initially invested into the company plus any retained earnings.

Retained earnings are calculated as following:Retained earnings (RE) = Beginning retained earnings + Net income –

- DividendsIn most cases, companies retain earnings in order to invest them in, for example,

buying new machinery or spend the money on research and development.If beginning RE + Net income – Dividends > RE, then the company is registering a

deficit.

A balance sheet represents a specific period (usually one day) and is most usually calculated on the last day of a company’s fiscal year, Dec 31.

ASSETS LIABILITIES

Current assets Current liabilities

cash and cash equivalent Dividends payable

accounts receivable Accounts payable

inventory Interest payment on long-term debt

Raw materials Taxes payable

Work-in-progress (WIP) Owner’s equity

Finished goods

Bank accounts

Checks

Stocks

T-bills

Fixed assets or tangible assets

Machinery

Computers

Building

Land

Intangible assets

Patent

Copyright

Goodwill

Franchises and licenses

Leasing

If, at the end of the fiscal year, a company decides to reinvest its net earnings into the company, the retained earnings will be restated from the income statement into the balance sheet.

net earnings + retained earnings = total net worthFor a balance sheet to be functional, total assets on the left side have, at least, to equal

total liabilities plus owner’s equity on the right side.

A balance sheet: It is also a support for the financial ratios to be calculated

It helps an investor to realize how liquid a company is and to analyze its growth potential

It shows how profits are used to finance the company’s operations and whether the company has enough cash for growth

It points to the inventory levels, whether they are stagnant or in progress, if debt is paid or to be paid

It shows what cash value would shareholders receive in case of bankruptcy It shows what is the value of current assets, those assets which can be easily converted

into cash. 3. Look at this example of a balance sheet. Fill in the missing words. Choose from the

following: patents, owner’s equity, accounts receivable, land, capital, accounts payable, WIP, current assets

BALANCE SHEET

(All figures in RON)

Assets 2005 Liabilities and owners equity 2005

5.000 Current Liabilities

Cash 500 4.000

T-bills 1.000 Dividend payable 2.000

7.000 Taxes payable 3.000

Total Current Assets

13.50

0 Total Current Liabilities 9.000

Inventory Long-term Liabilities

Raw materials 825 Long-term Bank Loan 5.000

750 Total Liabilities

14.00

0

Finished Goods 1.200

Total Inventory 2.775

20.00

0

Long-term assets Retained Earnings

28.27

5

30.00

0 Total Net Worth

48.27

5

Machinery

20.00

0

Depreciation (machinery)

-

5.000

Intangible assets

1.000

Total Long-term assets

46.00

0

Total Assets

62.27

5 Total Liabilities + Net Worth

62.27

5

4. Read now the complete balance sheet above and provide answers to the requirements below:

Is the company liquid enough to pay off its debts, or it needs to take a loan? Is the company financing itself through reinvested earnings or debt? What does a low cash ratio indicate? Calculate the debt ratio by using the balance sheet above. Calculate the current ratio by using the balance sheet above What would a high amount of leverage indicate?