New Business Owners' Guide to Reading Balance Sheets
A balance sheet is a summary of the financial balances of an individual or organization. It is one of the crucial financial statement when it comes to managing your business.
Understanding of Accounting Terms
Accounting is the practice of documenting and tracking financial transactions. Accounting principles are used by individuals and corporations to measure their financial health and performance. Accounting may also help individuals and businesses meet their tax requirements.
International Accounting Standard 1 (IAS 1) Presentation of Financial Statements specifies the general standards for financial statements, such as how they should be formed, the minimum content requirements, and overarching concepts such as going concern, the accrual foundation of accounting, and the current/non-current difference.
However, to comply with IAS 1, users need to understand the accounting terms used in the financial statements. Knowing some basic accounting terms can help interface more effectively with the business world. The accounting terms that will be discussed here are divided into these categories: Statement of Financial Position (Balance Sheet) and Statement of Profit or Loss (Income Statement).
Summary Content:
BALANCE SHEET
It depicts the current relationship between a company's assets, liabilities, and shareholder equity. We can calculate the company's net value using this information. The major items on a balance sheet are:
- Current Asset (such as cash at bank, trade receivables and prepayment)
- Non-Current Asset (such as property, plant and equipment, long term investment)
- Current Liability (such as trade payable, bank overdraft and accrual)
- Non-Current Liability (such as non current portion of term loan, hire purchase liability
1. ASSETS
An asset is defined by the accounting standard as an economic resource that is controlled by the entity with probable future economic benefits flow to the entity.
There are two types of assets which are tangible and intangible assets. Tangible assets are physical items that can be touched such as PPE while intangible assets that has no physical substance such as goodwill and software.
PROPERTY, PLANT AND EQUIPMENT (PPE)
Examples of PPE are Land, Building, Machinery and Vehicles. PPE initially is measured at historical cost and will be depreciated throughout its useful life. The amount presented in the balance sheet will be the carrying amount after being deducted by the accumulated depreciation. Also known as fixed asset.
RECEIVABLE (DEBTOR)
Receivable account arises when customers owe money to company. There are two types of receivable account which are trade receivable and other receivable.
- TRADE RECEIVABLE: Credit transaction which related with day-to-day business operation
- OTHER RECEIVABLE: Credit transaction which is not related with day-to-day business operation
INVENTORY
It refers to all items that are purchased or manufactured by company for selling to customers to make profit. Raw materials, work in progress and finished goods are all items included in the inventory. IAS 2 requires inventories to be measured at the lower of cost and net realizable value (NRV).
GOODWILL
Goodwill is associated with the purchase of one company by one company. The value of a company’s brand name and solid customer base represent some reasons why goodwill exists. Goodwill is difficult to price, and negative goodwill can occur when an acquirer purchases a company for less than its fair market value. Negative goodwill is usually seen in distressed sales and is recorded as income on the acquirer's income statement. Brand and Patent are the examples of goodwill.
2. LIABILITY
Liability is a present obligation of past event that is expected to result in outflow of economic resources.
PAYABLE (CREDITOR)
Payable account arises only when company owe money to suppliers. Same as Receivable, there are also trade payable and other payable in payable account.
BANK OVERDRAFT
It is supplied by the bank in the form of an extended credit facility, which takes effect after the account's principal balance approaches zero. In other terms, a bank overdraft is an unsecured kind of borrowing that is primarily utilized to meet short-term liquidity needs.
3. EQUITY
Typically referred to as shareholders' equity (or owners' equity for privately held companies), represents the amount of money that would be returned to a company's shareholders if all assets were liquidated (convert into cash) and all company's debt were paid off in the case of liquidation.
ASSET – LIABILITY = EQUITY
RETAINED EARNING (RE)
The part of a company's profits that are not given as dividends to shareholders but are instead reinvested back into the company (sometimes also known as accumulated profits/losses). Because Retained Earning are recorded under shareholders' equity, they provide as a handy connection between the income statement and the balance sheet.
OPENING RE
(+/-) NET PROFIT/LOSS
(-) DIVIDEND
CLOSING RE
SHARE CAPITAL
Amount invested by company’s shareholder for use in the business operation.
INCOME STATEMENT
Revenue and expenses of the company will be recorded here. From income statement, we can know the company’s performance in term of profit or loss for the accounting period. All revenue and expenses are recorded using accrual basis when the transaction occur instead of when cash is received.
1. REVENUE
Income generated by the sale of goods/services related to the business operation.
2. COST OF GOODS SOLD (COGS)
Cost related to the goods/services sold by the company either manufacturing cost or purchase cost. Direct cost such as raw material and labor cost will be included in the COGS amount while indirect cost such as marketing and advertising cost are excluded.
Formula to calculate COGS:
(Opening Inventory + Cost of Goods) – Closing Inventory
3. OPERATING EXPENSES
Selling and Distribution Expenses
Selling expenses are incurred to promote the goods/services to customers while distribution expenses are related to warehousing, packaging and other costs incurred on preparing to deliver goods/services to customers.
Administrative Expenses
Expenses that will still be incurred, even in the absence of any sales or selling activity such as warehouse rental, staff salaries, bank charges, etc.
Depreciation
Decreasing the asset’s value over its useful life. There are two methods to calculate depreciation:
| METHOD | STRAIGHT-LINE METHOD | REDUCING BALANCE METHOD | |
| Definition | Depreciation amount same throughout the useful life of the asset. | Depreciation amount different each year as depreciation is charged based on percentage amount on the asset’s value. | |
| Example:
Computer: RM2000 useful life: 5 years | Depreciation:
RM 2000/5 years =RM 400 | Depreciation rate: 10%
|
RATIO
1. LIQUIDITY RATIO / SOLVENCY RATIO
To assess if current assets can pay off the current liabilities.
- CURRENT RATIO
Current Assets/Current Liabilities - QUICK RATIO
(Current assets – Inventories)/Current Liabilities
2. WORKING CAPITAL RATIO
Same as liquidity ratio. However, it is crucial for the creditors to analyze company’s liquidity and how fast company converts the assets into cash.
- WORKING CAPITAL RATIO
Net Sales/Working Capital - INVENTORY DAY RATIO
(Inventory/Cost Of Goods Sold) *365 days - RECEIVABLE DAY RATIO
(Receivable/Sales) *365 days - PAYABLE DAY RATIO
(Payable/Cost Of Goods Sold) *365 days
3. PROFITABILITY RATIO
To assess how effective company generates profit from the assets and equities.
- GROSS PROFIT RATIO
(Gross Profit/Net Sales) *100 - OPERATING PROFIT RATIO
(Operating Profit/Net Sales) *100 - NET PROFIT RATIO
(Net Profit/Net Sales) *100
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