2. UNDERSTANDING THE BALANCE SHEET (BS)
Normally, when a person with no financial background comes across a BS, they are
overwhelmed by the many different terms, most of which are not easy to understand.
My first piece of advice is that you focus on “the big numbers”, on the most significant
figures that appear in that financial statement.
Bear in mind that in finance our goal is not to be extremely accurate but rather to make
it easier to understand what is behind the numbers, i.e. what decisions have been taken in
order to reach one figure or another in the BS statement. Sometimes it is useful to
rearrange the standard BS, grouping or even not considering certain entries that are not
significant for our analysis (auditors use an expression called “no material adjustment” to
refer to that level (in monetary terms) whereby even if it is completely wrong, it does not
affect the image of the company).
For example, accounts receivable can be split into customer gross, net of provisions,
notes receivables, doubtful receivables, etc. This is useful for accountants and professional
financial analysts but is not necessary for our diagnosis.
3. SIMPLIFYING THE BALANCE SHEET
• The most significant entries that almost
any BS will contain are shown in the
graph on the right.
• The BS includes two main sources of
information:
– Assets. Assets refer to company
investments (this is where we put the
money).
Cash
Account
Receivables
Inventory
(or Stock)
Fixed Assets
Account
Payables
Short-Term
Debt
Long-Term
Debt
Equity
Assets
Destination of
funds. Where the
money is
invested.
Liabilities
Source of funds.
Where the
money comes
from.
4. SIMPLIFYING THE BALANCE SHEET
• The most significant entries that almost
any BS will contain are shown in the
graph on the right.
• The BS includes two main sources of
information:
– Assets. Assets refer to company
investments (this is where we put the
money).
– Liabilities. Liabilities also called
liabilities and Equity, and refer to
how the company is financed (where
the money comes from).
Cash
Account
Receivables
Inventory
(or Stock)
Fixed Assets
Account
Payables
Short-Term
Debt
Long-Term
Debt
Equity
Assets
Destination of
funds. Where the
money is
invested.
Liabilities
Source of funds.
Where the
money comes
from.
5. SIMPLIFYING THE BALANCE SHEET
• The most significant entries that almost
any BS will contain are shown in the
graph on the right.
• The BS includes two main sources of
information:
– Assets. Assets refer to company
investments (this is where we put the
money).
– Liabilities. Liabilities also called
liabilities and Equity, and refer to
how the company is financed (where
the money comes from).
• Since all the money received is placed
(invested or held), the assets are equal to
the liabilities, and that is why the Balance
Sheet balances! ... in accounting terms at
least.
Cash
Account
Receivables
Inventory
(or Stock)
Fixed Assets
Account
Payables
Short-Term
Debt
Long-Term
Debt
Equity
Assets
Destination of
funds. Where the
money is
invested.
Liabilities
Source of funds.
Where the
money comes
from.
6. Cash
Account
Receivables
Inventory
(or Stock)
Fixed Assets
Account
Payables
Short-Term
Debt
Long-Term
Debt
Equity
Assets
Destination of
funds. Where the
money is
invested.
Liabilities
Source of funds.
Where the
money comes
from.
Lets start with the Assets.
Where has the company invested its financial
resources?
• First: in Fixed Assets. Fixed assets are
investments necessary to develop the
company activity. Fixed Assets are usually
held in the company for a long period of time.
• It is customary to describe as long-term any
period longer than one fiscal year or one
natural year. An example of a fixed asset
could be plant and machinery.
• Looking at a standard Balance Sheet
statement, we will see intangible fixed assets,
tangible fixed assets and financial fixed assets,
and their depreciation value. For our analysis,
we will group them all under Net Fixed Assets
or even just Fixed Assets.
SIMPLIFYING THE BALANCE SHEET
7. Cash
Account
Receivables
Inventory
(or Stock)
Fixed Assets
Account
Payables
Short-Term
Debt
Long-Term
Debt
Equity
Assets
Destination of
funds. Where the
money is
invested.
Liabilities
Source of funds.
Where the
money comes
from.
With Fixed Assets will see Inventories (or stocks), Accounts
Receivable, and Cash at hand and or in banks.
• Inventories. These are the goods that the company will
sell. Some of them will require transformation (raw
materials) while others will be ready for sale (finished
goods). Goods are valued at cost of acquisition or
production cost.
SIMPLIFYING THE BALANCE SHEET
8. Cash
Account
Receivables
Inventory
(or Stock)
Fixed Assets
Account
Payables
Short-Term
Debt
Long-Term
Debt
Equity
Assets
Destination of
funds. Where the
money is
invested.
Liabilities
Source of funds.
Where the
money comes
from.
With Fixed Assets will see Inventories (or stocks), Accounts
Receivable, and Cash at hand and or in banks.
• Inventories. These are the goods that the company will
sell. Some of them will require transformation (raw
materials) while others will be ready for sale (finished
goods). Goods are valued at cost of acquisition or
production cost.
• Accounts receivable. Most companies keep significant
amounts under Accounts Receivable; in other words,
significant amounts of money invested in its clients,
waiting to be collected. We are basically giving a loan to
our clients to finance sales, non-interest-bearing loans
that clients will pay back (hopefully) within agreed terms
(30 days/60 days/90 days, etc.).
SIMPLIFYING THE BALANCE SHEET
9. Cash
Account
Receivables
Inventory
(or Stock)
Fixed Assets
Account
Payables
Short-Term
Debt
Long-Term
Debt
Equity
Assets
Destination of
funds. Where the
money is
invested.
Liabilities
Source of funds.
Where the
money comes
from.
With Fixed Assets will see Inventories (or stocks), Accounts
Receivable, and Cash at hand and or in banks.
• Inventories. These are the goods that the company will
sell. Some of them will require transformation (raw
materials) while others will be ready for sale (finished
goods). Goods are valued at cost of acquisition or
production cost.
• Accounts receivable. Most companies keep significant
amounts under Accounts Receivable; in other words,
significant amounts of money invested in its clients,
waiting to be collected. We are basically giving a loan to
our clients to finance sales, non-interest-bearing loans
that clients will pay back (hopefully) within agreed terms
(30 days/60 days/90 days, etc.).
• Cash. We will also find a line called “Cash” or
equivalents, such as bank accounts, or any other short-
term financial investment.
SIMPLIFYING THE BALANCE SHEET
10. Cash
Account
Receivables
Inventory
(or Stock)
Fixed Assets
Account
Payables
Short-Term
Debt
Long-Term
Debt
Equity
Assets
Destination of
funds. Where the
money is
invested.
Liabilities
Source of funds.
Where the
money comes
from.
With Fixed Assets will see Inventories (or stocks), Accounts
Receivable, and Cash at hand and or in banks.
• Inventories. These are the goods that the company will
sell. Some of them will require transformation (raw
materials) while others will be ready for sale (finished
goods). Goods are valued at cost of acquisition or
production cost.
• Accounts receivable. Most companies keep significant
amounts under Accounts Receivable; in other words,
significant amounts of money invested in its clients,
waiting to be collected. We are basically giving a loan to
our clients to finance sales, non-interest-bearing loans
that clients will pay back (hopefully) within agreed terms
(30 days/60 days/90 days, etc.).
• Cash. We will also find a line called “Cash” or
equivalents, such as bank accounts, or any other short-
term financial investment.
Other assets. The most significant assets have already been
described, but other assets can find with different
descriptions that are usually not significant if compared with
the total assets of the company. For the purposes of our
analysis, we will group these other entries under “Other
Assets”.
SIMPLIFYING THE BALANCE SHEET
11. Cash
Account
Receivables
Inventory
(or Stock)
Fixed Assets
Account
Payables
Short-Term
Debt
Long-Term
Debt
Equity
Assets
Destination of
funds. Where the
money is
invested.
Liabilities
Source of funds.
Where the
money comes
from.
Lets take a look at the Liabilities side. This may appear as
just “Liabilities” or “Liabilities and Equity” both descriptions
represent the same thing: source of funds. Separating
Liabilities from Equity tells us about the finance structure of
the company (if you are interested, numerous research
papers have been published on this subject). Lets look at the
different sources of funds:
• The first thing that we can find is Equity, or the funds
that belong to shareholders. Shareholders’ funds can
come from direct disbursements (shareholders pay to
acquire shares) or can be retained earnings that are kept
in the company to reinvest in additional assets. Again,
for the purposes of our analysis, we can group both
sources in the same line: Equity (more advanced
financial studies offer much more detailed explanations
of decisions about earnings vs dividend policies).
SIMPLIFYING THE BALANCE SHEET
12. Cash
Account
Receivables
Inventory
(or Stock)
Fixed Assets
Account
Payables
Short-Term
Debt
Long-Term
Debt
Equity
Assets
Destination of
funds. Where the
money is
invested.
Liabilities
Source of funds.
Where the
money comes
from.
• Another source of funds is Debt.
– Short-term debt
– Long-term debt
In SMEs, all debt is provided by financial entities,
usually banks. In much larger companies, the
company itself can issue debt in the capital
markets. Banks will determine the cost of the debt
(interest rate). The cost of debt issued by the
company will be determined by the market
(financial market); to help “the market” (or the
investors) to better fix the cost of debt, they use
Rating Agency reports. These reports tell us about
the risk of the company related to its capacity to
honour debt issued.
SIMPLIFYING THE BALANCE SHEET
13. Cash
Account
Receivables
Inventory
(or Stock)
Fixed Assets
Account
Payables
Short-Term
Debt
Long-Term
Debt
Equity
Assets
Destination of
funds. Where the
money is
invested.
Liabilities
Source of funds.
Where the
money comes
from.
Under Accounts Payables, we will include
those emerging from company operations:
suppliers, trade creditors, other creditors,
Government taxes, etc. These can be divided
into two groups:
• Trade creditors: which include creditors
that sell us raw materials or provide
services directly related with operations.
• Other creditors: the rest of creditors that
provide us few days to pay their invoices.
For creditors that cannot be easily included
under trade creditors, we can use this
general description, which is sufficient for
our analysis.
SIMPLIFYING THE BALANCE SHEET
