Chapter 2 Lesson C - How to read a Balance Sheet

Introduction of the Host
Mrs.Geetha Dasaraty is a commerce graduate with a Masters in Business Administration specialising in finance. Her stint with a Coimbatore based company and later with a consulting firm in Chennai has provided her with a decade of experience in project finance and appraisals, accounting and tax laws. She is a freelance writer and money matters are her forte. She is currently pursuing her final course in Company Secretaryship and is doing a course on Vaishnavism. She has a passion for literature and Carnatic music. She is also a violinist. About the Class
12 lessons, one a month. Each lesson is further subdivided into 4 chapters

Chapter 2 Lesson C - How to read a Balance Sheet
In the previous lesson we saw that a balance sheet is a statement which shows the financial position of a business at a particular point of time. The balance sheet is a statement of net wealth or net worth. The difference between excess of 'assets' and 'liabilities' in the balance sheet is 'net worth'.

The balance sheet enables people to get to know the working results and other financial affairs of the concern. But, the accounting jargons, makes it difficult for the layman to comprehend the balance sheet.

Given below are a few explanatory notes on how to read and understand a balance sheet.

• The first thing one should look for in a balance sheet is whether the net worth of the concern is positive or negative. A positive networth indicates that the concern is in a position to meet all its liabilities. A negative net worth indicates that the concern's assets are not sufficient to meet its liabilities. It indicates that additional capital will have to be brought in, to enable the concern to meet its liabilities.
  
  
• An important issue in the assessment of a balance sheet relates to the liquidity of a concern. This may be inferred from the position of current assets vis-a -vis the current liabilities.Where the current assets exceed current liabilities, the concern would be in a position to meet its immediate liabilities. Where the current liabilities exceed current assets, it would imply that the concern would not be in a position to meet its liabilities. This situation implies that the short-term creditors of the company will not be paid, resulting in a credit squeeze on the concern.
  
  
• The next issue involves the investments held by the concern. Investments may be in the form of deposits, shares etc. Where the market value of the investments is less than the book balance it indicates that the investments if sold will result in a loss.



• The stocks and debtors of a concern are crucial indicators of the health of a concern. Where the stock levels are very high, it would mean that either the company is not able to sell what it produces or the stocks held by the concern have become obsolete and may not be usable.
  
  
• Where dues to the concern in the form of debtors is very high, it indicates that the concern's collection levels are not good. In such an event, it is quite probable that the debtors may not be fully realisable.Where debtors are not fully realised it would result in a loss to the concern and in turn affect the liquidity of the concern.
  
  
• The fixed assets of the concern may be in the form of land, building, plant and machinery, equipment etc. The value of fixed assets should normally be shown at the depreciated value. Where no depreciation is provided, it means that the fixed assets are overvalued, thereby not reflecting the correct financial position.
  
  
• The dividend declared by the company is an indicator of the concern's liquidity position. It also throws light on the management policy of rewarding the owners' of the concern, namely the shareholders. A consistent rate of dividends indicates a conservative long-term dividend policy of the management.
  
  
• Another important indicator of a concern's health is the loans of the concern in relation to the net worth.Where the loans owed by the concern are more than twice the net worth,it indicates that the concern has overborrowed and it would not be safe to have other borrowings. The profit margins of the concern would be under severe strain in the event of such over borrowings. It would lead to a situation where the concern would have to borrow to meet its interest payments.
  
  
• A very high balance of cash and bank accounts indicate that there has been a lot of idle funds in the concern.These need to be properly invested in income yielding instruments.Prudent and proper management of cash is required to optimise returns to the concern.
  
  
• Another aspect of a balance sheet one should watch out for, is what is frequently called window dressing. Any balance sheet is designed in a particular form. Very often, the balance sheet are addressed more to the form than the substance.The art of preparing a balance sheet more to confirm to the legal form than to reflect the correct financial position is 'window dressing'.

• Dues to statutory authorities such as PF, ESI, Sales tax,Income tax,etc are shown as liabilities in the balance sheet.Where such dues are outstanding for a long term it would mean that the statutory dues are not being remitted as required by law. This points to a severe cash crunch being forced by the concern.

Questions - Chapter 2 Lesson B
I. Fill in the blanks

a. Properties and possessions of a business are known as the ... of the business.
b. A balance sheet is a statement of what the concern .... and what it ....
c. According to the fundamental accounting equation ,assets are equal to owners and ...... equities.
d. Liquidity of a concern is its ability to meet ..... liabilities out of its current assets.

II. Indicate the correct answer.
1.Which one of the following is an example of current asset
a.Land
b.Plant and machinery
c.Patents
d.Prepaid expenses

2.Unexpired income is
a. Liability
b. an asset
c. a revenue
d. an expense

Goodwill is
a. current assets
b. fictitious asset
c. fixed asset
d. intangible asset

4. Both assets and owners equity would be increased by
a. Capital brought in
b. Purchase of an asset on credit
c. Payment of creditors
d. Proprietor's drawings.