Balance Sheet: A Statement of Wealth

The Balance Sheet provides a snapshot of a company's financial position at a specific point in time. It represents all assets owned by the company and the claims against those assets by both owners (equity) and outsiders (liabilities). Therefore, it can be considered a "Statement of Wealth."

Key Concepts:

• Assets: Resources owned by the company that are expected to provide future economic benefits.
• Liabilities: Obligations of the company to outsiders (creditors, lenders, suppliers).
• Equity (Shareholders' Wealth): The owners' stake in the company; the residual interest in the assets after deducting liabilities.

The Fundamental Accounting Equation:

Assets = Liabilities + Equity

This equation highlights the core principle: a company's assets are financed by either debt (liabilities) or equity.

Information Provided by the Balance Sheet:

The balance sheet offers valuable insights for various stakeholders:

1. Company Size and Growth:

   • Total asset value indicates the size of the company.
   • Comparing total assets over multiple periods reveals the company's growth trajectory.
   • Comparing a company's total assets to its competitors within the industry provides insights into its relative market position.

2. Asset Composition:

   • The balance sheet reveals how a company's assets are structured. Different industries have different asset compositions:
     • Manufacturing Companies (e.g., Tata Steel): Typically have significant investments in fixed assets (Property, Plant, and Equipment - PP&E) like machinery and factories.
     • Service Companies (e.g., Infosys): Tend to have fewer fixed assets and more current assets (like cash and receivables) or intangible assets.
     • Trading Companies (e.g., DMart): Usually hold substantial inventory (a current asset).

3. Debt and Financial Leverage:

   • The balance sheet shows the extent of a company's liabilities (what it owes to others). These liabilities can be in the form of loans, accounts payable (to suppliers), or other obligations.

Balance Sheet Formats and Consolidated Financial Statements

This section discusses different balance sheet formats and the concept of consolidated financial statements, particularly focusing on the distinction between standalone and consolidated statements and the treatment of minority interests.

Balance Sheet Formats

There are two primary ways to present a balance sheet:

1. Horizontal Form: Assets are listed on one side, and liabilities and equity on the other. This creates a balanced "T" shape.

2. Vertical Form: Assets are listed first, followed by liabilities and then equity, presented in a top-down format. This is the more common format today.

Historically, Indian companies followed a different sequence—Equity first, then Borrowings (Liabilities), and finally Assets. This reflected the typical business formation process: raising equity, then borrowing funds, and finally investing in assets. However, to align with international practices and facilitate easier comparisons, the sequence was changed to the now-standard Assets, Liabilities, and Equity.

The Companies Act 2013 in India, specifically Schedule 3, prescribes the standard format for balance sheets. It uses five major headings:

• Non-Current Assets
• Current Assets
• Equity
• Non-Current Liabilities
• Current Liabilities

This discussion will initially use the older sequence (Equity, Liabilities, Assets) for easier understanding of the consolidation process.

Holding and Subsidiary Companies:

• Holding Company: A company that controls another company (the subsidiary) and holds more than 50% stake in that company.
• Subsidiary Company: A company controlled by another company (the holding company).

Standalone vs. Consolidated Financial Statements

• Standalone Financial Statements: Reflect the financial transactions of a single legal entity (a company). This is based on the accounting concept of a business being a separate entity.

• Consolidated Financial Statements: Combine the financial statements of a parent company (holding company) and its subsidiaries as if they were a single economic entity. This is required when a company controls one or more other companies.

Consolidation Example

Let's illustrate consolidation with a simplified example:

Scenario 1: 100% Ownership

• The investment of ABC Ltd. in XYZ Ltd. is eliminated in the consolidated statement because it represents an investment in itself (within the consolidated entity).

Scenario 2: 80% Ownership (Minority Interest)

If ABC Ltd. owns only 80% of XYZ Ltd., the remaining 20% is held by minority shareholders (also known as non-controlling interest).

• Minority Interest Calculation: (XYZ Ltd.'s Assets - XYZ Ltd.'s Liabilities) * Minority Shareholders' Holding = (300 - 100) * 20% = 40

• The equity of the consolidated entity now includes the minority interest as a separate component.

Key takeaway: When a holding company doesn't own 100% of a subsidiary, the minority shareholders' interest (now termed "non-controlling interest") needs to be shown separately in the consolidated balance sheet.

Important Note: These examples are simplified. Real-world consolidations involve many more complex adjustments.

The Balance Sheet: A Snapshot in Time

The balance sheet is a "snapshot" of a company's financial position at a specific point in time. This is crucial to understand because the balance sheet's values are only accurate for that exact moment. The heading of a balance sheet typically reads something like "Balance Sheet as of 31st March 2020." This signifies that the data presented reflects the company's financial position on that specific date. The financial situation would likely be different even a day later, on 1st April 2020, due to ongoing business transactions.

Accounting Periods and Reporting Delays:

• In India, the standard accounting period for companies is generally from April to March. Therefore, balance sheets are usually prepared as of 31st March of each year.
• There's often a significant time lag between the balance sheet date and the date the statement is actually published. This is because compiling and auditing the financial data takes time. For example, if a balance sheet is dated 31st March 2024, it might not be available until August 10th, 2024.

This delay raises concerns about the relevance of the information for users of financial statements. If a balance sheet as of 31st March is only available in August, the financial position of the company might have changed considerably in the intervening months. This can make the information less useful for making timely decisions.

Example:

Imagine a company had a large sale in April. This sale would significantly impact its cash balance, accounts receivable, and potentially inventory. If the balance sheet as of 31st March doesn't reflect this sale, it provides an incomplete and potentially outdated picture of the company's financial health.

Quarterly Reporting to Address the Issue:

To mitigate the problem of delayed annual financial statements, listed companies are required to publish quarterly financial statements. These provide more frequent updates on a company's financial performance and position, making the information more timely and relevant for investors and other stakeholders.

Sources of Capital for a Business

Capital is essential for starting and running a business. It's broadly raised from three primary sources:

1. Equity Capital: This is the capital invested by shareholders.

   • Initial Investment: Shareholders contribute equity at the beginning of the business.
   • Additional Investment: They may invest more equity during major expansions or investments.

2. Retained Earnings (Internal Equity): As a company becomes profitable, a portion of the profit is retained and reinvested back into the business. This retained profit acts as an internal source of equity.

3. Borrowed Capital (Loan Funds/Debt): This involves borrowing funds from financial institutions (banks) or the market through various debt instruments.

Financial engineering has introduced innovative methods for raising capital, including:

• Convertible Debentures: These are debt instruments that can be converted into equity shares after a specified period. They offer the security of debt with the potential for equity participation.
• Lease Finance: This is a form of borrowing where a company leases assets instead of purchasing them outright, providing access to capital equipment without a large upfront investment.

** Note** Trade Credit as a Source of Capital- Purchasing goods on credit from suppliers is a common form of short-term financing. It allows businesses to defer payments and manage their cash flow.

Order of Permanence of Funds

Sources of funds can be ranked by their permanence, from most to least permanent:

1. Equity: Considered the most permanent form of capital as it represents ownership in the company.
2. Long-Term Debt: Debt with a maturity of more than one year.
3. Short-Term Debt: Debt with a maturity of less than one year.
4. Dues to Suppliers (Trade Credit): Represents credit extended by suppliers for goods purchased. This is also a source of short-term financing.