Financial Statements (ii)

In our previous post, we discussed the basics of financial statements and learnt about two basic items in a balance sheet: assets and liabilities. We also understood how assets and liabilities of a company are always equal. In this article, we will continue with our earlier example where we were trying to setup an auto parts manufacturing plant.
Let’s say you decide to name your firm ABC Inc. As discussed in the previous article, total assets of ABC Inc. is worth Rs 1,00,000 and total liability is also equal to Rs 1,00,000. We further classified assets into current assets and fixed & immovable assets. Liabilities were classified as shareholder’s equity and long term bank liability. Please refer to the table below to understand basic structure of ABC Inc’s balance sheet.

AssetsLiabilities (incl equity)
Fixed AssetsShareholder Equity
Plant Building40,000Friends of father50,000
Current AssetsLiability
Raw Material20,000Bank Loan50,000

Assets are sourced by using funds, liabilities are the source of funds. As discussed earlier and as can be seen from the above table assets are always equal to liabilities. Lets now discuss few other few commonly used terms: debt, equity and leverage.

Debt is a liability and refers to the the amount of loans raised by the company on which it is has to pay interest every financial year. In our example ABC Inc. this is equal to the amount of Rs.50,000 taken as loan from the bank. Equity refers to the initial investment put in by different investors/shareholders. In this case, it would be equal to Rs 50,000 investment put in by your dad’s friend. A company can raise more funds through equity route by issuing new shares. In such a scenario equity will increase by a proportionate  amount. Leverage is the ratio of debt to debt plus equity (debt/(debt+equity). In ABC’s case leverage is 50% (=50000/100000). Hence ABC is 50% levered. The debt/equity ratio of 1:1 or 50%:50% in this case, is also known as the capital structure of the firm. It tells us how much debt company has borrowed, compared to equity.

The above explanation completes our discussion on basics of balance sheet. Read on to learn about income statements.