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The most important equation in the world of finance can well be ‘Assets = Liabilities plus net worth (owners' equity),' note N. Ramachandran and Ram Kumar Kakani in How to Read a Balance Sheet ( www.tatamcgrawhill.com ).
Tracing the origin of balance sheet's name to this equation, the authors go on to describe ‘liabilities' as claims of outsiders against an entity, while shareholders' fund can be taken to mean the claims of owners against a company. Since the owners can be paid only from the residue left after settling the outside claim, the owners' claim is also known as a residual claim, the book instructs.
Comparative figures
The authors hasten to caution that analysing the balance sheet of a company for one particular period of time may not give you a clear picture of the financial health of the company. Their advice is that the figures of a particular balance sheet item compared over consecutive years can give you an idea of the better or worse performance of the company in relation to that component.
An example given in the book is of how a heavy increase of a company's debt may deter a prospective lender to the company, because he will be doubtful of the company's ability to meet its bulging obligations.
“Simultaneously, the lender might also compare the proportion of debt in a particular company's balance sheet with that of its peers from the same sector to see if it is an industry-wide trend or a company-specific trend.” This is similar, as the authors analogise, to looking at the report card of a child's school performance and then comparing the same with his/her past performance and also the performance of the buddies!
A chapter titled ‘What to see in a balance sheet' begins by drawing attention to ‘components of capital employed,' more particularly the relative proportions of debt and equity. “If a company is increasing its long-term liabilities considerably without increasing its shareholders' funds, then it can indicate that the company is taking more risks.”
Educative material for beginners in the world of finance.
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