Posted by: Niyati on Fri, Aug 31st, 2018
Understanding Balance Sheets and Annual Reports
Balance sheets and annual reports are key to understanding the basics of assessing the financial performance of a company. Many a time one hears various terms representative of capturing and documenting an organization’s financial performance, such as quarterly results, audited annual reports, earnings call, investors’ presentation, annual general meeting, share price movements, listings, and many others. Of these, annual reports are an important component in that they detail the company’s financial performance over a specific period of one year (January to December, April to March, or any other equivalent as accepted by accounting principles).
Annual reports comprise three key components, namely, the balance sheet, the income statement (profit and loss statement), and the cash flow statement. This article discusses the key components of annual reports in general and balance sheets in particular.
An Overview of Annual Reports
An annual report is a detailed report provided by organizations, and to be published mandatorily by entities listed in the stock market for the perusal of shareholders and other stakeholders. It summarizes the company’s performance in the previous financial year. In India, specific sections such as the balance sheet, also need to be filed with the Registrar of Companies. If listed, there are also exchange related filings that need to be completed. In many listed companies, annual reports are also published on the organization’s website.
Components of the annual report can include the following:
- Operating and financial review
- Director’s report
- Management discussion and analysis
- Auditor’s report
- Financial statements – balance sheet (statement of financial position), income statement (profit and loss statement), cash flow statement, changes in equity.
- Corporate governance
- Notes to financial statements
- Accounting policies (such as IFRS, US GAAP, Indian Accounting Standard (Ind AS))
The annual report may also be illustrated with several charts and other details for the consumption of stakeholders (for example, it may include corporate social responsibility related items).
Some of the key components of annual reports are the financial statements and related information, such as accounting policies and balance sheets.
Focussing on the balance sheet, let us try and understand its basic concepts.
What is the Balance Sheet?
A balance sheet presents the companies assets, liabilities, and shareholders equity at a point in time, i.e., ‘as of a given date’ (usually December 31st or March 31st, whichever denotes the end of the financial year). It also provides information on what the company owns and what the company owes (to creditors and shareholders).
The assets represent what the company owns, and the liabilities represent what the company owes to others.
The shareholders capital represents the equity contributions of all stockholders of the company and the accumulated profits (i.e., retained earnings) which also belong to them.
Assets and liabilities are current (short-term) and non-current (long-term).
Current: cash and cash equivalents, marketable securities and investments that can be easily liquidated or sold, assets held for trading or sale, such as certain shares or bonds, inventories, receivables, accrued income, prepaid taxes, and prepaid expenses.
Non-current: fixed assets (such as land, building, furniture and fixtures, equipment), financial assets held till maturity, investments in joint ventures and associates/subsidiaries, deferred tax assets, and goodwill.
Current: short-term loans, payables to suppliers or vendors, accrued expenses, interest payable, portions of long-term debt that are due/maturing this year, provisions for expenditures, taxes payable this year.
Non-current: long-term loans, employee benefits payable, deferred tax liabilities.
An important aspect to remember is that the balance sheet also presents the net assets which can be derived by:
- Assets = Liabilities + Shareholder’s Equity.
- Net Assets = Assets – Liabilities.
Preparing the Balance Sheet
Preparation of balance sheet can be a complex process, and the larger the firm, the more complex it gets. For example, imagine the preparation of the balance sheet of large global, diversified conglomerates such as GE or Reliance, or large financial services powerhouse like Goldman Sachs or UBS, with various products and services and exposures to myriad, complex financial instruments.
Many firms may use simple to complex accounting software to help this process.
Typical steps involve the following:
- Recording financial transactions in journals
- Consolidating the same in ledgers (for similar transactions)
- Preparing the trial balance using information across ledgers
- Passing necessary adjustments
- Using this information to prepare the balance sheet (and also the income statement)
The final step is the presentation of the balance sheet in the required format in conformance with the accounting standards.
The annual balance sheet is presented as a part of the annual report, i.e., the balance sheet at the close of the fiscal year, along with the income statement and cash flow statement of the fiscal year.
Understanding how to use the balance sheet
The balance sheets help us to understand the details of the assets and liabilities of a company and the capital structure (composition of debt and equity). In conjunction with the profit and loss statement and the cash flow statement, one can derive various financial ratios which represent the performance of the company. This also helps compare the position of one company against other players in the market, as well as in making fundamental assumptions on the future outlook for the company. It plays a vital part in company valuation, using various methodologies.
The balance sheet and other financial statements help us in calculating various financial ratios such as profitability ratios, leverage ratios, operating ratios, and valuation ratios. Such information is very useful to investors in assessing the health and outlook for a company, and also to various regulators.
In a nutshell, understanding the basics of annual reports and financial statements, including the balance sheet, is fundamental for corporate finance and investing applications. Understanding the basics is important as competency can be built with clear and strong foundations. The topics underlying the financial statement analysis are indeed vast and efforts to understand the significance of these basics continue life-long.
It helps to undertake structured financial training in the areas related to balance sheets and annual reports from reputed financial training providers like Centre for Investment Education & Learning (CIEL) [accredited by the National Institute of Securities Markets (NISM) under Regulation 7(2) of the SEBI (Investment Advisers)]. Please visit CIEL to know more about our introductory course on Online course on Balance Sheet and Annual Reports.