Understand Balance Sheet | Explained With Story.

Understand balance sheet

In this article we will understand in whole Balance Sheet in very unique way. First we will create a business and run it .Then then balance sheet of that business will get automatically formed.

What is Balance Sheet :

In layman language balance sheet is a statement which shows the current position of business. Like how much cash do business have, amount of receivables, capital invested in that business and many more .

Unlike other profit and loss or cash flow statement which are for particular period . Balance sheet is for a particular date as it shows the position of the time when it was created.

Hence above every balance sheet heading as below.

Understand Balance Sheet- Heading

As against other financial statements

Understand balance sheet-cash flow statement title
understand balance sheet - profit and loss statement

Balance sheet has two sides. One is what a particular business owns (Asset Side) and the other side is what it owes (Liability Side).

Assets : An asset is any resource owned by business or individual having economic value which can be owned controlled and will provide future benefit to owner.

Liability : Liability is anything that person owes to another which has to be set off by either accepting another liability or by outflow of any type of assets or monetary resources.

Money does not come into business out of thin air when any transaction happens any of the following changes happens in Balance Sheet.

  • One asset increases and other decreases
  • One liability increases and other decreases
  • one liability on creases for which one asset increases
  • one liability decreases for which other asset decreases.

So whenever any transaction happens its effect goes to at two places in such a way that both sides of Balance Sheet remain tallied.

Important Assumptions

Although every business has a owner but still a business is considered as separate artificial person in the eyes of law.

Definition of Company As per Companies Act , 2013 (India)

An incorporated association which is artificial judicial person, having a separate legal entity, with a perpetual succession and a common seal and capital compromised of transferable shares and limited liability.

Because of this capital induces in the business is considered as liability. In short capital is money which artificial person owes to owner of business.

Let’s Start a Business

Thomas is 24 year old young graduate. He have a wonderful idea of starting a Kitchen Appliance manufacturing business. Which will be named as Kaizen Inc.

Understanding balance sheet - Thomas

Thomas have own capital of 100000 $ which he is going to invest in business .

At this stage balance sheet if Kaizen Inc. will form like this.

Balance sheet as on 31.12.2020

Liabilities$Assets$
Capital100,000Cash and Cash Equivalent100000
Total100000Total100000

As said above capital is liability which business owes to its owner and asset against it is cash.

Now the main things in business is its place of existence. Thomas need some pace to open a production facality , he can rent one but decides to buy one as he finds it viable one.

 With 100,000 in hand he buy a land for factory worth of 50,000$ and machinery to make and molds of 30,000$.

Important things:

When assets are bought for company these are not owned by owners of business. Assets are owned in the name of that artificial person (A Company).

Balance sheet as on 31.12.2020

Liabilities$Assets$
Capital100,000Land and Building45,000
Work in Progress5,000
Machinery30,000
Cash20,000
Total100,000Total100,000

All the construction of building is not completed yet so the part of building that is half completed is classified as Work In Progress which will be completed in foreseeable future.

Now all things are set to start business operations whether it is factories license workers recruitment .

First to start production what we need is raw materials.

Thomas can directly go to market and buy required material. But he do not want to engage his capital in it. Instead he decides to obtain materials on credit from his friend Xavier who owns Dixon Inc.

Balance sheet as on 31.12.2020

Liabilities$Assets$
Capital100,000Land and Building45,000
Work in Progress5,000
Machinery30,000
Creditors20000Cash20,000
Inventory20,000
Total120,000Total120,000

As Dixon Inc sold goods on credit to Kaizen Inc. the amount of good to be paid liability(owes) for Thomas’ company. What kaizen get in return of accepting liability is goods which it owns and recorded under the head Inventories of asset side.

Raw material is not the only thing that is required for production. There are many expenses which have to be incurred for the process of production and selling.

Salary and BonusesElectricityRepairs and maintenancePacking materialTransportation chargesPrinting and stationary.
Royalty feesRentAdministrative dept. costsUtilitiesDuties and taxesProfessional And Legal Fees

Some costs can be directly attributable to individual product like raw material packing charges these costs are called as Direct Costs. And those which are not attributable but required to  made for production and selling are indirect costs like rent, printing and stationary are called as Indirect Costs.

Say, total of all expenses Thomas incurred is say 10,000$

Electricity 2000$

Royalty 1000$

Rent      3000$

Transportation 1500$

Misc Expenses    1500$

Since all of the above expenses are payable by Kaizen Inc it will form part of liability side. But If we add this expenses to payable then totals of both side of Balance side will not match.

Balance sheet at on 31.12.2020

Liabilities$Assets$
Capital100,000Land and Building45,000
Work in Progress5,000
Machinery30,000
Creditors20000Cash20,000
Expenses Payable20000Inventory20,000
Total130000Total120000

To understand this we need to understand supply chain of company.

Production starts >>Raw material Incurred >> Expenses incurred during production >> Semi finished goods >> Finished goods.

Thus Expenses + raw material = finished goods

Finished goods = 10000(Expenses)+ 15000 (Raw material) = 35000$.

Balance sheet as on 31.12.2020

Liabilities$Assets$
Capital100,000Land and Building45,000
Work in Progress5,000
Machinery30,000
Creditors20000Cash20,000
Expenses Payable20000Inventory
         Raw material5000
     Finished Goods35000
Total130000Total130000

Kaizen have 35000 $ of products which is to be sold in market. But not every customer pays all the money upfront. Some may take delivery of goods on credit just like Dixon Inc gave to Kaizen Inc.

Thomas is very good salesperson . He sold all the finished goods for cost + 30% profit margin. Out of which 25000 $ goods were sold for cash and remaining for credit.

Thus total revenue to Kaizen is  45,500$ and profit is 10,500$.

Revenue from goods that are sold on credit is company’s assets as this will cause future inflow of funds. Revenue over and above 25000 $ which is 20,500$ will form part of debtors on asset side.

The owner of business is one who paid the capital thus profit will added to capital but in different head called as reserves and surplus.

Balance sheet as on 31.12.2020

Liabilities$Assets$
Capital100,000Land and Building45,000
Reserves and surplus10500Work in Progress5,000
Machinery30,000
Creditors20000Cash45000
Expenses Paable20000Inventory
      Raw material5000
       Finished Goods0
Trade Receivables20500
Total145500Total145500

Thomas is very industrial person he is always in search of the opportunity to buy wonderful things at cheap price. One day he heard that there is one company name Best Pro Ltd. Which also sells kitchen appliances and whose production facility is near the his company factory is open for sell.

Thomas is interested in deal so he asked for Financial statements and selling price of business.

Best Pro Ltd. Balance Sheet as at 31.03.2020

Liabilities$Assets$
Capital70000Fixed assets70000
Debt10000
Creditors15000Cash15000
Inventories10000
Total95000Total95000

Also Read | Analyse Balance Sheet Line By Line

When he read that statements he come to know that book value of company is 70,000$(book value is obtained when all the liabilities are reduced from assets). But seller is willing to sell this business for not below  120,000$ all in cash.

Thomas is aware of potential this business have so he thinks this business is at undervalue price.

But the problem is that as you can see in the Kaizen’s Balance Sheet they do not have that much cash to pay.

Now there are two ways in which Thomas can raise this cash one is by bringing capital into business. And other is taking debt from the bank.

As Thomas does not have any capital nor any of his friends and relatives are willing to invest in business he choose to ask bank for debt.

Based on the past business operations and skills Thomas have bank decides to lend Thomas’ company a loan of 70,000 by hypothecating fixed assets of Kaizen Inc.

Balance sheet as on 31.12.2020

Liabilities$Assets$
Capital100,000Land and Building45,000
Reserves and surplus10500Work in Progress5,000
Machinery30,000
Debt70000
Creditors20000Cash115000
Expenses Payable20000Inventory
       Raw material5000
      Finished Goods0
Trade Receivables20500
Total220500Total220500

Now Thomas have 120000 of cash to buy business . Thomas without wasting any time closes deal with Best Pro Inc and acquire it.

As Kaizen bought 100% of Best Pro Inc both the balance sheets will merge.

Balance sheet as on 31.12.2020

Liabilities$Assets$
Capital100000Land and Building115000
Reserves and surplus10500Work in Progress5,000
Machinery30,000
Debt85000
Creditors35000Cash15000
Expenses Paable20000Inventory
       Raw material5000
       Finished Goods10000
Trade Receivables20500
Total200500Total250500

But there is 50,000 rupees difference in Balance Sheet.

This difference arise because we pay 120,000$ but we only got net assets of 70,000$. The remaining 50000 is for goodwill considered as goodwill of business.

When business is acquired by company amount paid over and above the book value is considered as goodwill as any company is definitely worth more than sum of its individual components.

Balance sheet as on 31.12.2020

Liabilities$Assets$
Capital100000Land and Building115000
Reserves and surplus10500Work in Progress5,000
Machinery30,000
Debt85000
Goodwill50000
Creditors35000Cash15000
Expenses Payable20000Inventory
       Raw material5000
       Finished Goods10000
Trade Receivables20500
Total250500Total250500

Thomas is ambitious person. He have gained lot of experience in Kitchen Appliance Industry. Now he want to expand his business to other countries also. For that he need lot of capital. To obtain this there is only one way  INITIAL PUBLIC OFFERING.

Until now Thomas owns 100% of business but he is willing to dilute his share to 50%. So Thomas is going to raise 100,000$ dollars through an IPO.

As you know Thomas has created a very unique company and seeing potential of growth Kaizen Inc  is definitely worth more than 200000 $ (100000$ Thomas’ capital + 100000$ through IPO).

So what Thomas is going to do is to charge premium on share capital.

Thus Particulars of IPO Will be as below .

Capital to be Issued100000
Divided In100000 Shares
Face value per share1 $
Offer Price /Share5$
Premium / Share4$
IPO Size5$/share*100000 Shares=500,000$

Thomas announces IPO. It was fully subscribed and thus Thomas raised 500000$.

With his capacity he doubled his production capacity and invested his money to expand his network. He invested remaining capital in shares and governments bonds.

Balance sheet as on 31.12.2020

Liabilities$Assets$
Capital200000Land and Building215000
Reserves and surplus10500Work in Progress5,000
Share premium400000Machinery130,000
Debt85000
Goodwill50000
Investments100000
Creditors35000Cash115000
Expenses Payable20000Inventory
       Raw material5000
       Finished Goods10000
Trade Receivables20500
Total700500Total700500

One Important thing is missing in this balance sheet is provisions . Provisions is amount set aside for future cash outflow which is going to happen because of events in the past. It may be required by law to create provisions.

Most common Provision is Provision For Taxation.

The provision amount is deducted as expenses from income and kept in balance sheet.

Like say Kaizen Inc need to make provision of 1500 $. So this amount will be deducted from Income and will be added to head of provision. Both are credit items .

Reserves are also more or less same thing money from income are set aside for specific purpose and there are some restrictions for use of this fund. Like fund in capital reserve can only be used for buying fixed assets.

Most common types of reserves are.

  • Debenture redemption reserve
  • General reserve
  • Capital reserve
  • Revaluation reserve
  • Investment reserve
  • Foreign exchange reserves.

Balance sheet as on 31.12.2020

Liabilities$Assets$
Capital200000Land and Building215000
Reserves and surplus9000Work in Progress5,000
Share premium400000Machinery130,000
Debt85000
Goodwill50000
Investments100000
Creditors35000Cash115000
Expenses Paable20000Inventory
       Raw material5000
Provisions1500      Finished Goods10000
Trade Receivables20500
Total305500Total245500

Bottomline

It is not hard to understand Balance Sheet. Just few things have to be kept in mind like separate existence of a company, double entries system (If value of one item change then some other item will be affected in such a way that balances on the side will remain same.) and only recording of monetary transactions.

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