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Anatomy of Financial Statement: Balance Sheet

In my previous post, I explained in detail on how Income Statement is prepared using café shop as an example. I have also showed you how two companies with different business industry has a different way of presenting its Income Statement. Hopefully, by now you should be able to read and understand the Income Statement of a company. If you haven’t read my previous post, you can find it here. In this post, I’m going to focus on Balance Sheet using the same example, café shop, to illustrate it. Let’s get to it.

Balance Sheet Sections

In a typical Balance Sheet, you will see that there are 5 categories:

#1: Non-Current Assets

These are assets that are not likely to be sell off and turn to cash within a year. In a café operation, your non-current assets would be the coffee machines, silverware, dishes, tables & chairs, mugs, etc.

Coffee Shop Equipment

While these assets are not meant to be sell-off but for the café operational use only, it is subjected to wear and tear. Chairs may be broken and coffee machine may be malfunctioning over time. As such, under the accounting rules, these assets are to be depreciated from its initial purchase costs based on the expected useful life of each assets (usually determine by the company). That is why you will see in the income statement there is a depreciation charge under SGA expenses.

As a result of depreciation, the amount shown in the Balance Sheet is the net costs (known as “Net Book Value”) after taking into account the accumulated depreciation of each assets.

#2: Current Assets

These are assets that can be readily convert to cash within a year. Usually, the common assets that you will see under this category is the following:

Inventories

Coffee Ingredients_1

Inventories are assets that held readily for sale, in the process of production into finished product or in the form of raw materials to be consumed in the production of finished product. In the case of café operation, this refers to the coffee beans, fresh milk and pastries ingredients. Some café like Starbucks selling merchandise (i.e. mugs, tumbler, etc.), this is also classify as inventory.

Receivables & Cash at Bank

Receivables are money to be received from third parties within a year. It can be classify further into trade and non-trade. Trade receivables are money to be receive from customers upon rendering services or selling products on credit terms.

Non-trade receivables are money to be receive from third parties other than those directly related to the company’s business operation. Some examples of non-trade receivables are prepayment of rental expenses and any deposit paid that are refundable within a year.

Cafe Business Model

In the case of café operation, the trade receivables are the purchase of food and beverages by customers using credit card. This is because you do not receive cash immediately until the credit card company makes the payment on behalf of the customer after charging a percentage of fee against the total amount.

Cash, on the other hand, is more straightforward. In the case of café operation, any cash paid by customers for the food and beverages served will eventually be deposited into the bank. At the end of the year, the closing balance of the bank account will be shown in the Balance Sheet.

#3: Equity

In layman’s term, equity refers to the capital that is invested into the business by the shareholders every year (also known as “shareholders’ funds”). Basically, there are two main items to take note. The first being the share capital of the business. This refers to the initial capital invested into the business by the shareholders (usually, during when company is incorporated). Share capital will only increase when a company is raise funds through issuing new shares.

The second item is retained earnings of the business. This refers to the amount of profit generated by the business that is retained or reinvested into the business after taking into account the dividend distributed to shareholders.

Total Equities

If you remember my previous post on Income Statement, I highlighted that the profit for the year on this café operation is about RM18,000. Assuming there are no dividends paid to the shareholders, this would mean that 100% of the earnings are retained and reinvested into the café operation.

#4: Non-Current Liabilities

Long-Term Loans

Non-current liabilities are long-term financial obligations that are not due to be settled within a year (usually, is more than 1 year). For café operation, the non-current liabilities will be the money initially borrowed from the bank for starting the business. If the café shop is on a finance lease agreement (in layman’s term, rental) for period of 5 years, this is also classify as non-current liabilities. However, a portion of the finance lease where it is expected to be settled within a year is classify as current liabilities.

#5: Current Liabilities

These are short-term financial obligations that are due to be settled within a year such as follows:

Payables

This are amount expected to be paid within a year. It is somewhat similar to the receivables where it can be classify into trade and non-trade. Trade payables are amount payable to creditors that supply goods or services that are directly attributed to the business activity. Examples are the purchase of raw materials for production of finished goods.

Non-trade payables (sometimes refer as “other payables) are amount payable to creditors for supply of goods or services not directly attributable to the business activity. Examples are the employees’ bonus payable, dividends payable, deposit payable, etc.

Coffee Ingredients_2

For café operation, the trade payables are the purchase of coffee beans, fresh milk and pastries ingredients on credit terms.

Other Current Liabilities: Short-term Borrowings & Finance Lease

Under the accounting rules, a company is required to separate out its bank borrowings and finance lease into those portion that are to be settled within a year (classify as current liabilities) and those that are not due to be settled within a year (classify as non-current liabilities).

Short-Term Loans

For illustration purposes, we can assume that the other current liabilities for café operation is as per the diagram above.

Combining it all together

I have looked into each category of the Balance Sheet item in detail. So how do the Balance Sheet look like for café operation if we combined all the above five elements together? See below:

Balance Sheet Illustration

If you realized from the above balance sheet, the total assets of RM105,000 agrees with the total equity & liabilities amount. That’s why it is implied that the total assets is funded by both equity and liabilities.

MY INSIGHTS

The Balance Sheet provides us a snapshot of company’s financial health. You do not want to invest in a company that are highly indebted. This increase the risk of default (unable to service its debt) if any unforeseen event arises like the covid-19 outbreak.

I hope by now you get the point of how balance sheet is prepared and what each category in the Balance Sheet means. Let’s examine the final key financial statement which is the Cash Flow Statement.

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Thomas

Co-founder of Stocks Insights. Prior to this, he was attached with medium-size audit firm for 2 years working as an external auditor where he has performed statutory audit on companies from various industries including oil & gas, retailers, manufacturing, industrial products & machinery, etc. He is also involved in Enterprise Risk Management exercise and the internal control framework review for entities undergoing a listing exercise on Bursa Malaysia and SGX Catalyst Board. He is also an ACCA member.

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