The knowledge of accounting is very important as investor and internal manager to measure health of a business. The most important is the ability to understand financial statements. Financial statements consists of balance sheet, income statement, cash flow statement, and retained earning statement. In this post, I will share more about balance sheet and statement of cash flows.
Balance sheet provides information on assets, liabilities and shareholders’ equity. As the result, balance sheet provides a basis for calculating rates of retur and evaluating capital structure of the company. Analysts use information in balance sheet to assess company’s risk and future cash flows. Analysts use balance sheet to asses company’s liquidity, solvency, and financial flexibility.
Liquidity is the amount of time that is expected to elapse until an asset is realized or converted into cash or until a liability has to be paid. Creditors is interested with short-term liquidity to see whether the company able to pay its short-term debts. Solvency refers to the ability of a company to pay its debts as they mature. Ratio debts to assets should be lower to get higher solvency. Both liquidity and solvency will affects financial flexibility, which measures the ability of company to take effective actions to alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities.
Eventhough, balance sheet also has its limitations. First, most assets and liabilities and reported at historical cost. Therefore, sometimes balance sheet is criticized for not report fair value. Second, companies use judgement and estimates to determine many items reported in balance sheet. For example, good will and brand recognitions may be judged differently from various companies. Third, balance sheet ignore some items that cannot be record objectively. For example, knowledge and skill of employees cannot be put into balance sheet. Many items also reported in an “off balance sheet” manner, like third party’s assets under managements in bank industry.
Balance sheet accounts has three general classes of items :
1. Assets: Probable future economics benefits controlled by company as result of past transactions or events. Assets may consist of current assets (cash, cash equivalents, and inventory), long term investments, PPE(Property, Plant and Equipment), intangible assets, and other assets.
2. Liabilities: Probable future sacrifices of economics benefits arising from present obligation of company to transfer assets or provide services to other party in the future as result of past transaction or events. Liabilities may consist current liabilities and long term debt.
3. Equity: Residual interest in the assets of company that remains after diducting its liabilities. In a company, equity is also the ownership interest. Equity may consist capital stock, additional paid-in capital and retained earnings.
Statement of Cash flows
Cash flow statement is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities.
Operating activities involve the cash effects of transaction that enter into the determination of net income. Investing activities includes the making or collecting loans and acquiring or disposing of investments (both debt and equity) and PPE. Financing activities includes liability and owners’ equity items, such as obtaining share from owners or providing them return of their investments and borrowing money from creditors and repaying the amounts borrowed.
The basic format of cash flow statement :
Cash flows from operating activities xxx
Cash flows from investing activities xxx
Cash flows from financing activities xxx
Net increase (decrease) in cash xxx
Cash at the beginning of year xxx
Cash at the end of year $XXX