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MENTORING - Fundamentals - Company fundamentals - Balance Sheet analysis -…
MENTORING - Fundamentals - Company fundamentals - Balance Sheet analysis
A P&L is a flow information. That is it contains data between two points of time. That is why we call it as P&L for a period (quarter or half year or year or any other period).
However, a company's prospects keep changing on a daily basis. That is reflected in a Balance Sheet.
A Balance Sheet is a stock information. It is always given at a point in time. That means you have stopped the company today and checked its balance sheet to see how well it is place.
METAPHOR: A P&L is like a video taken and a BS is like a photo taken of the company.
To set up a company, one needs capital. What kind of capital?
Two types of capital types can be ideated.
Capital in terms of ownership -
Equity and debt. Equity is inside capital, debt is outside capital. But both are liabilities to the company from the respective owners. Equity comes from the equity owner, and has to be returned to him/her. Debt comes from outside lenders, and has to be returned to them. Hence both are liabilities. These people can be called stakeholders, means they have control.
Capital in terms of timeframe -
Long term capital, also called capital
expenditure
. Short term capital, or working capital. Both of these are attained using a mix of equity and debt. So the source of this capital is above (equity and debt). The timeframe division between long and short terms is one year. That is beyond one year, it is called long term and within one year, it is called short term.
Why we need to understand this division of long term and short term capital. To plan better and allocate resources well.
So a company's balance sheet is generated with
liabitlies
(inside and outside) and that leads to
assets
, which are key to generating
revenue
at an
expense
in a profit and loss statement.
The accounting equation for a company can be written as below. Shareholder EQUITY (inside capital) + LIABILITIES (monetary DEBT and non-monetary components) = ASSETS. So EQUITY = ASSETS - LIABILITIES.
A balance sheet comprises two sides - assets and liabilities
Liabilities comprise shareholder equity (paid up in cash), debt and other liabilities. Creation of a liability brings in cash, but deletion of a liability consumes cash.
Assets comprise various things that consume cash when they come into the company, but create cash when they are worked well with.
Both assets and liabilities are of two types. Short term and long term. Short term are those that are consumed within a financial year, while long term are those that are consumed beyond one year.
Short term assets or liabilities are called current assets or liabilities
Long term assets or liabilities are called non-current assets or liabilities.
Now link these to long term capital (or capital expenditure) and short term capital (or working capital). For a company to run, it needs both short term capital and long term capital. However, the life blood of a company is on working capital.
That is why we will look at working capital to assess a company's balance sheet strenght.
A company's success lies in the efficiency of its capital allocation policy. This is the performance metric for a management. Hence, we will calculate the return on capital employed generated by management.