What Is a Balance Sheet Explained in Simple Terms

WHAT IS A BALANCE SHEET EXPLAINED IN SIMPLE TERMS

Balance Sheet can be explained from various perspectives. One way to explain it, especially to those who are new to the field of accounting or with little credit exposure is from liquidation perspective.

What is liquidation :

Liquidation is the process by which a company comes to an end i.e. the company terminates and ceases to exist. When a firm is terminated or bankrupt, its assets are sold and the proceeds are used to pay creditors. Any leftovers are distributed to shareholders.

In this blog post, we will see in simple terms what a balance sheet is from the perspective of liquidation.

This is the balance sheet format :

A balance sheet has two columns – the left hand column lists liabilities and right hand column lists assets. This is a standard presentation format of balance sheets.

Liabilities / Assets
Liability item 1
Liability item 2
Liability item 3
and so on / Asset item 1
Asset item 2
Asset item 3
and so on

Try to remember this – liability means money goes out, asset means money comes in :

Though not strictly correct, to make things simple, remember liabilities as something negative and assets as positive. That means you wish to avoid liabilities and wish to have more assets. The reason is that liabilities are amounts that you have to pay. For example, as an individual, if you took a housing loan from a bank, it is a liability because you have to pay that amount. On the other hand, if you have a fixed deposit in bank, that is an asset because you will receive that amount. Similarly if you have a own house, that is also an asset because if you decide to sell it, you will receive money.

So if money comes in, it is an asset. If money goes out, it is a liability. Here, the timing is not important. A house is an asset not because money comes in today itself. Infact, you may never sell it. But still it is an asset because it has the potential to give you money should you ever plan to sell it. Similarly, supposed you borrowed Rs. 1 lakh from your relative who allows you to repay it only after 10 years. It is a liability because one day in future you have to repay him. That means if you borrowed Rs. 100/- from your neighbour and have to repay it today itself, that is also a liability. So the timing is not important. Whether the money comes in or goes out today or tomorrow or 50 years from now is not relevant.

Let us see a few other liabilities and assets for an individual.

• Loan borrowed from relative or friend is a liability because you have to pay them at some point in future. The day you repay that amount, money goes out and hence it is a liability
• The amount in your savings bank account is an asset because you can go to the bank and withdraw the amount any time. In this case, money comes in and hence it is an asset
• Your vehicle is also an asset. You may not have plans to sell it but still it is an asset because if there arises a situation where you are tight on cash and need to sell the vehicle, it will result in some money coming in. Therefore it is an asset
• You received this months' electricity bill. Say, the bill is dated September 5 and you have received it on September 10. The due date i.e. last date for payment is October 10. This is a liability because you have to pay the bill by October 10 and when you make that payment, money will go out and hence it is a liability

Now that you have some clarity on what is an asset and what is a liability, let us turn to a company.

Companies also have assets and liabilities. Loan taken from bank is a liability because the company has to pay it at some point in future and then money goes out. Finished goods in godown are asset because these goods will be sold and company will receive money from them. Here a few more items.

• Suppose the company purchased raw material from a supplier. However the supplier gave credit period i.e. he delivered the raw material to the company but did not insist on immediate payment. He gave time for 2 weeks for payment. This is a normal practice in business. This item i.e. creditors is a liability because after two weeks, the company has to make the payment
• Suppose that the company pays salaries on 1st of every month. So, March salaries are paid on April 1. When we prepare the balance sheet of the company as on March 31, the company has not yet paid salaries of March. So there will be an item called salaries payable. This is a liability because the company has to make payment.
• Machinery of the company is an asset. Normally, company will not sell its buildings or machinery. They are used continuously in the business. Company does not buy machinery to sell them. But still, for the purpose of classifying it as asset or liability, you have to understand that the company need not pay any money regarding this machinery since it is already purchased. So it is not liability. However if the company plans to sell it, it will receive some money. Therefore machinery is an asset

Concept of balance sheet :

Now that you have the required basics, let us see what a balance sheet is. Recall the term liquidation (refer the beginning paragraphs of this article). Let us now assume that the company is being liquidated. Maybe the owner of the company is no more interested in running this company. So he decides to close the business. So he plans to sell whatever is there in the company such as land, buildings, machinery, finished products, office furniture, vehicles, fans, lights, etc. Whatever the company has, he has sold and got an amount of Rs. 100 lakh. In terms of balance sheet, this is what the assets side of the company would look like.

Liabilities / Amount / Assets / Amount
(Rs. in lakh)
There will be liability items also in this balance sheet but let us focus on assets items only for the moment / Land / 10.00
Buildings / 25.00
Machinery / 20.00
Finished products / 15.00
Office furniture / 10.00
Vehicles / 5.00
Fans, lights / 3.00
All other items / 12.00
Total / 100.00
So the asset side of the balance sheet tells us this : if today we sell all the belongings of the company in the market, we will realise an amount of Rs. 100 lakh. This is simply what the asset side of a balance sheet represents.

So the owner got Rs. 100 lakh by selling the assets. Can he take that Rs. 100 lakh, deposit it into his personal account and enjoy his life with that amount. No, he cannot do that because these assets worth Rs. 100 lakh were purchased not only by the owner's investment but also other sources. So first, he has to repay those outside borrowings and only then he can take whatever is left. Let us now look at the liabilities side of this company.

Liabilities / Amount / Assets / Amount
(Rs. in lakh)
Owners own investment (including original capital invested by the owner and profits retained in the business ) / 20.00 / Land / 10.00
Term loan from bank / 25.00 / Buildings / 25.00
OCC from bank outstanding / 15.00 / Machinery / 20.00
Raw material creditors / 10.00 / Finished products / 15.00
Income tax payable / 5.00 / Debtors / 10.00
Salaries payable / 3.00 / Office furniture / 10.00
Electricity bill payable / 2.00 / Vehicles / 5.00
Loans taken from friends and relatives / 15.00 / Fans, lights / 3.00
All other items / 5.00 / All other items / 2.00
Total / 100.00 / Total / 100.00

So, out of the Rs. 100 lakh received by selling the assets, the owner has to repay bank Rs.40 lakh (term loan plus OCC), pay raw material creditors Rs. 10 lakh, etc. These outside payments total Rs. 80 lakh. Once he repays this Rs. 80 lakh, he will be left with Rs. 20 lakh which he can take.

So the liability side of the balance sheet tells us this : if today the company is liquidated, who are all the people the company has to settle dues. This is simply what the liability side of a balance sheet represents.

Residual claim :

Observe carefully that owners investment (also called capital) is classified under liabilities side. This is because the owners have only residual claimi.e. after settling dues of everybody else, only then the owner can take the remaining amount. Let us assume in the above example that there was a fire in the godown and all finished products worth Rs. 15 lakh was destroyed. Now by selling the assets of the company, only Rs. 85 lakh is realised. The owner cannot say "I will take my Rs. 20 lakh investment first and the balance Rs. 65 lakh I will distribute to others". He cannot say like that because the outside borrowings and dues are totalling Rs. 80 lakh which cannot be met by Rs. 65 lakh. Nobody will be willing to sacrifice his dues. So the owner should settle everybody dues first i.e. Rs. 80 lakh. Now, only Rs. 5 lakh is left. This he should take. Here, though the owner invested Rs. 20 lakh of his own money in the company, he was left with only Rs. 5 lakh. That is the nature of risk owner of a business takes. Only the leftover amount after settling all other dues, he can take. That is why we refer to owners claim as residual claim.

Ofcourse there are advanced issues such as what if the amount obtained after sale is not sufficient to pay all dues, etc. But at this stage you need not be worried about that. However there is one important point you need to be aware of.

A common gimmick of companies :

Balance sheet should show the correct position of the liabilities and assets. It should be the endeavour of the banker, analyst and anyone analysing a company’s balance sheet to ensure this point. Usually liabilities are stated as they are. For example, take term loan outstanding from banks. If the amount outstanding is Rs. 10 crore as on 31.03.2012, the company will not show Rs. 11 crore. Why would the company itself say it has to pay Rs. 11 crore to the bank when it has to pay only Rs. 10 crore? So there is no fun in inflating the liability amount. A company will not show a reduced amount also because if it shows only Rs. 9 crore, bank will immediately question that figure. Bank will not accept if company says the amount payable is less. So liability items are usually correct. But the story is different on the assets side.

On the assets side, the value of the asset is to be reported. For example, value of inventory. Note that inventory valuation is an exhaustive topic in itself and is beyond the scope of this article. But the point is that companies tend to play with figures on assets side. You should be very concerned about this since what a balance sheet essentially reveals is the following.

What a balance sheet really tells us is if the company were to wind up i.e. close the business today - in that case the balance sheet should tell us to whom all money is to be settled and how will the company meet that amount to be paid. Consider the following balance sheet.

Liabilities / Assets
Capital / 100 lakh / Cash and bank balance / 5 lakh
Reserves and surplus / 80 lakh / Debtors / 75 lakh
Unsecured loans / 25 lakh / Inventory / 125 lakh
Term loan from bank / 60 lakh / Fixed assets / 150 lakh
OCC limit outstanding / 40 lakh
Creditors / 50 lakh
Total / 355 lakh / Total / 355 lakh

The company has to meet total liabilities of Rs. 355 lakh. How it will meet this is available from the assets side. So the company will sell its fixed assets and realise Rs. 150 lakh. It will pursue with debtors and get the Rs. 75 lakh due from them. It will sell the inventory and realise Rs. 125 lakh. It already has some cash in hand and in bank. All these put together totals Rs. 355 lakh. Once the company receives cash of Rs. 355 lakh, it will clear bank’s OCC and term loan, repay the unsecured loans, pay the creditors and will be left with Rs. 180 lakh. The left over money belongs to promoters which is their investment in the business (both through initial investment and retained earnings). This is how the liabilities are settled.

Now, we are assuming that by selling the assets, the company will receive cash of Rs. 355 lakh. But what if some items are over-valued in the balance sheet. For example, the inventory shown as Rs. 125 lakh actually generated only Rs. 75 lakh on sale. If the cash from sale of all assets is less than Rs. 355 lakh, the company cannot meet all the liability payments. That is a problem. Therefore, asset side items needs to be checked whether the value shown is reasonable or not. Especially, with regard to inventory companies show value which can be arrived at by different methods. There is scope for reporting higher value. As a banker you need to be aware of this possibility of the company inflating asset side values to present a rosy picture.

In summary …

Hope this blog post has explained what a balance sheet is in simple terms. When you look at any balance sheet, imagine that if today the company is dissolved, the company will receive an amount of _____(whatever is the total of assets side) and with that amount, the company will settle all dues and borrowings. Who gets how much is shown under liabilities side. That is what a balance sheet is all about!