Are you a non finance person? Are you worried that you don't understand finance and feel that it is not your cup of tea? No need to be worried at all. Finance is not rocket science and not prerogative of few. Understanding finance is the easiest of disciplines of learning. The first step in understanding finance is having basic idea of accountancy. You need not know the journal entry and ledger posting concepts at all. If you know it is great, but if you don't, it hardly makes a difference. Then what do you really need to know in finance. Please remember that it is important to understand three critical statements to understand finance. Which are these statements? Any person trying to understand finance needs to know that it is critical to understand: 1) Balance Sheet, 2) Profit and Loss Account and 3) Cash Flow Statement.
Isn't it complex to understand these statements? Not really. To understand balance sheet, please note that you need to be clear about what are assets and liabilities. Asset is what a business owns. Liability is what a business owes. A loan raised from a bank is a liability for a business while a deposit made in a bank is an asset. So assets and liabilities are identified based on ownership. How do I understand what are different assets for a business. Generally assets owned by business are land, building, computers, software, bank deposits, cash, inventory (stock) etc. It will be advisable to go to the website of some of the companies and download their balance sheet and analyse the balance sheet for better understanding. Similarly there are liabilities in the balance sheet of a business. Liabilities, as explained earlier, are what business owes to the outsiders. Liabilities are categorized as internal liabilities and external liabilities. Internal liabilities are those which are to be paid back to the shareholders and it is know as shareholders claim on which is share capital and reserves and surplus. Liabilities include share capital, reserves and surplus, bank loans, creditors etc. Interestingly profit earned by a business is liability to the shareholders of a business and not asset as understood generally.
Balance sheet bifurcates liabilities into two parts: 1) Long Term Liabilities and 2) Current Liabilities. Long term liabilities are those liabilities which have to be paid back in more than a year while short term liabilities need to be paid back in a year or less than a year. Similarly assets are presented as Fixed Assets and Current Assets.
Once you have gone through balance sheet and looked at its various components, what do you need to do? There are certain ratios that help you in understanding balance sheet. For example to understand liquidity of a business, you need to understand current ratio which is a relationship between current assets and current liabilities. Similarly to understand how well a company is leveraged, one need to look at debt/equity ratio, which gives insight into how much debt company has raised against the equity shares that it holds. Balance sheet along with Profit and Loss account is used to find Return on Investment of a business. ROI is relationship between EBIT/Investment. EBIT stands for Earning before Interest and Tax.
Some of the other key concepts which can be understood with the help of balance sheet are net worth, working capital and capital employed. Net worth is defined are share capital plus reserves and surplus. Working capital is the total current assets employed in the business. Net Working capital is difference between current assets and current liabilities. Capital employed includes Networth plus long term liabilities.
When you look at balance sheet of a company, also go through the schedule which is given with each balance sheet. Schedule gives details of what each component of balance sheet is made of. Like if a company shows investments as assets balance sheet will show what these assets are actually.
About Author / Additional Info: