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Understanding the balance sheet

A balance sheet (also called statement of financial position) provides information about a company’s assets, which are resources controlled as a result of past events which are expected to generate future economic benefits; liabilities, which are obligations arising from past events expected to result in flow of economic benefits from entity; and equity, which is the residual interest of the owners and it equals assets minus liabilities.

Components of a balance sheet

A balance sheet can be expressed by the following equation:

\[ Assets = Liabilities + Equity \]

Value of shareholders’ equity on a balance sheet is not an indication of market value or intrinsic value of equity because some balance sheet elements are valued at historical cost while others at fair value, and even the fair values are dated, i.e. they are relevant only at the balance sheet date. Further, a balance sheet doesn’t capture goodwill, reputation, etc.

A balance sheet provides information on a specific point of time. If a company has a financial year based on the number of weeks, an extra week would affect the income statement and statement of cash flows more than a balance sheet.

Format of a balance sheet

Both IFRS and US GAAP require a balance sheet to classify assets and liabilities into current and non-current because such a classification is useful in liquidity analysis. Such a balance sheet is called a classified balance sheet. However, IFRS allows a ranking of assets based on liquidity if such a presentation provides more meaningful information. For example, a bank may adopt a liquidity-based presentation showing cash and cash equivalents at the top followed by progressively less liquid assets.

Current assets are those which are held primarily for the purpose of trading or which are expected to be realized in cash within one year or one operating cycle, whichever is longer. Current assets are generally maintained for operating purposes. Assets other than current assets are called non-current (long-term) assets.

Current liabilities are obligations that arise out of trading or which are expected to be settled in one year or one operating cycle whichever is greater. Certain liabilities such as accounts payable, accrued salaries, etc. are considered current liabilities even if they will be settled after more than one year. Liabilities other than current liabilities are called non-current liabilities.

The excess of current assets over current liabilities is called working capital.

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