Overview of the Balance Sheet (Financial Position Statement)

A balance sheet – financial position statement is one of the most important financial statements. Other important financial statements include the income statement, cash flow statement and statement of changes in equity.

A balance sheet is the financial position of the company at a given point in time. It is often called a “snapshot” of the company’s financial position.

How to think about a balance sheet (financial position statement)


A good way to compare the balance sheet statement, income statement and cash-flow statement is to think of a river leading to a dam. The income statement and a cash-flow statement record the movement of money over a specific period of time. It is similar to recording the volume flowing down a river over a specific period. The balance sheet – financial position statement is the dam. Everything collects there.

Therefore, by looking at the balance sheet we can see how everything comes together at a given point in time. If the company is reporting strong cash-flow in the statement of cash-flows, then that cash must be collecting somewhere, in the balance sheet. Provided a balance sheet is constructed honestly and correctly, it is a wonderful source of information about the company. Like a dam, any poisonous material or waste, gets washed down into the balance sheet. Therefore, paying careful attention to the balance sheet (financial position statement) allows to evaluate important information about the company.

Understanding the balance sheet (financial position statement)


To understand the balance sheet (financial position statement), one first needs to understand the difference between assets and liabilities. A simple explanation is as follows: if you take an unpaid vacation or are between jobs for a while, assets will or will have the potential of adding money to your bank account every month. Liabilities, however, will deduct money from your bank.

For example, if you own a fully paid-off house, which is currently empty, this is an asset. You may choose to earn money from this asset by renting it out. Therefore, even if you are not working, you will have rental income generated from your asset. However, if you leased an expensive car and lost your job, the bank will still deduct money from your bank account every month. Therefore, this is a liability. Alternatively, if the car is fully paid-off, it is an asset and you could generate income from it.

We also can define assets and liabilities more formally.

ASSETS

Assets are any tangible or intangible economic resources that a company or individual possesses and which can be used to cover the individual’s or company’s debt. For example, in the case of an individual, retirement savings and stocks are examples of assets. In the case of a company, fully owned equipment and buildings are examples of assets.

As represented on the balance sheet, current assets are assets which are excepted to be converted into cash within 12 months and non-current assets are assets which are expected to be converted into cash at some point in the future which is longer than 12 months.

LIABILITIES

Liability is a legal obligation to settle debt which arises as a result of a past transaction or event. A liability should, by law, be settled at a specified future period or over a specified period and, possibly, at specified intervals.

As represented on the balance sheet, current liabilities are debts which must be settled within 12 months and non-current liabilities are debts which must be settled at some point in the future which is longer than 12 months.

An example of personal liability can be a personal loan that must be repaid to the bank. Company liability examples include accrued expenses such as wages as well as long-term loans.

 

Terminal Cash flow in capital budgeting decisions

Terminal cash flow refers to the cash flow, which takes place at the end of the project life. Terminal cash flow takes into account a net salvage value received at the end (liquidation) of the project (such as sale of the asset).

Terminal cash flow excludes operation cash inflow from the last year of the project but includes cash flow due to change in net working capital. Generally, change in net working capital results in the cash inflow which is the recovered amount of cash outflow (due to increase in net working capital) that were taken into account at the beginning of the project (when calculating the initial investment).

The calculation of the terminal cash flow is as follows:

After-tax proceeds from the new asset

LESS: After-tax proceeds from the old asset

LESS/ADD: Change in net working capital

= TERMINAL CASH FLOW

As stated above, when we calculate a terminal cash flow, we reverse the change in net working capital, which was taken into account during the calculation of the initial cash outflow (initial investment) .

If there was an increase in net working capital at the beginning of the project than we see it as inflow when calculating the terminal cash flow and vice versa. In other words, if there was an outflow due to change in net working capital at the beginning of the project than we reverse it by adding it back during calculation of the terminal cash flow.

Tax considerations in calculation of the terminal cash flow are the same as explained in initial cash outflow (initial investment) section earlier.

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Operating Cash Inflows

Operating cash inflows is a second variable that we must take into account when determining cash flows from the project. It refers to incremental (additional) cash inflows over the duration of the project. The cash inflows do not take into account interest payments and are calculated as follows:

Revenue

LESS: Expenses (excluding depreciation and interest

 

= EBDIT (Earnings before depreciation, interest and taxes)

LESS: Depreciation

 

= EBIT (Earnings before interest and tax)

LESS: Taxes

 

= NOPAT (Net operating profit after taxes)

ADD: Depreciation

 

= OPERATING CASH INFLOWS

 

Income Statement Format

Familiarity with the income statement format is important for anyone who wants to succeed in business studies and a business career. You need to be familiar with the format to the point of being able to write down the format from memory.

The income statement, which is also referred to as profit and loss statement (P&L), is one of the most important financial statements. Other important financial statements include the balance sheet, cash flow statement and statement of changes in equity.

A good way to compare the income statement, balance sheet (financial position statement) and cash-flow statement is to think of a river leading to a dam. The income statement and a cash-flow statement record the movement of money over a specific period of time. It is similar to recording the volume flowing down a river over specific period. The balance sheet (financial position statement) is the dam. Everything collects there.

The income statement calculates if the business generated a profit or incurred loss during a specified financial period. In other words, it shows profitability of the organization over a certain period.

If profit was generated during then the bottom line of the statement will be a net profit after taxes, which is also called the net income. The general format is presented below.

General income statement format


Sales revenue

LESS: Cost of goods sold*

= Gross profit

LESS: Operating expenses

= EBIT (earnings before interest and tax/operating profit)

LESS: Interest

= Net profit before tax

LESS: Taxes

= Net profit after tax

LESS: Preferred stock dividends

= Earnings available for common stockholders

To calculate Cost of goods sold, one needs to follow the steps:

Opening inventory

Add: Purchases

Less: Closing inventory

= Cost of goods sold