27 August 2010

Fundamental Analysis: Balance Sheet: Total Assets = Total Liability + Total Equity

Balance sheet in a financial report shows the financial portfolio of a company. Three components can be found in balance sheet, that are, total assets, total liabilities and total equity. Therefore, from the balance sheet, value investors can figure out whether this company is using lots of debt to expand their business and boost their income or has ability to improve their financial condition in such a way that and thus reduce the risk of bankruptcy or others.

Balance Sheet: Total Assets = Total Liability + Total Equity

Yes, this was very strange for me as well when I first saw the formula of total assets equal to the sum of total liability and total equity. Don't worry, an example below will help you have a better understanding about the role of balance sheet in a company.

Example:
At the beginning of year 0:
After Company X is listed with market price of $1000 and number of shares of 1000 or $1 per share. Besides, let's Let's say, that company X used this money to buy a plant of $200.00 and goods of $200.00. Next In addition, this company makes a long term borrowing of $200.00 from bank with instalment $50.00 per year.  

The balance sheet of company X at the beginning of year 0 is shown below:
Non-Current Assets
Property, plant and equipment:  $200.00

Current Assets
Inventory : $200.00
Cash and cash equivalents: $800.00

Total Assets: $1200.00
Non-current Liabilities
Long term borrowing : $200.00

Total Liabilities: $200.00

Equity
Share capital: $1,000.00

Total Equity: $1,000.00

At the beginning of year 1:
After one year, let's assume the company has sold out $100.00 goods with net profit of $50.00. But only $30 has been received and the remainder becomes a receivable payment with a period of one year. Besides, in In order to expand this business, the company have brought a new plant which that costs $200.00 by using their cash. Furthermore, company X decides to increase $400 to its inventory since company X has higher expectation in to the incoming year. But this time, company only pay 50% to its creditor.

Therefore, the balance sheet at the beginning of year 1 becomes:
Non-Current Assets
Property, plant and equipment:  $400.00




Current Assets
Inventory: $500.00 ($100 + $400)
Accounts receivable: $120.00
Cash and cash equivalents: $430.00


Total Assets: $1,450.00
Non-current Liabilities
Long term borrowing: $150.00
Current Liabilities
Short term borrowing: $50.00
Accounts payable:  $200.00

Total Liabilities: $400.00

Equity
Share capital:  $1,000.00
Retained Profit: $50.00

Total Equity: $1,050.00
Explanation: (To check your calculation answers, simply highlight the black area below)

Adding inventory of $400 = $200(cash) + $200(payable)
Selling Profit ($50) + cost ($100) = $150 = Received Cash of $30 + Receivable of $120
Cash equivalents = $800 + $30 - Increase of inventory ($400) = $430
Note: $50 from long term borrowing is shifted to current liabilities.                              

At the beginning of year 2:
Company X has successfully sold its goods with cost of $300.00 and profit of $200.00. However, the company is required to clear its current liabilities now. And assuming Assuming the company has successfully received all previous receivables from its customers. But but in this period, up to new receivables of $300.00 haven't been received from its customers has been accumulated.

Therefore, the balance sheet at the beginning of year 2 becomes:
Non-Current Assets
Property, plant and equipment: $400.00



Current Assets
Inventory: $200.00
Accounts receivable: $300.00
Cash and cash equivalents: $500.00


Total Assets: $1,400.00
Non-current Liabilities
Long term borrowing: $100.00
Current Liabilities
Short term borrowing: $50.00
Accounts payable: $0.00

Total Liabilities: $150.00

Equity
Share capital:  $1,000.00
Retained Profit: $250.00
Total Equity: $1,250.00
Explanation: (To check your calculation answers, simply highlight the black area below)

Inventory: $500 - selling cost of $300 = $200.00
Cash equivalents: $500 = $430 + received cash from selling of $200 + previous receivable of $120 - payable of $200 - borrowing installment of $50 
Retained Profit: $250  = previous profit of $50 + current profit of $200

Now, the company has decided to reward their investors with dividend of $0.10 per share or total amount of $100.00. Since the dividend is paid by cash, both amount in Cash and cash equivalent and Retained profit is deduced reduced for this dividend issue.

Therefore, the balance sheet at the end of year 2 becomes:
Non-Current Assets
Property, plant and equipment: $400.00




Current Assets
Inventory: $200.00
Accounts receivable: $300.00
Cash and cash equivalents: $400.00


Total Assets: $1,300.00
Non-current Liabilities
Long term borrowing: $100.00
Current Liabilities
Short term borrowing: $50.00
Accounts payable: $0.00

Total Liabilities: $150.00

Equity
Share capital: $1,000.00
Retained Profit: $150.00

Total Equity: $ 1,150.00

As you can see,  Total Assets = Total Liability + Total Equity. That's why we always say balance sheet must always BALANCE. Feel free to give me a comment about this topic. It will be a great support to Xaivier Blog.

Written by: Xaivier Chia
First edited at Oct 2010
Second edit: October 2014, by Xaivia Lim
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