Financial Statements (i)

Financial statements are used to gauge the health of a company. It’s always good habit to learn about a company before investing in the same. Financial statements can give us a quick snapshot of how much profit the company has been making over the years; how much of that profit has been returned to investors in the form of dividends; what are the liabilities and whether the assets are sufficient to fulfill these liabilities? Let’s discuss more about income statement and balance sheet, the two most important financial statements of a company. Let’s try to understand everything through an example.

Let’s assume you want to set up an auto parts manufacturing plant and need some money for the same. You have three options to raise funds:

Option 1: Take a loan at a fixed rate of interest from the local bank

Option 2: Take money offered by your dad’s friend and bring him on board as an investor/shareholder

Option 3: A mix of the above two options

Let’s say you opt for the third one. Your total initial requirement is Rs 1,00,000. You have decided to take a loan of Rs 50,000 from the bank and borrow the remaining Rs 50,000 from your dad’s friend. You intend to use the funds for the following purposes: Rs 40,000 for machines, Rs 40,000 for building & other infrastructure and Rs 20,000 for raw materials.

At this point, let’s define some basic terms. All the tools, machines, infrastructure, building and other things acquired by you for manufacturing auto parts are called assets. More precisely, everything bought and owned by you using the money you raised, is classified as an asset. Assets are created when funds are utilised to buy articles that are going to help generate cash in the future. In this case, machines are acquired using the funds you raised and will help you generate cash in the future.

Assets can be further broken down into fixed, tangible & immovable assets and movable current assets. Plant and machinery will be classified as fixed, tangible and immovable assets because they are relatively immovable and have a very long life. Raw materials will be classified under movable current assets, as they have a very short life span and will be required to replenish at regular intervals.

Whereas assets are sourced by using funds, liabilities are the source of funds. As discussed, we have two sources of fund: banks and your dad’s friend. Total liability is Rs 1,00,000. The most important thing to understand here is assets are always equal to liabilities. The amount you borrowed from bank needs to be repaid over the next few years and will be classified as long term liability. Money you raised from your dad’s friend is not a loan but an investment in your company. Thus it is classified as shareholder’s equity and your dad’s friend will be a shareholder of the company.

So to conclude and summarise, assets are obtained by using funds and liabilities represent sources of funds. Hence assets are always equal to liabilities.