The Balance Sheet details the financial position of a company on a particular date; the company’s assets (that which the company owns), and liabilities (that which the company owes), grouped logically under specific heads. It must however, be noted that the Balance Sheet details the financial position on a particular day and that the position can be materially different on the next day or the day after.
Sources of funds
A company has to source funds to purchase fixed assets, to procure working capital and to fund its business. For the company to make a profit, the funds have to cost less than the return the company earns on their deployment.
Where does a company raise funds? What are the sources?
Companies raise funds from its shareholders and by borrowing.
a) Shareholders’ Funds (Total Share Capital in XYZ’s Balance Sheet)
A company sources funds from shareholders by the issue of shares. Shareholders’ funds is the balance sheet value of shareholders’ interest in a company. For the accounts of a company with no subsidiaries it is total assets minus total liabilities. For consolidated group accounts the value of minority interests is excluded. Minority interest refers to the portion of a subsidiary corporation’s stock that is not owned by the parent corporation.
Shareholders’ funds represent the stake shareholders have in the company, the investment they have made.
o Share Capital
Share capital represents the shares issued to the public. This is issued in following ways:
o Private Placement – This is done by offering shares to selected individuals or institutions.
o Public Issue – Shares are offered to public. The details of the offer, including the reasons for raising the money are detailed in a prospectus and it is important that investors read this.
o Rights issues – Companies may also issue shares to their shareholders as a matter of right in proportion to their holding. So, if an investor has 100 shares and a company announces a 2:1 rights, the investor stands to gain an additional 200 shares. Rights issues come at a price which the investors must pay by subscribing to the rights offer. The rights issues were often offered at a price lower than the company’s market value and shareholders stood to gain. With the freedom in respect of pricing of shares now available, companies have begun pricing their offerings nearer their intrinsic value. Consequently, many of these issues have not been particularly attractive to investors and several have failed to be fully subscribed. However, strong companies find subscribers to their rights issues as investors are of the view that their long term performance would lead to increase in share prices.
o Bonus shares – When a company has accumulated a large reserves out of profits, the directors may decide to distribute a part of it amongst the shareholders in the form of bonus. Bonus can be paid either in cash or in the form of shares. Cash bonus is paid in the form of dividend by the company when it has large accumulated profits as well as cash. Many a times, a company is not in a position to pay bonus in cash (dividend) in spite of sufficient profits because of unsatisfactory cash position or because of its adverse effects on the working capital of the company. In such a case, the company pays a bonus to its shareholders in the form of shares. Bonus shares are shares issued free to shareholders by capitalizing reserves. No monies are actually raised from shareholders. Nothing stops a company from declaring a bonus and dividend together if it has large accumulated profits as well as cash.
Reserves – Reserves are profits or gains which are retained and not distributed. Companies have two kinds of reserves – capital reserves and revenue reserves:
• Capital Reserves – Capital reserves are gains that have resulted from an increase in the value of assets and they are not freely distributable to the shareholders. The most common capital reserves one comes across are the share premium account arising from the issue of shares at a premium and the capital revaluation reserve, i.e. unrealized gain on the value of assets.
• Revenue Reserves – These represent profits from operations ploughed back into the company and not distributed as dividends to shareholders. It is important that all the profits are not distributed as funds are required by companies to purchase new assets to replace existing ones, for expansion and for working capital.
b) Loan Funds
The other source of funds a company has access to is borrowings. Borrowing is often preferred by companies as it is quicker, relatively easier and the rules that need to be complied with are much less. The loans taken by companies are either :
o Secured loans – These loans are taken by a company by pledging some of its assets or by a floating charge on some or all of its assets. The usual secured loans a company has are debentures and term loans.
o Unsecured loans – Companies do not pledge any assets when they take unsecured loans. The comfort a lender has is usually only the good name and credit worthiness of the company. The more common unsecured loans of a company are fixed deposits and short term loans. In case a company is dissolved, unsecured lenders are usually paid after the secured lenders have been paid. Borrowings or credits for working capital which fluctuate such as bank overdrafts and trade creditors are not normally classified as loan funds but as current liabilities.
Fixed Assets (Net Block in XYZ’s Balance Sheet) –
Fixed assets are assets that a company owns for use in its business and to produce goods. Typically it could be machinery. They are not for resale and comprises of land, buildings i.e. offices, warehouses and factories, vehicles, machinery, furniture, equipment and the like. Every company has some fixed assets though the nature or kind of fixed assets vary from company to company. A manufacturing company’s major fixed assets would be its factory and machinery, whereas that of a shipping company would be its ships. Fixed assets are shown in the Balance Sheet at cost less the accumulated depreciation. Depreciation is based on the very sound concept that an asset has a useful life and that after years of toil it wears down. Consequently, it attempts to measure that wear and tear and to reduce the value of the asset accordingly so that at the end of its useful life, the asset will have no value.
As depreciation is a charge on profits, at the end of its useful life, the company would have set aside from profits an amount equal to the original cost of the asset and this could be utilized to purchase another asset. However, in the inflationary times, this is inadequate and some companies create an additional reserve to ensure that there are sufficient funds to replace the worn out asset. The common methods of depreciation are:
o Straight line method – The cost of the asset is written off equally over its life. Consequently, at the end of its useful life, the cost will equal the accumulated depreciation.
o Reducing balance method – Under this method, depreciation is calculated on the written down value, i.e. cost less depreciation. Consequently, depreciation is higher in the beginning and lower as the years progress. An asset is never fully written off as the depreciation is always calculated on a reducing balance.
Land is the only fixed asset that is never depreciated as it normally appreciates in value. Capital work in progress – factories being constructed, etc. – are not depreciated until it is a fully functional asset.
Investments
Many companies purchase investments in the form of shares or debentures to earn income or to utilize cash surpluses profitably. The normal investments a company has are:
o Trade investments – Trade investments are normally shares or debentures of competitors that a company holds to have access to information on their growth, profitability and other details.
o Subsidiary and associate companies – These are shares held in subsidiary or associate companies. The large business houses hold controlling interest in several companies through cross holdings in subsidiary and associate companies.
o Others – Companies also often hold shares or debentures of other companies for investment or to park surplus funds.
Investments are also classified as quoted and unquoted investments. Quoted investments are shares and debentures that are quoted in a recognized stock exchange and can be freely traded. Unquoted investments are not listed or quoted in a stock exchange. Consequently, they are not liquid and are difficult to dispose of.
Investments are valued and stated in the balance sheet at either the acquisition cost or market value, whichever is lower. This is in order to be conservative and to ensure that losses are adequately accounted for.
Current assets –
Current assets are assets owned by a company which are used in the normal course of business or are generated by the company in the course of business such as debtors or finished stock or cash.
The rule of thumb is that any asset that is turned into cash within twelve months is a current asset.
Current assets can be divided essentially into three categories :
o Converting assets – Assets that are produced or generated in the normal course of business, such as finished goods and debtors.
o Constant assets – Constant assets are those that are purchased and sold without any add-ons or conversions, such as liquor bought by a liquor store from a liquor manufacturer.
o Cash equivalents – They can be used to repay dues or purchase other assets. The most common cash equivalent assets are cash in hand and at the bank and loans given.
The current assets a company has are:
• Inventories – These are arguably the most important current assets that a company has as it is by the sale of its stocks that a company makes its profits. Stocks, in turn, consist of:
o Raw materials – The primary purchase which is utilized to manufacture the products a company makes.
o Work in progress – Goods that are in the process of manufacture but are yet to be completed.
o Finished goods – The finished products manufactured by the company that are ready for sale.
Valuation of stocks
Stocks are valued at the lower of cost or net realizable value. This is to ensure that there will be no loss at the time of sale as that would have been accounted for. The common methods of valuing stocks are:
o FIFO or first in first out – It is assumed under this method that stocks that come in first would be sold first and those that come in last would be sold last.
o LIFO or last in last out – The premise on which this method is based is the opposite of FIFO. It is assumed that the goods that arrive last will be sold first. The reasoning is that customers prefer newer materials or products. It is important to ascertain the method of valuation and the accounting principles involved as stock values can easily be manipulated by changing the method of valuation.
Debtors –
Most companies do not sell their products for cash but on credit and purchasers are expected to pay for the goods they have bought within an agreed period of time – 30 days or 60 days. The period of credit would vary from customer to customer and from the company to company and depends on the credit worthiness of the customer, market conditions and competition. Often customers may not pay within the agreed credit period. This may be due to laxity in credit administration or the inability of the customers to pay. Consequently, debts are classified as:
1. Those over six months, and
2. Others
These are further subdivided into;
1. Debts considered good, and
2. Debts considered bad and doubtful
If debts are likely to be bad, they must be provided for or written off. If this is not done, assets will be overstated to the extent of the bad debt. A write off is made only when there is no hope of recovery. Otherwise, a provision is made. Provisions may be specific or they may be general. When amounts are provided on certain identified debts, the provision is termed specific whereas if a provision amounting to a certain percentage of all debts is made, the provision is termed general.
Prepaid Expenses –
All payments are not made when due. Many payments, such as insurance premium, rent and service costs, are made in advance for a period of time which may be 3 months, 6 months, or even a year. The portion of such expenses that relates to the next accounting period are shown as prepaid expenses in the Balance Sheet.
Cash & Bank Balances –
Cash in hand in petty cash boxes, safes and balances in bank accounts are shown under this heading in the Balance Sheet.
Loans & Advances –
These are loans that have been given to other corporations, individuals and employees and are repayable within a certain period of time. This also includes amounts paid in advance for the supply of goods, materials and services.
Other Current Assets –
Other current assets are all amounts due that are recoverable within the next twelve months. These include claims receivable, interest due on investments and the like.
Current Liabilities – Current liabilities are amounts due that are payable within the next twelve months. These also include provisions which are amounts set aside for an expense incurred for which the bill has not been received as yet or whose cost has not been fully estimated.
Creditors –
Trade creditors are those to whom the company owes money for raw materials and other articles used in the manufacture of its products. Companies usually purchase these on credit – the credit period depending on the demand for the item, the standing of the company and market practice.
Accrued Expenses –
Certain expenses such as interest on bank overdrafts, telephone costs, electricity and overtime are paid after they have been incurred. This is because they fluctuate and it is not possible to either prepay or accurately anticipate these expenses. However, the expense has been incurred. To recognize this the expense incurred is estimated based on past trends and known expenses incurred and accrued on the date of the Balance Sheet.
Provisions –
Provisions are amounts set aside from profits for an estimated expense or loss. Certain provisions such as depreciation and provisions for bad debts are deducted from the concerned asset itself. There are others, such as claims that may be payable, for which provisions are made. Other provisions normally seen on balance sheets are those for dividends and taxation.
Sundry Creditors –
Any other amounts due are usually clubbed under the all-embracing title of sundry creditors. These include unclaimed dividends and dues payable to third parties.