Let’s say you decide to name your firm ABC Inc. As discussed in the previous article, the total assets of ABC Inc. are worth Rs 1,00,000 and total liability is also equal to Rs 1,00,000. We further classified assets into current assets and fixed & immovable assets. Liabilities were classified as shareholder’s equity and long term bank liability. Please refer to the table below to understand the basic structure of ABC Inc’s balance sheet.
| Assets | Liabilities (incl equity) | ||
|---|---|---|---|
| Fixed Assets | Shareholder Equity | ||
| Plant Building | 40,000 | Friends of father | 50,000 |
| Machines | 40,000 | ||
| Current Assets | Liability | ||
| Raw Material | 20,000 | Bank Loan | 50,000 |
| Total | 1,00,000 | Total | 1,00,000 |
Assets are sourced by using funds, liabilities are the source of funds. As discussed earlier and as can be seen from the above table assets are always equal to liabilities. Let's now discuss a few other commonly used terms: debt, equity and leverage.
Debt is a liability and refers to the number of loans raised by the company on which it has to pay interest every financial year. In our example ABC Inc. this is equal to the amount of Rs.50,000 taken as a loan from the bank. Equity refers to the initial investment put in by different investors/shareholders. In this case, it would be equal to Rs 50,000 investment put in by your dad’s friend. A company can raise more funds through the equity route by issuing new shares. In such a scenario, equity will increase by a proportionate amount. Leverage is the ratio of debt to debt plus equity (debt/(debt+equity). In ABC’s case, leverage is 50% (=50000/100000). Hence ABC is 50% levered. The debt/equity ratio of 1:1 or 50%:50%, in this case, is also known as the capital structure of the firm. It tells us how much debt the company has borrowed, compared to equity.
The above explanation completes our discussion on the basics of the balance sheet. Read on to learn about income statements.
In this article, we will be covering the other important financial statement of a company, called Income Statement.
A balance sheet gives us an idea about the assets and liabilities of a company, as of a specific date. All the items defined in a balance sheet are as of a specific date. On the other hand, items covered in the income statement give details about what has happened over a specific period of time. We will revisit this issue after understanding the basics of the income statement. Please refer to the below table to understand the basic structure of ABC Inc’s income statement
| Item | Amount (in INR) | Description |
|---|---|---|
| Sales Revenue (a) | 1,00,000 | Amount of units sold in a year multiplied by the price per unit (1000*100) |
| COGS (b) | 70,000 | Amount of units sold multiplied by the cost in making each unit (1000*70) |
| Gross Profit (c=a-b) | 30,000 | |
| SG&A (d) | 10,000 | General costs incurred in day to day operations: rent, utilities, insurance etc |
| EBIT (e=c-d) | 20,000 | Earning before Interests and Taxes are paid |
| Interest (@10%)(f) | 5,000 | Interest paid to the bank at the rate of 10% (0.1*50,000) |
| PBT (g=e-f) | 15,000 | Profit before taxes are paid |
| Tax (@20%) (h) | 3,000 | Taxes paid to the government @20% (0.2*PBT) |
| PAT (i=g-h) | 12,000 | Net income generated by ABC Inc in the given financial year |
| Dividends (j) | 2,000 | Dividends distributed to shareholders (friends of Dad) |
| Retained earnings (k=i-j) | 10,000 | Income reinvested in ABC Inc to expand the business |
As can be seen in the above table, our starting point is total sales/revenue generated by the company over a specific time period, one full year in ABC Inc.’s case. Various costs incurred by the company during this period are subtracted from the sales number to arrive at a profit after tax / net income.
A company can utilize profit after tax in 3 different ways:
Early-stage companies tend to retain most of the earnings as they have enormous potential to grow and capture market share. On the other hand, mature companies who have already grown a lot tend to distribute most of the income to shareholders in the form of dividends, due to a lack of growth opportunities.
This clarifies how the income statement includes items that give details of what has happened over a specified time period. For example, one cannot declare what is the revenue as of a particular date, because revenue is generated over a period of time. It is important to specify over what period this revenue is generated. On the other hand, one can always specify the number of assets as of a particular date.