How to Analyze Balance Sheet of a Company?

thumbnail
Reading Time: 7 minutes

Firstly, what is the balance sheet?

Balance Sheet is a statement of accounts which tells us about the financial position of the company at a particular point in time. Unlike P&L which takes into account sales and profits over a period (a quarter or a year), the balance sheet is the financial position of a company as on that particular date usually at the end of half-year or financial year.

There are three main components of a balance sheet namely “Assets”, “Liabilities” and “Shareholders equity”. The assets are also called as application of funds and liabilities and shareholders’ equity as sources of funds.

Assets are the economic value of what the company owns typically plants, machinery, investments, intangible such as goodwill etc. Assets can be subdivided into two Non-current assets and Current assets.

Liabilities are what the company owes to other stakeholders’ i.e. lenders, creditors etc. It could be in terms of cash or goods or services. Again liabilities can be short term as well as long term.

Shareholders equity – In simple terms, it is the residual value that reflects the excess of firm’s assets over its liability. For example, a company has assets worth Rs. 100 but it has to pay Rs. 80 to its creditors/borrowers. Then equity shareholders value is the residual amount (Rs. 20) after having paid the company’s liability which in this case is Rs. 80. (Explained in detail below)

In formula terms, if we put it,

Assets – Liabilities = Shareholders equity

Or Assets = Liabilities + Shareholders equity

Now let’s individually look at individual components of the Balance Sheet and what constitutes them.

Please note: We will take the most commonly used items found in almost every balance sheet of a company. Further, certain items can be classified under both short term as well as long term; they mean the same but the difference is the duration. Short term liabilities/assets are paid/or earned within an accounting period (a year) whereas non-current assets and liabilities are anything beyond an accounting period.

Property, plant and equipment (Fixed Assets)

Every company owns some amount of fixed asset be it in terms of machinery, vehicle, land, Furniture etc. This is also called a gross block. But, most of these fixed assets (except land) are depreciated overtime to recover the cost that was incurred to purchase the fixed asset. The net block arrived from deducting depreciation forms part of fixed assets in the balance sheet. A consistent increase in Fixed Assets usually entails that the company is in expansion mode.

Capital Work in Progress (CWIP)

It includes fixed assets that are under construction or maintenance at the time the balance sheet is being prepared. Once it is completed, it is then moved on to the fixed assets. This has to be looked in relation to the fixed assets because a small amount of CWIP could mean maintenance Capex or small expansion. However, if it is huge that means the company is expanding meaningfully.

Also Read on FinMedium:  All about Mutual Funds-II - EquityManiac

Intangible Assets

These assets have economic value but are not physical in nature. These include goodwill, patents, trademark, computer software, copyrights that belong to the company. The costs of these intangible assets are amortized over their useful lives and the net block is added to the intangible assets. Higher intangible assets are usually good as it can prove valuable for the firm and its long term success.

Intangibles Assets under development

This is similar to CWIP but for Intangible assets. This could be pending copyrights, patents etc filed by the company.

Deferred Tax Assets/Liability

The financial statements are prepared in accordance with the company’s act; however the taxable profits are based in line with the Income-tax act. There is a difference between accounting profits and taxable profits as certain items may or may not be allowed under the income tax act or vice versa.

So, when the accounting profit is greater than profits according to the income tax act which means the company has paid lower taxes and therefore, a Deferred Tax Liability is created. Similarly, if the tax profits are greater than the accounting profits, a Deferred Tax Asset is created in the balance sheet. A common example would be depreciation as the rate of certain items could differ in both these standards.

Having Deferred Tax Asset is obviously better for any company as it has already paid the taxes but the same is not recognized in the financial statements. A stable or minor portion of DTL is also not a problem for the company.

Investments/Loans and Advances/ Other non-current assets

As the name suggests, these assets are held by the company having both a short term or a long term view for the asset. If it is short term, they form part of current assets or if they are held for long term then they form part of non-current assets.

Some of the examples of each category would be, a) Investments – Company investing into its subsidiary, holding mutual funds, other listed companies etc, b) Loans and Advances – Loan given to subsidiary, employees, customers etc. c) Other non-current assets – Balance with government, excise department or any prepaid expense etc.

The higher it is the better it is for the company; however one must check notes of these to understand where the company has put its funds. Further, a higher portion of the balance sheet into investment/loans could also mean less confidence in the core business as the management chose to invest in other assets instead of using it for expanding its business operations.

Inventories

Inventories are goods which are available for sale including finished goods, goods in process or raw materials. It is one of the most important items in the balance sheet and needs to be monitored carefully. It is like a double-edged knife as having low inventory would delay in fulfilling customer requirements leading to a drop in sales. However, having too much inventory would include the cost to store and could result in wastage of goods due to damage.

Also Read on FinMedium:  Market Update for 19/08/2020: | Street-fluence

The prudent way to analyze inventory would be to analyze inventory turnover ratio (Sales/ Average Inventory) or inventory to sales ratio over the last five years to get a clear trend.

Trade Receivables

A company has sold its product to its customer but is yet to receive the payment of it. The pending amount from customers forms trade receivables. It is needless to say the lower the number the better it is for the company as higher trade receivables could increase the risk of default by customers. Further, it affects cash management as the company has not received payment from clients which otherwise could have been used to pay off creditors, loans, or even invest. This usually forms part of current assets, however, if the payment is not expected within a year then it can also be part of non-current assets.

Cash and Bank Balance

The most liquid item in the balance sheet is cash and cash equivalents. Cash levels need to be carefully managed as too much cash is also not good as the company could have invested in expanding, or other investments which would have yielded returns or could have just returned it to the shareholders in the form of dividend. Too little cash levels would indicate that the company’s is not able to convert profits into cash. Therefore, healthy level of cash is necessary for every company. Analyzing cash as a percent of total assets over the last five years would give a clear picture of the same.

Borrowings Short term/Long term

Loans taken by companies in the form of term loans, foreign loans, working capital loans forms part of borrowing. It could be both short term as well as long term. Higher borrowed funds are not a healthy sign for any company. One can look at Debt to equity ratio (total debt divided by equity) of a company to get a clear understanding. Anything higher than one is not a good sign.

Long term/ Short term Liabilities

Apart from the usual liabilities, companies have certain other smaller liabilities which they need to pay and these are clubbed under other long term or short term depending on the period. It also includes current maturities of long term debt (which ideally should be added to borrowings above). Some of the other examples include security deposit taken from clients, employee related liability, lease, contingent liability etc.

Long term/ Short term Provisions

Provisions are an amount which is set aside to cover a probable future expense or reduction in the value of an asset. For example, if a company thinks that some amount of trade receivable will not be recovered, so it creates a provision in the balance sheet as doubtful debt or bad debt. Some other examples would provisions for employee gratuity, retirement obligations etc, income taxes, depreciation etc.

Both liabilities and provisions should be as low as possible.

Also Read on FinMedium:  Power of compounding and a math of 15 year old – Coffee with Abhishek

Trade Payables

This is what the company owes to its creditors. For example, a tyre manufacturing company purchases rubber (raw material) from its suppliers but it is yet to pay the amount to the supplier. This amount forms Trade Payables. These are usually payable within a year but can also form part of long term liabilities, but one must note that there could be an interest cost if it is for long term.

Equity Share Capital

It is the total capital raised by the company to issue shares. The shares are issued at face value also known as par value. For example, if a company has 10 cr shares outstanding and the face value of the company is 10, then share capital would be equal to Rs. 100 cr.

Reserves & Surplus

It is the accumulated profits that the company has earned over the years after paying dividend to its shareholders. It constitutes of three reserves, first is general reserve which is the accumulated profits which is not distributed to shareholders. Second is the securities premium reserve, which is the premium over and above the face value of a share.

For example, if a company has a face value of Rs. 10 and has set the issue price at Rs. 100 which means that Rs. 10 will go into the equity share capital account whereas Rs. 90 would be a part of securities premium reserve. The third one is a capital reserve which is set aside for any major long term projects or expense. The higher the reserve & surplus the company the better it is for the investors. Addition of share capital and reserves and surplus would give you the book value of a firm which is used by investors to value the stock.

Minority Interest

As the name suggest, it is the ownership in an entity which is less than 50% also known as non-controlling interest. It represents the portion of its subsidiaries which is owned by minority shareholders. Let’s take an example; company A owns 80% in company B which is valued at Rs. 100 cr. Now on its financial statement company A cannot claim the entire value of company B as 20% belongs to minority shareholders. Therefore, company A would have to put Rs. 20 cr in the balance sheet as minority interest.

It is debatable on whether Minority interest is a liability because cash won’t be paid out to clear this liability as it would be in the case of any other like debt, creditors, provisions etc. Therefore, instead of the number itself, one must look at the percentage of controlling stake as that will determine the influence and voting rights of minority interests over the decision-making process.

Source Link

Every Wednesday and Saturday, we send Info-Graphic and FinMedium Weekly Digest newsletters to our 25000+ Subscribers.

Join Them Now!

Please Share :)
Monergise
Monergise helps you stay updated with the current trends and make better investment decisions. All the articles are written by a group of finance professionals having experience of more than 10 years in Indian markets.
Back To Top