In order to make sense of balance sheets and statements, you need to get a grip on some fundamental accounting principles. All financial statements are based on the balance sheet and the statement of cash flows.
Everyone knows that the balance sheet is one of the most important parts of a company’s financial report. It’s a critical look at the cash position, receivables, and long term liabilities of a business. But why is the balance sheet important? It’s because a company’s financial health can be determined from one two-page report. In other words, a properly crafted balance sheet will give you an idea of what a company is worth.
This article is part of a series that will cover the fundamental analysis process. In this section we will learn how to read a balance sheet and understand the activities it represents.
Of the three financial statements, the balance sheet is perhaps one of the most important reports. Why? Because it gives us a complete history of the company, from the beginning to today.
The income statement provides information on the state of profitability for the year. The cash flow statement provides information on cash flows during the year. But the balance sheet shows the state of assets, liabilities and equity since the date of incorporation of the company.
The balance sheet is a well-known indication of how the company has managed its finances. More efficient use of finances ultimately leads to better profitability and cash flow.
It can be said that for a company everything starts with a balance sheet. We’ll find out more.
The above diagram is a graphical representation of the balance sheet. What is a balance? This means that the assets on one side and the equity plus the liabilities on the other side are in balance. This is the most basic understanding of balance that we need to remember. This gives us an equilibrium formula.
In general, this is what the balance sheet tells us about the company.
Funding Source: The liabilities side shows the sources from which the company draws its finances. A company can finance its activities in two ways: (a) through equity and (b) through debt. The balance sheet shows the ratio of equity to debt.
Honesty: In this form of financing, the company sells the ownership (shares) of its business to the stock market. People buy these shares and become shareholders. The money earned from the sale of shares is equity.
Responsibility: There are two types of bonds: Long term and short term. When a company takes out a loan with a repayment period of more than 12 months, it is a long-term commitment. Similarly, loans with a maturity of less than 12 months are short-term debt (also known as short-term debt). The money accumulated by the debt is a liability of the company.
Use of resources : On the liabilities side, we see two sources of funds: Equity and debt capital (total capital). On the asset side, we will see how the company uses these resources to manage its operations. Corporate governance can be seen as a two-fold process: (a) the operation of the company and (b) the growth of the company.
Fixed Assets : They consist mainly of fixed assets. The majority of the total capital (equity and long-term debt) is used by the company for the acquisition of fixed assets. In other words: This money will be used to build up the company’s infrastructure.
Current Assets : The other part of the total capital is used to meet the present and future needs (cash flow) of the company. What are the current needs? Expenditure already booked (current liability). What are the future requirements? Working capital (future unrecognized current liabilities).
Balance sheet analysis – How to read a balance sheet
Is it easy to read a balance sheet? First, divide the entire report into five sections. What are these sections? The five sections are as follows: (1) Equity, (2) Long-term liabilities, (3) Short-term liabilities, (4) Long-term assets and (5) Current assets.
Let’s go through the balance sheet items line by line for better understanding.
The first part of the balance sheet will be equity. The company indicates here how much equity (also called net assets) it has accumulated at the time of incorporation (since inception).
From the above screenshot, the total share capital of the company (as on 31 December 19) is Rs. 1,932.26 crore. This amount is further divided into equity of Rs. 96.42 million and other capital of Rs. 1,835.84 million. To learn more about each failure, read notes #16 and #17.
For more information on share capital, see note 16. The company has a share capital (the maximum amount it can raise in the stock market) of Rs. 100 million. Out of this amount, the company has already raised Rs 96.42 million (paid-up capital). How is equity calculated? Share capital = number of shares issued x par value (Rs. 9.64 million x Rs. 10 per share = Rs. 96.42 million).
[P.Note: Shares are often issued at a price well above their face value. These are shares issued at a premium. This leads to the company having to raise additional capital in delta (delta = sales price – nominal value). However, this delta is not included in equity. It is included in other capital (other capital > general reserves > share premium). Although not all companies reflect this in their balance sheets].
For details of the remaining capital, see note 17. It consists of two main elements. First, there are total reserves of Rs. 837.4 crore. Secondly, retained earnings amount to 1,030.76 million rupees. What are general reserves and retained earnings?
All profits recorded in the company’s income statement are first transferred to the balance sheet (other capital). One part is retained as a general reserve and the other part as retained earnings.
General reserves are established to manage the future needs of the company. Retained earnings are the accumulated net income of the company (to date) less allocations to general reserves. From this amount (retained earnings) dividends are paid to the shareholders.
The liabilities side of the balance sheet begins with the long-term debts. The screenshot shows that the long-term liabilities amount to Rs 2,978.43 crore. A more detailed breakdown of this liability is also provided in notes 18 to 21. Let’s break up the different notes.
Note 18 relates to financial liabilities (loans) of the company amounting to Rs. 53.14 million. My first impression was that this was a bank loan with a term of over 12 months from reporting. In fact, however, it was deferred sales tax due in the future.
Note 19 relates to non-current provisions. In general, an entity’s accruals are funds that the entity sets aside for employee benefits. Provisions are made in our operations for compensation, incentives, benefits and contingencies.
See Note 20 for information on deferred tax liabilities. This is another type of accrual that is maintained in the general ledger for future tax payments. Why did the entity recognize such a provision? If they foresee a situation in which their tax burden could increase, they make a provision for this today.
What you see in the screenshot above is the company’s current engagement report. In the year ended December 19, the company reported a current liability of Rs. 2,147 million. For a breakdown of total current liabilities, see also notes 46, 22, 23 and 24.
The Company has not drawn down any amounts for loans. This means that the company has not taken up any short-term loans with banks and the like.
The bulk of the company’s current liabilities consist of trade payables of Rs. 1,494 million (=34+1460). These are mainly outstanding invoices from suppliers.
The company has drawn Rs. 431.47 million under other financial liabilities. Details of the financial obligations can be found in note 22.
As with long-term provisions, the Company also tracks employee benefits payable within the next 12 months. A provision for these payments is included in current provisions. The company has made a provision of Rs 85.46 crore. The breakdown is shown in note 23 (see screenshot above).
On the next line of the balance sheet we have other current liabilities. In our example, the company booked Rs. 133.96 million. For more information on this article, see note 24. In general, companies reflect their legal obligations in this regard. All undertakings not falling under the above headings will be posted here.
Let’s see how the company uses its capital. How is the capital used? Through the accumulation of long and short term assets.
What are fixed assets? These are mainly the fixed assets of the company (also called tangible fixed assets). Other types of fixed assets may be financial assets (e.g. long-term investments). You can read more about this in the notes.
Note 4 contains detailed information on property, plant and equipment. Take a look at the screenshot above. This heading includes items such as land, buildings, facilities, equipment, furniture, office supplies and vehicles. These are all important assets that should add long-term economic value to the business. Of all the types of plant, this is the most capital intensive (especially for manufacturing companies).
The next asset on the balance sheet is work in progress (Rs. 143.3 million). This is also classified as property, plant and equipment, but is recorded separately because the construction/completion work is not yet complete. Upon completion of the execution work, their numbers are transferred to the fixed assets.
Financial assets include investments (Rs. 743.6 million). Details can be found in note 5. Note 5 shows that the company has invested its cash in two areas. The first are tax-free bonds (Rs 724.72 million) and the second are shares (Rs 18.88 million).
The other type of financial assets recorded by the company in its balance sheet are loans (Rs. 46.98 million). Details can be found in note 6. As you can see, most of the credit falls within the bailout range (Rs 36.08 billion). This is usually money paid by the company for properties/apartments rented by the company for office purposes etc. The second most common form of borrowing is cash advances to employees or group companies.
A significant part of the capital raised by the company remains tied up in current assets. This is the portion of the money that cannot be used to increase capital assets, make long-term investments, etc. It is essential for the company to keep a part of its assets as liquid as possible. This money is called current assets.
In general, the whole basket of current assets can be divided into two categories. These are, on the one hand, stocks and, on the other hand, readily realisable financial assets (e.g. cash, short-term investments, customer payments, etc.).
In note 8, our sample company provided details of its inventories amounting to Rs. 1,283.07 million. Check the list of materials under the Inventory section. This gives the impression that these elements are not necessarily fluid. Let’s divide the whole list into 4 types: work in progress (not liquid), semi-finished products (not liquid), finished products (liquid when there is demand) and spare parts (not liquid). Therefore, some analysts use equity figures to assess the actual liquidity level of a company.
Note 9 gives details of our first financial asset (investment of 1,007 kroner). These are all investments to be made in the next 12 months. Typical types of short-term corporate investments include promissory notes, government bonds, term deposits, debt funds, etc.
The next item under financial assets is trade receivables (Rs. 124.33 billion). These are mainly unpaid payments to be collected from customers. A good company will also include in the notes the breakdown of receivables into secured and unsecured receivables.
Cash and cash equivalents are the safest form of cash a company can have. This part of the balance sheet plays a decisive role in determining whether or not a company is sufficiently liquid. Generally, a company maintains its cash in checking and savings accounts to meet its short-term cash needs.
Other items included in current assets may be short-term loans granted by the Company to its employees or to Group companies. These are non-cash items that can easily be offset in due course (through adjustments, etc.).
Under Other current assets, our sample company has reported an amount of Rs. 26.02 million. You have provided details of this item in note 15. These are mainly advances to suppliers, employees, etc. In our example, the company also borrowed from government agencies. Ideally, this should be adjusted in payables or decrease in receivables. But the company put it here because they probably don’t expect that cash flow to happen any time soon. This could be a kind of NPA for the company.
How does the balance sheet relate to the income statement?
Click on image to enlarge
- Retained earnings and PAT : Retained earnings in the balance sheet are updated whenever the company makes a net profit (PAT). The net result appears in the profit and loss account of companies.
- Debt and financial costs : Liabilities (long-term and short-term borrowings) on the balance sheet increase the company’s financial costs, which are recognized in the company’s income statement.
- Liabilities and expenses : The liability side of the balance sheet is the portion of the expenses that the company will incur in the next fiscal year (FY).
- Tangible fixed assets and depreciation : Tangible fixed assets (fixed assets, etc.) are valued in the balance sheet. This value is stated after deduction of accumulated depreciation. Depreciation for a given year is shown in the income statement.
- Investments and other income : The investments made by the company (long and short term) appear on the company’s balance sheet. The income from these investments is recognised in the income statement as other income.
- Trade receivables and revenues : Companies often sell their products and services on credit to their customers to generate revenue (the revenue is reported in the P&L report). The payment of this loan, which must take place within the next 12 months, has been included in the balance sheet as a receivable.
Reading the balance sheet is only half the battle. It becomes even more interesting to find out the meaning of the numbers printed here. How do you do that? If we can understand the whole thing (business) from the point of view of balance, the effect can be phenomenal. The following is a very simplified illustration of the company’s balance sheet:
Take a look at the infographic above. It gives an indication of the role played by the source of financing (equity and liabilities) in the financing of fixed and current assets. They will also be able to understand what kind of assets create long-term value for shareholders and what kind of assets only bring cash to the company.
Financial ratios and valuation models such as NCAVPS, DCF, Absolute PE, residual income model, etc. should be studied to better understand the balance sheet.
Have fun investing.
Frequently Asked Questions
How do you read a fundamental analysis on a balance sheet?
A fundamental analysis is a financial analysis that focuses on the company’s financial position and how it has changed over time. It is a type of analysis that uses financial data to determine the value of a company.
How do you read balance sheet?
The balance sheet is a financial statement that lists a company’s assets, liabilities, and owner’s equity.
What do you look for in a balance sheet analysis?
The balance sheet is a snapshot of a company’s financial health at a specific point in time. It is a summary of the company’s assets, liabilities, and owners’ equity. The balance sheet is a snapshot of a company’s financial health at a specific point in time. What is the difference between assets and liabilities? Assets are resources controlled by the company, which are used to generate revenue. Liabilities are obligations the company owes to someone else.
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