Understanding the different types of financial documents and the information each contains helps you better understand your financial position and make more informed decisions. Among all the financial statements one of the most important is the balance sheet.
A balance sheet is a snapshot of financial position of a company at a given point of time. Think of it as a photograph of all the assets (what a company owns) and liabilities (what a company owes, or has to pay) taken at the end of every financial year.
Why balance sheet is important?
As I mentioned earlier, a balance sheet is an account of all the assets and liabilities of the company at a given point of time. Balance sheets are a great source for comparing business value with market value.
By analyzing the balance sheet, you can understand if the company is trading at a discount and if it’s a good investment for long term.
How do I analyze a balance sheet?
In order to analyze a balance sheet, you must be aware of terms used in them and understand what they mean. To make your job easy, here are the most important terms used in a balance sheet.
Total Share Capital:
There are two ways a company can raise capital to fund its business. By taking loans (debt financing) or by selling a part ownership of a company to investors (equity financing).
The amount of capital a company raises by selling part ownership in the business is called share capital.
Companies that have smaller capital base compared to their Net Worth combined with good earnings growth are considered good investment.
Reserves and Surplus:
Whenever a company makes a profit, a part of it is distributed to shareholders as dividend and the rest of it is ploughed back by the company for future purposes. Over the years, all the profits accumulated together form reserves and surplus.
Reserves and surplus can be used to fund company’s business expansion such as buying plant and machinery, acquisitions, etc. In some cases, if a company does not need capital for the foreseeable future, reserves can also be used to issue bonus shares.
Companies that increase their reserves at a faster rate are usually considered as good investment.
If there is a decline in reserves during a financial year, an investor must check if company has issued bonus shares oir has bought new assets or made an acquisition. If none of these cases exist, then one must stay away from such companies.
Total shareholder’s Fund:
Total shareholders fund is the sum of share capital and reserves and surplus. Since every shareholder of the company is a part owner of the assets of the company, they collectively own the share capital (capital raised from shareholders) and reserves (accumulated profit from previous years)
Provisions, Payable and Liabilities:
Long Term Provisions:
Every company sets aside some capital for unforeseen events and expenses such as provisions for repairs and maintenance, provision for depreciation of assets etc. All such expenses are met by using funds from long term provisions
Short Term Borrowings:
Also known as short term debt, this account contains all the liabilities that are due within a year. The short term borrowings may include short term bank loans or commercial papers.
Just like any other borrowing, a high short term borrowing is an indicator of poor fundamentals as it is company’s liability that is due soon.
If a company is unable to pay its liabilities, it has to default on payments which will be catastrophic for the company.
Trade payables is the amount of goods or services a company has bought on credit and has to pay at a later date. Just like our credit cards where we buy first and pay later. These are short term liabilities and form a part of current liabilities.
Most companies try to delay payables as much as possible in order to be able to used the cash for other productive purposes.
Large trade payables are good sign but one must also make sure that company has enough cash or short term assets to cover its payables, so that it has the ability to honour its payments when demand is raised.
Current liabilities is a sum of all the short term liabilities a company owes, including short term borrowings, Trade payables short term provisions.
Since these liabilities had to be paid within a year, an investor must check if the company has enough current assets to cover all it current liabilities.
The best way to ensure this is by looking at the current ratio of the company, which is calculated by dividing current assets by current liabilities. If current ratio of a company is above one, it can be assumed that company has enough short term resources to pay its short term liabilities.
Short term provisions:
Just like long term provisions, short term provisions is the amount of capital set aside for expenses that are due within a financial year. Short term provisions include, provisions for doubtful debt, provision for tax, discount to debtors etc.
Every company needs plants machinery or office space to produce goods or provide services. These resources are called assets. There are two types of assets. Tangible and intangible. Tangible assets are the ones with physical existence which includes plants and machinery, office space, inventory etc.
Companies engaged in asset heavy businesses like power production, infrastructure, Iron and steel production, have large tangible assets. In order to be profitable, a company should be able to utilize its assets efficiently.
The best way to measure asset utilization is by looking at the asset turnover ratio.
Asset Turnover Ratio is a measure of company’s ability to measure how efficiently a company is utilizing its assets to generate sales. Higher the ratio, better the utilization.
Intangible assets are the assets that do not have a physical existence. However, they have a value that appreciate with time. Assets such as patents, brand name, trademark, copyrights, intellectual property rights etc are intangible assets.
In some companies, Intangible assets are more valuable than tangible assets. For example, the total market capitalization of Coca Cola is $188 billion, while the brand value of Coca Cola is $79.2 billion. Clearly, the brand value of Coca Cola forms a significant portion of its market value.
In such cases, one should also take into account intangible asset of the company to arrive at proper valuation.
Capital Work in Progress:
A company is an ongoing entity, constantly buying assets to expand its business. There are times when an asset is incomplete(such as a factory under construction). In such case, all the costs incurred on that asset is transferred to an account called capital work in progress.
Once these assets are ready, all the amount in capital work in progress becomes a part of that asset.
It is important for a company to create more assets to expand its business but if capital work in progress forms a large part of the total assets, then iit means that the capital invested in the asset is stuck and the asset in an unproductive asset.
Non Current Assets:
These are long term assets that are not likely to be turned into cash within one year. Non current assets may include tangible or intangible assets. Companies that are capital intensive have large non current assets.
Since assets decline in value because of depreciation, companies with large non current assets are considered risky.
Investors looking to invest in such companies must keep tracking value of assets, any large dip in non current assets means huge depreciation or impairment charges.
Current asset is cash or any other asset that can be turned into cash within one year. Current assets include cash in hand, short term bonds, accounts receivable, inventory, interest due within a year.
A company must have enough current assets to meet its current liabilities. If a company has insufficient current assets to cover its current liabilities it runs a liquidity risk. This means that company is unable to pay its short term obligations and may have to default on its payments.
Businesses sometimes sell goods or services on credit, that is, they provide the product bill them, but collect payment at a later date. Such transactions come under trade receivables.
A company should be able to collect its payables quickly for an uninterrupted cash flow.
If the trade receivables are piling up faster than trade payables, then its a red flag for company’s short term liquidity.
A balance sheet is a great way to reveal financial standing of a company. If analyzed properly, it gives a lot of hints about what to expect from a business in the future.
An investor willing to invest in the company must analyze at least past 5 years of historical balance sheets and notice the changes in various aspects mentioned above.
If you are willing to dig deeper, you can also compare the balance sheet of the company with its peers in the same sector to understand which company is doing better and what are possible future prospects.
I hope you find this post useful, do let me know your opinions, and if you have any questions feel free to comment them down below.