A Balance Sheet contains the sources of funds for a company and application of those funds at any point of time. As is logical, sources of funds and their application must match at aggregate level, hence, both the sides of the balance sheet must match at all times (as also the name suggests). This is something that we all have learnt in our school level but what makes it interesting when it comes to studying from the perspective of an Analyst.
So let’s delve deep into the topic “Understanding Balance Sheet from an Analyst Point of View”
Given below is an example of balance sheet:
Sources of Funds: A company has two primary sources of funds, owners’ funds or equity capital and borrowed funds or debt capital. Let us see each one of them in brief below:
Equity: This is the money which the promoters bring into the business when it is launched, and subsequently by additional shareholders as and when required, who also become owners of the company to the extent of their shareholding. This is the owners’ investment in the business.
An Increase in the equity capital may dilute the proportionate holding of existing shareholders and therefore their participation in the profits of the company. A dilution may occur because of additional share capital being raised or a conversion of debt into equity. In the above example, we have Equity as Rs. 200.
Reserves & Surplus: As the company makes profits, they are moved each year from the P/L statement into the balance sheet under the head ‘Reserves & Surplus’. Thus, this is also shareholder’s money, which they chose to keep in the company and reinvest in the business. While equity may be called contributed capital, reserves and surplus is called retained capital.
Apart from the reserves created out of retained profits, the balance sheet may show other reserves such as share premium reserve (collected when shares are issued as premium to face value) or a revaluation reserve, which are not created out of the profits earned. In the above example, we have R&S = Rs. 28.
Net-worth: Equity Capital and Reserves & Surplus together represent Shareholder’s Funds also known as Net-worth or owners’ capital.
In the above example, adding Equity Capital of Rs. 200 and Reserves & Surplus of Rs. 28, we get Net-worth (Shareholder’s Funds) as Rs. 228. [Equity Capital 200 + Reserves & Surplus 28 = 228]
Long Term Debt: Any debt taken for a period of more than 1 year is considered to be noncurrent
liability or a long term loan. This may be in the form of term loans taken from financial institutions or debt securities issued such as debentures. Investors prefer companies with low liabilities. However, the nature of the business and the lifecycle of the company may dictate the level of debt in the balance sheet.
Industries such as IT, education, Business Process Outsourcing (BPO) etc. do not require huge investments either in capital assets or for procuring raw materials and other expenses. Hence, such sectors generally exhibit a balance sheet which has very low long term debt. In case a company has high debt in this sector, it would generally be temporary for expansion purposes when the company is in the growth stage.
Companies in the banking and non-banking space cannot be analyzed on this parameter as their business requires them to garner long term deposits, which are then dispersed as loans. Heavy capital goods based manufacturing companies need to have a judicious mix of debt and equity, depending upon the project at hand, type of industry, interest rates, etc.
In the above example, Long Term Debt is Rs. 200.
Current Liabilities: These are liabilities or payments, which have to be made within a year. Salaries, Utility payments, Trade payables, working capital loans, short-term debt raised through the issue of commercial papers, unclaimed dividends, maturing long term debt and others are typical examples of current liabilities.
Current liabilities are analysed to determine the efficiency with which the working capital is managed. For example, the Trade payables days calculated as trade payables/Cost of sales x 365 days, is the time taken to pay the suppliers. A high number indicates that the company is in a strong position and is able to get credit from its suppliers without tying up its cash. But very high trade payable days should be investigated to see if the company is facing a fund crunch or even insolvency.
In the above example, Current Liabilities stand at Rs. 22 in the form of Bills Payable.
Application of Funds: This is the right side of the Balance Sheet, where details of assets are given. A company can have fixed long term assets like plant and machinery or short term assets like investments in liquid funds or inventory. Let us see in detail the two broad heads of Application side of the balance sheet.
Fixed Assets: These are assets which a company builds to produce goods and services. A manufacturing plant would need heavy machines, a software company would need computers, a real estate company would need land, etc. these are all assets from which the company would generate revenues. Furniture and vehicles are assets which are required by all companies. Although these assets do not generate revenue, they are an essential part of business.
Along with tangible assets such as plants, machines, cars, furniture, computers etc., some balance sheets may also possess intangible assets such as patents, licences, brand value and others.
The asset turnover ratio, calculated as sales/fixed assets, indicates the efficiency of the assets created by the company in generating revenues.
In the above example, Fixed Assets are at Rs. 300 which consist of Plant & Machinery = 100 + Land= 200.
Current Assets: These are assets that you expect to sell, or convert into cash, within one year. They include:
Cash , Marketable securities—traded investments that can be easily converted to cash , Trade accounts receivable , Employee accounts receivable , Prepaid insurance , Inventory. Current Assets are those which can be converted into cash within a year. Inventory, trade receivables, investments, short term loans and advances and cash are all examples of current assets.
Current assets analysis is important to understand the working capital situation of the company. A large level of inventory or trade receivables may mean capital tied up and the company may be paying a high cost for debt. Analysing the current assets relative to past trends and peer group companies will give insights into the working capital management of the company. Lower inventory days and trade receivables days augur well for the company. In the above example, Current Assets are Rs. 150 ( Cash and Cash Equivalent 50 + Inventory 100) .
So here we conclude in brief the Basics of Balance Sheet and its importance while analysing the company. In the next two posts we will cover the essence of the Cash Flow Statement. The 3 very important pillars of the company.