Why We Should Analyse The Balance Sheet?


Why analyze the balance sheet?

A balance sheet is the representation of a company’s financial health. It is like a company’s credit report because it tells you how much the company owns(assets) relative to what it owes(liabilities) at a specific point in time.

It basically lists, the assets that the company owns and the liabilities that the company owes to others. The difference between the two represents the ownership position (stockholder’s equity).

What the balance sheet tells us about the company?

Liquidity: The company’s ability to meet its current or short-term obligations.

Financial health: The company’s ability to meet its obligations over the long-term, this concept is actually similar to liquidity, except that it takes a long term perspective.

Financial strength reflects the company’s ability to:

1. Secure adequate resources to finance its future

2. Maintain and expand efficient operations

3. Properly support marketing efforts

4. Used Technology for the profitable advantage

5. Compete successfully

The balance sheet also helps us to measure the company’s profitability. This includes,

1. Return on equity

2. Return on assets

3. Return on capital employed

4. Return on invested capital

Analyzing the data in the balance sheet helps us to evaluate the company’s asset management performance. This includes,

1. Inventory turnover ratio

2. Total Asset turnover ratio

3. Days sales outstanding

Components of Balance Sheet:

A balance sheet contains the sources of funds for a company and application of those funds at any point in time. As it is logical, sources of funds and their applications must match at the aggregate level, hence, both sides of the balance sheet must match at all times, as the name suggests it is the 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 in 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 owner’s investment in the business. An increase in the equity capital may dilute the proportionate holding of existing shareholders and their participation in the profits of the company. Dilution may occur because of additional share capital being raised or conversion of debt into equity.

Reserves and surplus: As the company makes profits, they are moved each year from the P/L statement into the balance sheet under the head ‘Reserves and Surplus’. Thus, this is also shareholders’ money, which they chose to keep in the company and reinvest in the business. While equity may be called contributed capital, reserves and surplus are 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 a premium to face value) or a revaluation reserve, which are not created out of the profits earned.

Net worth: Equity capital and reserves & surplus together represent shareholders funds also known as net worth or owners’ capital.

Long term debt: Any debt taken for a period of more than 1 year is considered to be non-current liability or a long term loan. This may be in the form of 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 life cycle of the company meditate the level of debt in the balance sheet.

Industries such as IT, education, business process outsourcing(BPO) 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 that 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.

Current liabilities: These are liabilities or payments which have to be made within a year. Salaries, electricity 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 analyzed to determine the efficiency with which the working capital is managed. For example, the trade payable 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 it is able to get credit from its suppliers without tying up its cash. But very high trade payables should be investigated to see if the company is facing a fund crunch or even insolvency.

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 short term assets like investments in liquid funds or inventory. Let us see in detail the two broad heads of the application side of the balance sheet.

Fixed Assets: These are assets which 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, that are required by all companies. Although these assets do not generate revenue, they are an essential part of the business.

Along with tangible assets such as plant, machines, cars, furniture, computers, etc., some balance sheet may also possess intangible assets such as patents, licenses, 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 revenue.

Current assets: 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. Analyzing 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 receivable days augur well for the company.

The basic equation underlying a balance sheet is:

                             ASSETS – LIABILITIES = EQUITY

Which can also be expressed as :

                            ASSETS = LIABILITIES + EQUITY

Bottom line: The balance sheet is like a company’s credit report because it tells you how much the company owns (assets) relative to what it owes (liabilities) at a specific point in time. It tells you how strong the framework and foundation of the business is.