How to Analyse the Balance Sheet of a Company

Sufficient knowledge of various financial records like balance sheet, profit and loss account, free cash flow etc. help an investor to know the financial condition of a company and then he may decide accordingly. Among all the financial statements/records the most important and vital part is the balance sheet. In this column, we will understand the basics of the Balance sheet and how to analyse the balance sheet of a company.

What is balance sheet?

As the name itself carries the meaning, a balance sheet is a summarized description of all the financial transactions made by a company in a certain period. The balance sheet of a company expresses all the assets a company possesses. The asset includes liquid money, land property, factory, machinery, the investment made in different sectors. The balance sheet also includes all liabilities like loans, accounts payable, mortgages, deferred revenues and a company’s accrued expenses done at the last of a financial year.How to Analyse the Balance Sheet of a Company

Source: Titan company Balance Sheet

Why Balance Sheet Is Important?

The balance sheet of a company is an overview of the financial condition of the company. By checking the balance sheet of a company you can judge its business model i.e., how the company earns money and also the company’s reliability. After making the fundamental analysis i.e., compounded sales growth, debt ratio, return on equity etc. and qualitative analysis i.e., business model, management of the company, competitive advantage, entry barrier etc. most investors overlook or ignore the balance sheet of the company they invest in. All these above-mentioned factors are important. But only these factors are insufficient to provide a clear view about the assets and liabilities of a company. Here comes the role of the balance sheet.

The balance sheet of a company highlights the financial health of a company. It is needless to say how financial health matters to run the business in the long run. The balance sheet is the overview of the accounts of the business. Balance sheet speaks about how much a company earns, what its revenue source is, how it runs the day-to-day business, how much debt it has in the market, how much it needs to collect from customers, how much cash and inventory it possesses, whether the company has suffered any loss in the previous year or current year.

How to analyse the balance sheet of a company

As a sincere investor when you analyse or check the balance sheet of a company, you should consider the following points.

  • What assets a company possesses.
  • What liabilities a company owes.
  • How much debt a company has to pay in the short term as well as long term.
  • How much debt a company has relative to its equity.
  • What the tendency is of the customers to pay their bills.
  • Whether short-term cash or the money to run the day-to-day expenses of the business faces any shortfall or it is adequate for the company.
  • What the percentage is of the tangible asset i.e., factory, plants, units, machinery, etc. in the company’s total valuation.
  • How much time it takes to clear out the inventories.
  • Whether research or development budget to get patent shows upward results.
  • How much interest along with debt capital has to be repaid to any bank or financial institution in the short term.
  • What percentage of the profit the company spends to give dividends to its shareholders. And what percentage of the profit is invested in the expansion of the business or to buy machinery and other assets?

In order to check out the above-mentioned aspects of any company, you need to know the above-mentioned terms.

Shareholder’s Capital i.e., Total Share Capital, Reserves & Surplus & Total Shareholder Fund
Total Share Capital

To establish a business or to enlarge the existing business a company or an organization requires capital or fund. Then the company can raise the fund in two ways. The company can withdraw loans from a bank or a financial institution. Otherwise, the company can leave its ownership right partially for the investors from whom the fund raised in line of capital. By giving them the ownership right the company allows them to decide the company’s decisions accordingly.

The money which is raised from the shareholders is called share capital. The amount of share capital may increase time to time. A company may raise more share capital further reducing its stake in the company in line of the fund. When the money raised from the public by reducing the stake is called equity financing. Otherwise, when the money is raised in the form of debt from the banks or financial institutions it is called debt financing.

Reserves and Surplus

A company makes its reserves and surplus by accumulating profit after the company distributes its profit among the shareholders. Actually, reserves and surplus are accumulated over years with the profit. A company uses its reserves and surplus for the expansion of its business like buying new plants and machinery, acquisitions of another plant or machinery, increase in production and sells etc. A company may use its reserves and surplus for any emergency or unforeseen problems. In some cases, when a company decides not to use the fund for the future, it issues reserves as bonus shares.

An investor may check a company which is in a growing mode of gathering more and more reserves. If it is so, this is a good company for investment. A decline in reserves during any financial year may be for three reasons, the company has issued bonus shares or has bought new assets or has made an acquisition. If these three factors are not the reasons for the decrease in reserves and surplus, it is suggested not to invest in such a company.

Total shareholder’s Fund

Share capital raised by a company, reserves, and surplus all these three elements constitute total shareholder’s fund. A shareholder becomes the owner of the company partly. So, he or she is the owner of the respective company. Further, that shareholder remains responsible for any kind of profit or loss of the company.

Shareholder equity

Here another term arises that is shareholder equity. Shareholder equity is the net value of the company’s total assets after subtracting its all debts or loans i.e., liabilities if any. Shareholder equity expresses the financial health of a company. If the shareholder equity is satisfactory or remains increasing the company is considered a good bet for investment. Shareholder equity is a vital column in the balance sheet of a company.

Assets

We can understand assets & liabilities easily with an example. Let’s assume you want to set up a restaurant, but you do not have enough money. In this condition, you are left with two options. The first option is you may borrow the capital from an investor and in return, you may allow him an ownership right via equity. The second option is you may go to a bank for a loan and apply for a loan. In that case, the bank authority will ask you to submit the current status of your financial condition. Then you will table all the documents like savings account statement, investment record in bonds, equities, mutual fund, real estate, cars, furniture, computers, and counting.

You will have to write down all the mortgages, student loan, etc. if any. Finally, subtracting between assets and liabilities, you will calculate your net worth. This is your balance sheet, the detailed description of everything you possess. After you submit your balance sheet, the bank will calculate your creditworthiness. On being satisfied with you, the bank will provide you with a business loan.

While analyzing the balance sheet of a company you need to consider the tangible and intangible assets of the respective company.

Tangible assets

Every company is engaged in either production of goods or it provides services of any kind. To produce the goods each company is required plants, machinery, etc. And if it wants to provide services it needs a space. The plants, machinery, etc. or the office space a company owns are all together called assets of a company.

There are two types of assets namely Tangible and Intangible. Tangible assets are those things that maintain physical existence such as plants, machinery, office space, inventory etc. Fertilizer production, infrastructure, Galvanized Iron and steel production, automobiles or engineering works and many more like these companies have large tangible assets. So, while searching for a company you need to consider the asset turnover ratio. Asset Turnover Ratio is a measurement scale that checks how efficiently a company makes good use of its assets to yield earning. If the company performs well in this case of tangible property, you can hold that the company owns a class management team.

Intangible Asset

Brand reorganization, corporate reorganization, product quality distribution network, superior customary support etc all these are considered the intangible assets of a company.  The brand value or name of any company is in the billions of money. A portfolio of brand influences the sales and growth of the company in many ways. It is a competitive advantage than its peer companies.

Let’s understand this with an example. Whenever we talk or think about adhesive, the first names come to our mind are Fevicol, Fevistick, Fevikwik, m-seal, Dr. Fixit etc. All these are brands of Pidilite industries. The products of Pidilite Industries possess a superior quality. The company maintains a vast distribution network and superior customer service to establish this company as a market leader in the adhesive Sector or Industry.

Again, whenever we talk or think about Trolly or casual Bags the first names come to our mind are Aristocrat, Skybags etc. All these are brands of VIP industries. So, you need to consider these factors before making an investment in a company.

Non-Current Assets

Non-current assets are those which are inevitable instruments for the successful running of a business. They include permanent assets like property, land, factory, machinery, plant, equipment etc. Since this type of assets decline in value because of depreciation, companies with large Non-current assets are considered risky.

Current Assets

Liquid cash or anything that can be converted into cash within a short-term is called Current assets. Current assets include cash in hand, short-term bonds, accounts receivable, inventory and interest due within a year. A company should own sufficient current assets to fulfill its current liabilities. If a company has insufficient current assets to meet its current liabilities it may have to face a risk of liquidity. It means the company is unable to pay its short-term obligations and may have to be default on its payments.

Capital Work in Progress

A company runs in the path of an ongoing entity. It constantly buys assets of tangible or intangible nature to expand its business. There are times when an asset remains incomplete (such as a factory under construction). In such a situation, all the costs incurred on that asset are moved to an account called capital work in progress. When these assets get ready for use, the entire amount in capital work in progress turns into a part of that asset.

It is important for a company to create more assets to expand its business. If capital work in progress constitutes a large part of the total assets, it means that the capital invested in the asset is stuck and the asset in an unproductive one.

Inventory

It is the stocks or ready to sell products a company owns. A company with large inventory supplies its products at the time of sale. It is considered to be the portion of a company’s assets that are ready or will be ready for sale. Inventory data is important for a consumer durable sector i.e., garments, ornaments, mobile, gadgets, jewelry sector. Our country has many festivals throughout the year. Companies with huge inventories offer a sale on discount on several items. They can do so because they have available inventories to fulfill such a huge demand during the festive seasons. That is why inventories are vital and fruitful for such type of companies.

Trade Receivables

A company has to allow credits to its customers for a situation basis. Then, later the company collects the dues. This money to be collected is called trade receivables. A company should be able to collect its parables within time. The trade receivables should flow uninterruptedly.

Provisions, Payable and Liabilities
Long Term Provisions

A company maintains funds to meet any unforeseen events and expenses. It may be repairs and maintenance of machinery or property, depreciation of assets etc. There may be many more expenditures of emergency nature. So, a company has to keep aside a long-term provision to meet such expenses.

Short-Term Borrowings

It reveals a company’s debt in banks or any financial institutions. This debt has to be paid off within a short term of period. Short-term borrowings may be loans or commercial papers. If a company has high debt that needs to be covered up in a short-term, it indicates the respective company’s weak fundamentals. 

Trade payables

A company buys something on credit and it becomes subject to pay the bills later. This payment to be made is called Trade payables. Actually, everyone be it a company or something else has a tendency to delay the payments of bills as much as possible. A company always attempts to meet the expenses at hand like productive purposes. A company must be capable of paying back the trade payables at the raise of demand, though greater payables may be a good sign.

Current Liabilities

A company’s Current liabilities include short-term borrowings, trade payables, short-term provisions etc. An investor should be sure that the company has an adequate fund to pay off its liabilities. To check this, one method is to see the current ratio of the company. The current ratio is calculated on dividing current assets by current liabilities. If the result or the current ratio of a company becomes one or more, it indicates that the company owns sufficient short-term resources to pay off its all short-term liabilities.

Short-term provisions

Short-term provisions means the fund reserved for the expenditures like doubtful debt, provision for tax, a discount to debtors etc. These expenditures are to be met within a financial year.

So, the balance sheet will give you a clear picture about the financial health of a company. If you analyze the balance sheets of different companies of at least 5 years, you can get a clear view about which company is doing better than its peer companies. Then the balance sheet will help you to invest accordingly.

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