How to Read a Balance Sheet?

Introduction

A balance sheet is a financial statement that provides a snapshot of a company’s financial position at a specific point in time. It is an essential tool for all stakeholders, including shareholders and creditors, who need to evaluate a company’s financial health. In this article, we will understand how to read a balance sheet, break down its components and understand the information it contains.

How the Balance Sheet Works

A balance sheet contains three sections – assets, liabilities, and shareholders’ equity. As mentioned above the assets are funded by the latter two. Therefore, the accounting equation is:

Assets = Liabilities + Shareholders’ Equity

Hence a balance sheet is a detailed representation of the accounting equation on a particular day. So, if a company publishes a balance sheet today and then another one after 1 year, you will be able to see whether the assets increased or decreased in that period. And correspondingly whether the liabilities/shareholders’ equity increased as well to fund those assets, or decreased when the assets were liquidated as the borrowings were paid off.

The three sections of a balance sheet start with the assets listed at the top, followed by liabilities and then shareholders’ equity at the bottom. A balance sheet is a net-zero financial document, which means that there can be no difference between the assets and the sum of liabilities & shareholders’ equity. It must follow the accounting equation as a rule.

For example, let’s say a company borrows ₹10 crore to set up a large manufacturing plant. It takes a ₹7 crore loan from a bank and takes ₹3 crore from its investors. This will be represented as a ₹10 crore increase on the asset side, a ₹7 increase on the liabilities side and a ₹3 crore increase in shareholders’ equity.

The assets and liabilities sections are split into two sub-sections, that is ‘current’ (short-term) and ‘non-current’ (long-term). Assets are generally listed in the order of most liquid to the least liquid, whereas liabilities are listed in the order of short-term to long-term. Let us find out more about these sections before we learn how to read a balance sheet.

Types of assets

The term “assets” refers to the resources that a company owns and uses to generate revenue. Assets can be divided into two main categories: current assets and non-current assets.

1. Current assets are those that can be converted to cash in less than a year. These include inventory, accounts receivable, and cash as well as cash equivalents. Cash is the most common current asset, followed by cash equivalents, which are safe assets such as government bonds. Accounts receivable are the short-term obligations that customers owe to the company. Inventory is the complete aggregation of raw materials, work-in-progress (WIP) goods and finished goods that are ready to be sold.
2. On the other hand, non-current assets are those that are likely to be converted to cash after at least a year. These assets can be tangible assets (like buildings, machinery, land and other capital-intensive resources), or intangible assets (like patents, copyrights, and goodwill). Depreciation, or the reduction in the value of an asset over its useful life, is calculated and deducted from most of the fixed tangible assets.

Intangible assets like brand names are crucial to the success of a company. These typically show up on a balance sheet only when they are acquired and not developed in-house. The value of these assets is never clear and may also be overvalued or undervalued.

Types of liabilities

‘Liabilities’ are the financial obligations that a company owes to its third-party partners like suppliers and vendors. These are also classified as short-term and long-term (or current and non-current).

1. Current or short-term liabilities consist of all payments that are due within a period of 1 year. These include purchases made from suppliers on a credit basis, which is simply ‘accounts payable.’ There is also a short-term component to long-term borrowings, which is the interest payment on the borrowed principal sum. This component is recorded under the current liabilities sub-section. Dividend payments that have been approved but not disbursed also fall under current liabilities.
2. Non-current or long-term liabilities encompass all financial obligations that are due to be fulfilled any time after a 1-year period from the creation of the balance sheet. These are generally long-term loans over a period of 5 years, 10 years etc. non-current liabilities also include corporate bonds, which a company issues to raise capital, as they mature only after a few years.

Shareholders’ equity

This is the money paid by the owners of the business and the other shareholders for an ownership stake in the company. Shareholder’s equity is also known as ‘net assets’ because the sum of assets and liabilities is subtracted from the total assets to arrive at this portion of the balance sheet.

How to read a balance sheet

This is one of the most important parts of fundamental analysis and must therefore be understood well. Here are things to check for when you look at a balance sheet:

1. Long-term assets: Owning long-term assets is not a sign of a successful business. If a company spots opportunities to outsource some parts of its manufacturing process due to the availability of idle capacity elsewhere, it may choose that path. This allows the company to remain asset-light and allows it to focus on growth.
2. High cash balance: One of the reasons for having a large amount of cash on hand is the business’s ability to generate that kind of cash flow year after year. This could be either because the company holds a monopoly in that segment, or it has recently sold off some valuable assets that are now lying as cash. This is a kind of red flag for investors.
3. Current Assets: One arrives at this section if the concern is the utilisation of working capital. A company must be able to finance its short-term obligations and recover quickly. Therefore, one much check whether the inventory is falling or rising in tandem with the increase in sales. A fall indicates robust demand for its products, whereas a rise indicates dwindling customer interest.
4. Liabilities: It is important to check whether a company has heavily borrowed money to sustain its operations because it should ideally be sustained by a robust cash flow. If shareholders’ equity is being diluted with increasing debt, it is a warning sign for investors.
5. Shareholders’ Equity: If the equity portion of the balance sheet consists of more bonus shares, the company can be deemed investor-friendly, which is a positive.

Analysing a Balance Sheet with Ratios

Here are a couple of ratios that one can use to analyse balance sheets:

1. Debt-to-Equity Ratio: (D/E Ratio): This is calculated by dividing the total debt by shareholders’ equity.

This indicates how much a company is leveraged to finance its operations. A high D/E ratio is good for a company looking to reduce its cost of capital, but detrimental if it does not generate meaningful returns.

2. Return on Equity (RoE): A key metric to evaluate profitability, RoE is calculated as a percentage of Net Profit divided by the Equity Share Capital.

High RoE indicates that shareholders are earning returns as the company continues to perform well.

3. Current Ratio: This ratio measures the liquidity situation of a company. Its formula is:

As a standalone indicator, this ratio does not provide the complete picture of a firm’s liquidity. Theoretically, this only tells us whether the company has enough current assets to cover off its current liabilities. However, a good measure of liquidity is the Cash Conversion Cycle, which tells us how fast these assets can be converted into cash.

These are only some of eh many ratios that can be used to gain a complete understanding of a company’s overall performance.

Conclusion

Understanding the data represented on a balance sheet is a critical part of investing. Investors must know exactly what to look for when they are presented with a financial document such like a balance sheet. Making informed decisions becomes possible only with the right kind of analysis, which comes with practice and patience.

Disclaimer: ICICI Securities Ltd. (I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. - ICICI Venture House, Appasaheb Marathe Marg, Prabhadevi, Mumbai - 400 025, India, Tel No : 022 - 6807 7100. I-Sec is a Member of National Stock Exchange of India Ltd (Member Code :07730), BSE Ltd (Member Code :103) and Member of Multi Commodity Exchange of India Ltd. (Member Code: 56250) and having SEBI registration no. INZ000183631. AMFI Regn. No.: ARN-0845. We are distributors for Mutual funds. Mutual Fund Investments are subject to market risks, read all scheme related documents carefully. Name of the Compliance officer (broking): Ms. Mamta Shetty, Contact number: 022-40701022, E-mail address: complianceofficer@icicisecurities.com. Investments in securities markets are subject to market risks, read all the related documents carefully before investing. The contents herein above shall not be considered as an invitation or persuasion to trade or invest.  I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. The contents herein above are solely for informational purpose and may not be used or considered as an offer document or solicitation of offer to buy or sell or subscribe for securities or other financial instruments or any other product. Investors should consult their financial advisers whether the product is suitable for them before taking any decision. The contents herein mentioned are solely for informational and educational purpose.