This is in a series of articles that will highlight the process of fundamental analysis. In this section, we will learn how to read a balance sheet report and also understand the business it represents.
Out of the three financial reports, perhaps the balance sheet is one of the most important reports of all. Why? Because it gives us the whole story of the company from its formation till date.
Profit and loss accounts give the status of profitability for a year. The cash flow report gives the status of cash flows for a year. But the balance sheet report tells the status of assets, liabilities, equity from the day a company is formed.
Talking about the balance sheet in more colloquial terms, we can say that it tells how a company has handled its finances. Better utilization of finances ultimately leads to more profitability and cash flows.
So we can say that for a company it all starts with its balance sheet. Let’s know more about it.
Simplified Balance Sheet
The above image is a graphical representation of a balance sheet. What a balance sheet balance? It is balancing Assets on one side and equity plus liabilities on the other. That’s the most basic understanding of a balance sheet report that we must remember. It gives us our Balance Sheet Formula.
From a general perspective, this is what a balance sheet reports tells us about the company.
Source of Fund: On the liability side, what we can find are the sources from where the company is arranging its finances. There are two ways a company can fund its business: (a) through the equity route and (b) through the debt route. A balance sheet report will tell what proportion is equity and how much is from debt.
Equity: In this type of funding, a company is selling the ownership (shares) of its business in the stock market. People are buying those shares and becoming shareholders. The money so accumulated from the sale of shares is the capital raised through the equity route.
Liability: There are two types of liabilities: Long term and short term. When a company takes a loan for which the payback time is more than 12 months, it is a long term liability. Likewise, loans with payback time shorter than 12 months will be short term liability (also called current liability). The money so accumulated from debt is a liability for the company.
Utilization of funds: On the liability side, what we have seen are the two sources of funds; equity and debt (total capital). On the asset side, we will see how the company uses these funds to run its business. Running a business can be seen as a two-fold process: (a) running the operations, and b) growing the operations.
Non-current Assets: These majorly are constituted by fixed assets. A major portion of the total capital (equity & long-term debt) is used by the company to buy property, plant, and equipment. In other words, this money is used to build the infrastructure of the company.
Current Assets: Another portion of the total capital is used to manage the current & upcoming needs (cash) of the company. What are the current needs? Already booked expenses (current liabilities). What are the upcoming needs? Working capital (non-booked future current liabilities).
Balance Sheet Analysis – How to read a balance sheet?
How to read a balance sheet with ease? First, divide the whole report into five sections. What are these sections? Five sections are: (1) equity, (2) non-current liability, (3) current liability, (4) non-current assets, and (5) current assets.
Let’s start reading the balance sheet items line by line for the best understanding.
The first section of the balance sheet will be equity. Here the company declares how much equity (also called net worth) they have built-up as-of-date (from the date of inception).
From the screenshot shown above, you can see that the total equity component of the company (as of 31-Dec’19) is 1,932.26 Crore. This value is further broken down into Equity Share Capital of Rs.96.42 Crore, and Other Equity of Rs.1,835.84 Crore. To know more about each of the broken-down items, we need to see Notes number 16 and 17.
Note 16 highlights more about Equity Share Capital. The company has an authorized share capital (maximum money it can raise from the share market) of Rs.100 crore. Out of this, the company has already raised Rs.96.42 crore (paid-up capital). How equity share capital is calculated? Share capital = Number of shares issued x face value (9.64 crore x Rs.10/share = Rs.96.42 crore).
[P.Note: Shares are often issued at price much higher than its face value. This is called shares issued at a premium. This results in the company raising extra delta capital (Delta = Selling Price – Face Value). But this delta does not go under the head “share capital”. It will be recorded under Other Equity (other equity > General Reserves > Security Premium Reserves. Though not all company display it on their balance sheet reports]
Note 17 highlights more about Other Equity. It has two main components. First, there are general reserves of Rs.837.4 crore. Second, Retained earnings of Rs.1,030.76 crore. What are general-reserves and retained earnings?
All profits recorded in the company’s P&L Account is first transferred to the balance sheet (Other Equity). One portion is kept as General Reserves and the other as Retained Earnings.
General reserves are kept aside to manage the future needs of the company. Retained earnings are accumulated net profit of the company (to date) minus transfers to general reserves. It is from here (retained earnings) the shareholders are paid dividends.
The liability section of the balance sheet starts with non-current liabilities (long-term liability). In the screenshot, you can see that the non-current liability is recorded as Rs.2,978.43 Crores. A further break-up of this liability is also provided with notes starting from 18 to 21. Let’s take up individual notes.
Note 18 talks about the Financial Liability (Borrowings) of Rs.53.14 crore by the company. My first impression was that it is a bank loan whose tenure is more than 12 months from reporting. But they were actually deferred VAT payable in the future.
Note 19 talks about long term provisions. Generally speaking, long term provisions of the company are generally funds kept aside by the company for employee’s benefits. In our example company, provisions are made for gratuity, incentives cum welfare benefits, and contingencies.
Note 20 talks about the deferred tax liability. This is another kind of provision kept in the book of accounts for future tax payments. Why did the company make this provision? When they foresee a situation where their tax burden may increase, they keep a provision for it from today.
What you can see in the above screenshot is a statement of the current liabilities of a company. In FY ending Dec’19, the company has posted a current liability of Rs.2,147 crore. The break-up of total current liability is also provided with details in Note 46, 22, 23 & 24.
The company has not posted any numbers under the head borrowings. This means that the company has not taken any short-term loans from banks etc.
A majority portion of the current liability of the company is associated with the trade payables of Rs.1,494 crore (=34+1460). These are basically invoiced bills of the suppliers waiting to be paid.
Under the head of other financial liabilities, the company has posted Rs.431.47 crores. The details of the financial liabilities are available under note 22.
Like non-current provisions, the company also tracks those employee benefits which are going to get due in the next 12 months. Provision for such payouts is made under the head current provisions. The company has kept a provision of Rs.85.46 crores. The break-up of it is provided in note 23 (see the screenshot above).
In the next line of the balance sheet, what we have is “Other current liabilities‘. Our example company has recorded Rs.133.96 crores against it. To know more about this line item, we will have to see note 24. Generally, companies post their statutory liabilities under this head. Any liability that cannot fit-in the above-listed headings will go here.
What we will see now is how the company is utilizing its capital. How the capital is utilized? By accumulating non-current and current assets.
What are non-current assets? These are mainly property, plant, and equipment of the company (also called fixed assets). Other types of non-current assets can be financial assets (like long-term investment). We can know more about them in the notes.
In Note 4 we can see the details about property, plant, and equipment. Check the above screenshot. It lists down items like land, building, plant, equipment, furniture, office items, vehicles under this head. These are all fixed assets that are expected to add economic value to the company in long term. Out of all the types of assets, this is the most capital intensive of all (especially for manufacturing companies).
The next line item on the asset side of the balance sheet is capital work-in-progress (Rs.143.3 Crore). This is also related to property, plant, and equipment, but is recorded separately as the construction/execution work is still not complete. Once the execution work is finished, their numbers will be moved to the property, plant, and equipment line.
Under the head financial assets, one line item is investments (Rs.743.6 crore). One can see its details in note 5. In the note-5, you can see that the company has invested its cash in two areas. First is tax-free bonds (Rs. 724.72 Crore), and second is shares (Rs. 18.88 Crore)
Another type of financial asset that the company has recorded in its balance sheet are loans (Rs.46.98 Crore). One can see its details in note 6. As you can see, a majority portion of the loan is under the head called Security Deposit (Rs.36.08 Crore). Generally, these are monies paid by the company against the property/apartments they have leased for office purposes, etc. The second common form of loans are monies issued to employees or group companies.
A good part of the capital raised by the company remains locked as current assets. This is that portion of the money that cannot be used for property, plant, and equipment expansion, purchase of LT investments, etc. It is of paramount importance for the company to keep some of their assets as liquid as possible. These liquid assets are referred to as current assets.
Generally speaking, the whole basket of current assets can be divided into two categories. First is inventory, and second is easily-liquifiable-financial-asset (like cash, short term investments, due payments from customers, among others).
In Note 8, our example company has provided the details of their inventories worth Rs.1,283.07 crore. Look into the list of items under the head inventory. It will give you the impression that these items are not strictly liquid. Let’s divide the whole list into 4-types: unfinished goods (illiquid), semi-finished goods (illiquid), finished goods (liquid if there is a demand), and spares (illiquid). It is the reason why some analysts remove inventory numbers to judge the company’s real liquidity levels.
In Note 9, we can see the details of our first financial asset (investments Rs.1,007 crore). These are all such investments which are getting matured within the next 12 months. Typical types of current investments by companies are T-Bills, government bonds, fixed deposits, debt mutual funds, etc.
The next line item under financial assets is the trade receivables (Rs.124.33 crore). These are basically outstanding payments waiting to be received from customers’ end. In notes, a good company also shows a break-up between receivables considered safe and unsafe.
Cash and cash equivalent is the most reliable form of liquid asset that a company can have. In judging, if the company is sufficiently liquid or not, this component of the balance sheet plays a decisive role. Generally, the company parks its cash in current accounts and savings accounts to meet its short-term liquidity needs.
Other items listed under the head ‘current assets’ can be short-term loans issued by the company to their employees or group-companies. These are such non-cash items that can easily be en-cashed when due (by the way of adjustments etc).
Under the head ‘other current assets‘ our example company has recorded an amount of Rs.26.02 crore. They have provided the details of this item in note 15. These mainly include advances paid to suppliers, employees, etc. Our example company has also included “Balances with government authorities” here. Ideally, this should either be adjusted under ‘account payables” or shall come under “trade receivables”. But the company has put it here because maybe they do not expect this cash-flow to happen any time sooner. It may be, kind of an NPA for the company.
How balance sheet is related to its P&L a/c?
- Retained Earnings & PAT: Retained earnings in the balance sheet gets updated every time the company makes a Net Profit (PAT). Net profit appears in companies’ profit and loss accounts.
- Debt & Finance Cost: The debt (long-term and short-term borrowings) in the balance sheet increases the companies finance cost which appears in companies’ profit and loss accounts.
- Trade payables & Expenses: Trade payables of the balance sheet is a portion of the expense to be incurred by the company in the next financial year (FY).
- Tangible Assets & Depreciation: Tangible assets (property, plant, and equipment, etc) valuation appears in the balance sheet. This value is net of accumulated depreciation. Depreciation applicable for a particular FY appears in the P&L account.
- Investments & Other Income: Investments (non-current and current) made by the company is recorded in the companies balance sheet. The income generated by these investments is recorded as other income in the P&L account.
- Trade receivables & Income: Companies often sell their products and services to their customers on credit to earn income (income appears in P&L account). This credit payment due, to be received by the next 12-months is recorded as trade receivable in the balance sheet.
Reading a balance sheet is only half the job done. It becomes even more interesting to make meaning out of the numbers printed here. How to do it? If we can understand the whole scheme of things (The Business) side of the balance sheet, its impact can be phenomenal. A very simplified representation of the balance sheet side of the business is shown below:
Look at the above infographics. It gives an idea of how the source of funds (Equity and liability) plays a role in funding non-current and current assets. You will also be able to understand which asset-type is building long-term value for shareholders and which asset-type is used only to ensure liquidity in the business.
To understand the balance sheet more deeply, you must learn about financial ratios, and valuation models like NCAVPS, DCF, Absolute PE, Residual Income model, etc.
Have a happy investing.
Hello Mani, Nice articles.
Do you have the software which I could or anyone use for calculation of P&L, balance Sheet and Cash Flow statement??
Some hands on might be more helpful as well sometimes.
Very nicely explained.Thanks
Thank You for this post Mani. A very well written article. Understanding balance sheet is not easy, but you made it look like a piece of cake.
What I really like about your blog posts is that they are very simple in language that even a layman with no background on finance can understand. Each and every subtopic is broken down and detail.
Thank You once again.
Mani Sir I have been using your analysis sheet to evaluate stocks and found it to be quite good. For the sheet I need to find the effective tax rate of future retail at equitymaster.com . However its not available on the website. Please advise/provide alternative. Thanks
If you are not able to source the value, assume it as 30%.