Chapter 7.14: Understanding Balance Sheet Analysis

In this section, we will look at the third important financial statement- the balance sheet. The balance sheet is a statement that gives an account of the assets, liabilities and equity of a company.

Let’s find out a bit more about it.

Understanding Balance Sheets : Assets and Liabilities

A company needs assets to run its operations. To buy them, it has to raise money. This comes from two sources- debt (borrowings) and equity. Debt brings about an obligation on the company, which it has to settle in the future. It is therefore recorded as a liability. Equity on the other hand is contributed by shareholders. It too is money that the company has to repay, but it is not a liability in the traditional sense because it also confers rights of ownership on the shareholders. It is therefore recorded separately. Since assets are completely financed by these two sources, the value of assets must be equal to the combined value of debt and equity. The balance sheet is nothing but a detailed representation of this simple relationship.

Therefore, the basic balance sheet equation is:

Formula of Assets by Kotak Securities

As it can be seen in the pro forma balance sheet below, assets are also referred to as uses of funds, whereas liabilities and equity, together are called sources of funds. Let’s discuss these concepts in greater detail.

Structure of a Balance Sheet

Structure of a Balance Sheet by Kotak Securities

Understanding Assets

An asset is anything that a company owns that is expected to generate revenue for it in the future. Accounting standards require an asset to be recognized only if its value can be measured reliably and it can be sold by the company in the future. It’s not compulsory for an asset to be tangible. Companies own a lot of intangible assets (i.e. assets that cannot be touched or felt) that bring them tremendous amount of revenue. Another way of distinguishing assets is on the basis of their useful life. Fixed assets are more permanent and provide benefits over a long period of time. Current assets are less enduring. They provide benefit over a short period of time (say upto one year). More information about these categories is presented below.

  • Fixed assets :

    As mentioned above, fixed assets are those assets that are expected to serve the company over a long period of time. While companies draw benefits from both tangible and intangible assets over the long run, the term fixed assets is only used to refer to tangible fixed assets.

    These are also sometimes referred to as ‘hard assets’. Common examples include plant & machinery, land, building and furniture. Companies also like to report long term financial assets, such as long term loans advanced and long term financial investments as fixed assets.

    All fixed assets, with the exception of land and financial assets, lose a part of their value every year. This is called depreciation. Annual depreciation is reported as an expense on the income statement each year. The accumulated amount of depreciation for each asset is recorded on the balance sheet. The reported value of the asset is net of this value.

  • Current Assets :

    Assets that only provide benefit or are expected to be realized in the short run are called current assets. They are not depreciated because most of them are not physical in nature and they don’t stay long enough to endure wear and tear.

    Current assets include:

  • Cash flow forecasting :

    This category includes all long-term assets that cannot be touched or felt. Common examples are- patents, copyrights, software products and goodwill. Since they cannot be seen, it is hard to demonstrate their revenue generating potential. Companies can very easily exploit this inability by reporting non-existent intangible assets on their balance sheet and artificially expanding it. Accounting standards are stringent regarding the recognition of intangible assets. They are normally only recorded when they have been purchased from outside.

    Internally developed intangible assets need to be thoroughly scrutinized before only a part of their cost can be reported on the balance sheet. Else, it is reported as an expense on the income statement.

    Like fixed assets, intangible assets, with the exception of goodwill, too lose value annually. This is called amortization. It’s treated identically to depreciation.

    Goodwill is the surplus amount a company pays to acquire another company, over the combined value of its assets.

    This is considered to be the price of the extra revenue generating potential the combination will bring, over the combined individual potentials of the two companies. Goodwill is not amortized. It is tested annually for impairment. Its value is reduced if it is considered impaired.

Explantion of Current Assets by Kotak Securities

  • Cash and cash equivalents :

    This includes cash held by the company at hand, at bank and in the form of short-term investment products such as commercial papers, t-bills and certificates of deposit (CDs). All these are highly liquid (i.e. can be converted into cash immediately) and safe (i.e. there is a high probability of money being recovered out of these.).

  • Inventories :

    Unsold goods, raw material and unfinished goods held by the company fall under this category. We discussed their valuation at length in the section on the income statement.

  • Accounts receivable :

    This item represents the amount a company is yet to receive from its customers. The cash component of annual sales is added to the cash balance. The non-cash component is recorded here. The balance of accounts receivable increases when a company sells goods on credit and decreases when it receives money from its customers.

  • Short term loans :

    This represents all the excess short terms funds that a company deploys as loans. It is an asset because it will bring revenue in the form of interest.

What is Stockholder’s Equity

Equity is defined as the portion of capital that is contributed by the equity holders in exchange for shares of the company. Equity capital is initially contributed by promoters. As the business grows, more funds are required to run it. Promoters raise these by listing the company on a stock exchange and selling a part of their stake in it for a higher price than its original value. This process is called an initial public offer (IPO). The value reported on the income statements is the original value of these shares. It also includes shares sold subsequently by the company. The surplus money received from the sale of these shares is recorded under the name ‘securities premium’. The sum of these two values is called ‘issued, subscribed and paid-up capital’.

Over time, as the activities of the company grow, other things also get added to equity. All these put together form the book value of equity. It is different from the market value of the company’s shares. Other components of equity include:

  • Retained earnings :

    This represents the proportion of a company’s net income that hasn’t been distributed to shareholders or used for share buybacks. It is retained by the company for future use.

  • Other reserves :

    Just like capital reserve, investors set aside funds to meet some other future requirements. One such reserve is the general reserve, which is set up to meet unexpected future needs. Other reserves may be dedicated to other specific needs. Together, along with the capital reserve, they are recorded under the name ‘reserves and surplus’.

  • Capital reserve :

    Companies need to invest in long term fixed assets in order to grow. To finance these investments without raising fresh equity or debt, companies set aside a part of their retained earnings as capital reserve.

  • Treasury stock :

    At various points in time, companies buy back their shares from investors in the stock market. These are subsequently extinguished. The value of these shares is recorded as treasury stock under equities. Companies may initiate share buybacks as a means to reward shareholders, to support market prices or to ward-off the prospects of a hostile takeover.

Understanding company debt, liabilities

The second component of capital is called debt. This is the portion of capital raised by a company by issuing bonds (generally called debentures) and raising loans through banks. It is recorded on the balance sheet as a liability. Companies also record other liabilities on the balance sheet, however, debt is the only significant long term liability. It is therefore recorded under the name long-term debt. Other categories of liabilities are more or less current liabilities, i.e. ones that are expected to be settled fairly soon.

Commonly reported current liabilities include :

  • Short term debt and current portion of long term debt :

    This includes the funds borrowed by a company to meet its short term needs. It also includes the proportion of long-term debt that will fall due within one year.

  • Accrued liabilities :

    Accrued liabilities arise when the company has received a service but is yet to pay for it. This represents obligations other than those that lead to accounts payable. Things that fall under this include accrued wages, rent etc.

  • Accounts payable :

    This represents the amount that a company is yet to pay its suppliers in lieu of the inputs purchased from them. The company expects to pay this amount within one year. Thus, it is recorded as a current liability.

Accounting theory is based on the concept of matching-off the maturities of assets and liabilities. This principal is used in the balance sheets by matching-off current assets against current liabilities and long-term assets against long-term liabilities. A violation of this norm could lead to repayment problems for the company.

This is because the revenues generated by the assets are used for the repayment of liabilities. A small amount of matching assets means that the company may not be able to generate enough funds in time to repay the liabilities. Investors like to test companies on the application of this concept in the short term.

This is done by calculating the difference between current assets and current liabilities. The resulting amount is known as working capital. Normally, a moderately positive value of working capital (i.e. a surplus of current assets over current liabilities) is considered healthy. A very high value means that the company has borrowed long term funds and over-blocked them in working capital. A negative value of working capital means that the company has too much short term borrowings and doesn't have enough current resources to repay them.

Capital structure decision

Both debt and equity come with their own benefits and limitations. A company must weigh these against each other to decide their optimum proportion in its capital. The relative proportions of debt and equity financing used by a company is known as its capital structure.

Debt capital is raised in the form of loans. The suppliers of this capital are therefore, not a part of the company and have no rights of ownership. Their interest is limited to recovering their money. However, interest payments (technically known a cost of debt) on loans are fixed.

This works as both an advantage and a disadvantage. On the one hand, companies have to pay this when the time comes, irrespective of their income for the period. On the other hand, an increase in income doesn’t lead to an increase in interest-related expectations of lenders. They know that this is all they are entitled to, irrespective of the revenue for the period.

Equity holders are co-owners of the company and have a role in taking key decisions of the company. They can also respond to unpopular decisions of the management by influencing share prices. This makes them a force to contend with. When a company raises money by selling more equity, it dilutes the promoters’ control further and makes shareholders stronger. No such dilution is required for raising fresh debt.

On the other hand, the cost of equity is the dividend that companies pay shareholders. Companies can change the dividend in less profitable periods or in times when cash is required. They can also choose to not pay the dividend for a period at all. This privilege is not allowed with debt. It is a different matter that shareholders look at dividends as a signal of the health of a company and can react adversely to its reduction or omission.

Companies balance all these factors and decide on their capital structure. Naturally, they also take advantage of situations such as a fall in interest rates or a surge in the stock market to change their capital structure if needed.

What next?

We have now completed are exploration of the three basic financial statements. In the next section, we will look at the other areas of an annual report that might contain information of interest to you. We will also try to understand what to deduce from it. click here.

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