Fundamental Analysis : Understanding Balance Sheet

By looking at the balance sheet of the company what one can understand?

It gives clarity about how the company has build wealth over the past years.

Balance sheet talks about from where the company is generating funds to run its business.

It also makes clear, where the company is using those funds.

Any company generate funds in three possible ways.

It can borrow money from stock market. This is called share capital in balance sheet.

The company can also retain its net profits to run the business.

This is called reserves and surplus in the balance sheet.

Company can also borrow funds from Bank etc.

This is recorded as long term borrowing and short term borrowing in balance sheet.

Hence, the total funds available with a company to run its business can be summed up like this:

Total Funds = Share Capital + Reserves + Debt.

{Note: Share Capital + Reserves = Book Value.}

This (total funds) is also called the total liability of the company.

How the company uses their generated funds is also indicated in the balance sheet.

Company use its generated funds to build assets. These assets intern generate income for the company.

Let’s see the important constituents of a balance sheet in more detail.

Balance sheet basically defines this equation:

Understanding Balance Sheet 1

If one read a balance sheet statement of a company, it will show how much accumulated wealth the company has amassed till that day.

Shareholders fund (Book Value / Net Worth)

Why it is called as shareholders fund?

Shareholders fund is that money that companies owe to their shareholders.

Shareholders have a legal claim on the company’s net profits.

Hence any funds that is retained by the company (Reserves) goes into the account of shareholders funds.

Company consider these funds as that money which they need to pay-back to the shareholders one day.

Book Value = Share Capital + Reserves

Share capital:

It is that money that the company has generated from its IPO.

Share capital is actually the borrowed money that the company has taken from the shareholders.

It is also treated as companies liability.

Reserves :

They are also referred as retained net profits of the company.

Why companies retain their profits? This is done to strengthen their balance sheet (financial position).

Companies used a reserves to buy new fixed assets. This day 2 by means of capital expenditure plans (CAPEX).

Companies also use their reserves to reduce there debt burden.

A portion of reserves is also used to pay dividends to its existing shareholders.

General there are two types of reserves. First, revenue reserve and second, is called capital Reserves.

Revenue reserves is again categorized into two types, first he is general reserves and second is specific reserves.

As the name suggests, general reserves is not apportioned for any specific purpose.

They are just kept in the balance sheet to strengthen the financial position of the company.

Specific reserves

They are those portion of money which is kept for specific purpose.

The the funds kept in the specific reserve shall be used only for the designated purpose.

How the reserves in the balance sheet is funded every year?

The net profit, in profit and loss account, is transferred to the company’s balance sheet as retained earnings.

This retained earning in turn is used as the reserves of the company.

If the company has made a loss in a particular financial year, no transaction is recorded in the reserves column of the balance sheet.

Sometimes, in case of loss, the company may even debit there reserves account in balance sheet to meet their requirements.

In such case one will find a dip in the reserves and surplus account as compared to the previous year.

One of the most important financial indicator detailed in the Balance Sheet is shareholders equity.

n doing a balance sheet analysis it plays an important role.

Net worth of a company is equal to total capital generated by the company by issuing stocks and accumulated retained earnings.

A continuously improving net worth is what investors likes to see in companies balance sheet.

Investors must compare last five years net worth of the company, and must also check growth rate.

It is important to check how the net worth of company has grown.

If increase in net worth is attributable only to the issuance of more stocks to public, then it is not good.

Ideally, the companies net worth must increase due to growth in retained earnings.

Liability

Non current liabilities

Non current liabilities are those liabilities of a company which is settled only after 12 months from the date of reporting.

These are such liabilities that company need not settle immediately.

If you will see in moneycontrol.com, you will find that non current liabilities are mainly recorded in two three some heads.

First he’s long term borrowing. Second, is deferred tax liability and third is long term provisions.

Companies which show the line item has long term borrowing, means that the company has taken that from the market (mainly banks).

It is very important for the shareholders to keep a note of how high is the long term borrowings of the company as compared to its equity.

Deferred tax liability is a provisional fund maintained by the company using which they will pay the forthcoming additional tax dues.

Has a part of non current liability the company also hello kids some funds in the name of long term provisions.

Here the company keeps some cash reserves for paying their employees.

These payments can be like gratuity, provident funds, leave encashment.

The provisions can also be made for income tax payment, payment of dividend to shareholders, dividend distribution tax etc.

Current liabilities

Current liabilities are those obligation of the company that they must meet before 12 months.

If you will look into balance sheet of any company in moneycontrol. you will find four line items under the heading current liabilities.

They are, short term borrowing, trade payables, other current liability and short term provisions.

Short term borrowing is essentially that loan that company has taken from Bank CTC to fund there day-to-day cash flow requirement.

In financial term this is also called as working capital of the company.

Trade payable is that money that a company must pay to its suppliers within next 12 months.

Short term provisions are again similar to long term provisions. The only difference here he is, this provisions me get used within next 12 months.

Assets

Generally in the balance sheet, assets are categorised into two main types: non-current assets and current assets.

Understanding Balance Sheet 2Non-current assets are basically property, plant, and equipment’s of the company.

Normal terms we call it as fixed assets of the company (Tangible assets).

 – Fixed Assets (Tangible Assets)

Fixed assets adults assets of the company which they use directly for the production of goods and services for their customers.

Common examples of fixed assets are land, factory buildings, machines, furniture’s, Motor vehicles etc.

Fixed assets are those assets of the company which company gathers to hold them for long-term.

Contrast to the fixed assets, an inventory is also an asset of the company.

But company maintains the inventory with the objective of selling them in near future.

 – Intangible assets

Assets of the company do not have a physical substance. You cannot physically see it and touch it. Example off in tangible assets can be like copyrights, trademarks, patents etc gathered by the company over a period of time.

Capital work in progress

These are those assets which were not ready at the time of preparation of the balance sheet.

These are those assets which are still not ready to produce goods and services for the company.

Hence, call costs that has gone into the preparation of that as it is shown as capital work in progress off the companies balance sheet.

Just to understand, let’s take a small example.

Pause cement manufacturing plant is putting up a new facility to manufacture a new brand of cement.

Average it may take 3 years for the company to start production from this new facility.

But the company will start spending money on this asset from the first months itself.

So, the cost that was into the preparation of the new cement plant will be booked as capital work in progress for the next three years.

As soon as the new plant will begin production, all capital work in progress associated with this new plant will be transferred as tangible asset.

Non-current investments

Current investments are those investments made by the company which day would like to hold for more then next 12 months. Example of such an investment can be stockholding of another company.

Generally current investments are reported in the balance sheet equivalent to the market valuation of the investment.

Current assets

Current assets are those assets of the company which is expected to be converted into cash within next one year.

It is the current assets of the company that helps them to maintain enough liquidity.

Current assets of the company helps in management of the current liabilities.

One of the most reliable forms of current assets is:

  • Cash and cash equivalent,
  • Inventory,
  • Investments,
  • Account receivables from its customers, and
  • Loans and advances given to associates/ suppliers.

Advances are also referred to as pre-paid expenses in some balance sheets.

To Conclude

Understanding Balance Sheet 3You can see the above snapshot of a typical balance sheet of a company and understand what is actually balanced in a balance sheet.

Total asset of a business is always equal to the sum of its total liability and shareholders funds.

How balance sheet is related with its profit and loss accounts?

Reserves & Surplus: in balance sheet gets updates every time the company makes net profit (PAT). Net profit appears in companies profit and loss accounts.

Debt (long term and short term borrowings) in balance sheet increases the companies Finance cost which appears in companies profit and loss accounts.

Trade payables of the balance sheet is a portion of expense to be incurred by the company in the next financial year (FY).

Companies often buy goods and services from the suppliers on credit.

All expenses which are booked by the company appears in the profit and loss accounts.

Tangible assets valuation appearing in balance sheet are recorded as net of accumulated depreciation (over last several years of operation).

Depreciation applicable only for a particular FY, appears in the companies profit and loss accounts.

Non-current and current investments made by the company is recorded in companies balance sheet.

The income generated by these investments are recorded as other income in profit and loss accounts.

Trade receivables appearing in balance sheet of the company is the out of sales revenue.

Companies often sell their products and services to their customers on credit.

This credit payment due, to be paid by next months are recorded as trade receivable.

Understanding Balance Sheet 4
Click here to enlarge

So now we can understand, how balance sheet and profit and loss accounts communicate with each other.

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2 Comments

  1. 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

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