How to read balance sheet

How to read balance sheet
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First Published: Mon, Apr 30 2007. 12 01 AM IST
Updated: Mon, Apr 30 2007. 12 01 AM IST
If the profit and loss (P&L) statement is the indicator of a company’s performance over a period of time, a balance sheet is a point in time summary of its assets, liabilities, and other financials not related to income and expenditure (these last are covered in the P&L statement). This point in time is usually the end of a financial period, a quarter, half-year, or full year.
All numbers represented in the balance sheet are drawn from the books of accounts of the company, on that particular date.
Consider a salaried person. He or she earns a salary which is credited to his or her bank account at the beginning of the month. He or she spends part of this on running the household and on other things. The monthly budget of this individual is similar to a profit and loss statement. However, there’s more to the state of the individual’s finances than this. There are assets (house, car, jewellery etc), loans to be repaid (housing loans, long-term personal loans etc), money to be retrieved (dues from employer or friends to whom money has been loaned), investments (in stocks, mutual funds etc) and the like. A point in time summary of these is a balance sheet. As in the case of the P&L statement, it makes sense to look at consolidated balance sheets.
Two quick points about balance sheets before we get to the actual entries. The first concerns an entry that most balance sheets have: goodwill. This is a non-cash asset that essentially speaks of the brand equity of a company, and its ability to exert influence with all stakeholders, investors, vendors and customers.
The second concerns structure. The balance sheet was originally conceived as a direct representation of the double-entry system. Assets were on one side, liabilities on another, and the sum of all assets matched the sum of all liabilities (even some very wise investors and analysts sometimes define net worth as the difference between assets and liabilities. Well, whichever way a balance sheet is structured, this will be zero). In keeping with the times, however, balance sheets have become contemporary. Most balance sheets are now vertically structured and show assets and liabilities as having been replaced by sources and application of funds. As in traditional balance sheets, the aggregate of the top half of the modern balance sheet, sources of funds, balances out the aggregate of the bottom half of the balance sheet, the application of funds.
The sources of funds include entries such as share capital, reserves and surplus and uncommon items. The application of funds includes entries such as fixed assets, investments, deferred tax and net current assets.
The schedules attached to a balance sheet provide details on almost all entries in the statement itself. Thus, while anyone interested in a summary of a company’s finances can find it in the balance sheet, it is the details in the schedules that are often more interesting and illuminating.
Last week, we took Infosys’ P&L statement to explain the basics and some nuances of reading such statements. This week, we look at the company’s balance sheet.
Share capital
This is the issued share capital of a company. It shows the number of shares—preference and equity—issued by the company to its shareholders such as you. A high share capital (especially as compared to debt) is an indication of strength; it is a measure of the company’s ability to fund its growth, expansion, and diversification from internal resources. Since Infosys is a debt-free company, its balance sheet does not show any loan funds. You will find this in the balance sheet of other companies.
Things to look for: Has the share capital increased or decreased since the company last published its balance sheet? Why?
Tip: Before investing in any company, do consider how frequently it expands its equity base. A frequent expansion of this can reduce earnings per share, which is net profit divided by the number of equity shareholders.
This is the amount set aside either from shareholders’ contribution, net profits, or revaluation of assets of a company. This is usually treated as part of a shareholder’s equity.
Things to look for: Return on net worth (RONW), which is a ratio of net income after taxes to net worth (share capital + reserves), is an indicator of the profitability of a business. Infosys’ RONW is 33.6%.
Tip: Generally, companies with huge reserves are likely candidates for issuing dividends, but this isn’t always true. Some companies with high reserves could use it to fund significant investment activity in the future. Sometimes, revaluation reserves are created to give a misleading picture of net worth (share capital plus reserves).
Minority interests
Minority interests on the liability side of a company represent the stake of other entities in a company’s subsidiaries. It is under liabilities because a company owes this amount to other stakeholders of the subsidiary company.
Things to look for:Worry about this only if the amount is significant in the context of the company’s earnings . Infosys’ minority interest in Infosys BPO Ltd (formerly Progeon Ltd) has been reduced to Rs4 crore from Rs68 crore because it bought back the stakes of some of the other shareholders in the company.
Tip: Ignore if the amount involved is insignificant.
Fixed assets
Fixed assets include immovable property such as buildings, plant and machinery. Any increase suggests that the company is in an expansion mode. The “net block” after taking into account depreciation indicates the actual valuation of the fixed assets. Capital work in progress represents capital expenditure incurred for expansion plans, which have not been completed yet.
Things to look for: Don’t miss out on asset turnover ratio. This ratio indicates how effectively the company is using its assets in relation to its earnings. This isn’t stated in the balance sheet, but you can look it up on several financial websites. Alternatively, you could just calculate it yourself by looking up revenue from the P&L statement.
For Infosys, the asset turnover ratio works out to 3.4x. In accordance with Generally Accepted Accounting Principles (GAAP), these assets are stated at their book value.
Tip: Check in ‘notes’ about the company’s future expansion plans, and about how long capital work in progress is going to stay that way (as work in progress).
If the company has made some investments out of its free cash, it is recorded under this head. These investments could have been made in mutual funds, shares of other companies, and so on.
Things to look for: If investments are declining, perhaps the company has announced significant investment plans in the future and is putting away the money for that. This number should be seen in relation to the cash in hand; sometimes, companies prefer to keep their assets liquid. The cash on Infosys’ books grew by 71%, while its investments declined by 96%.
Tip: Look at schedules forming part of the balance sheet to check on the specifics of the investment. Wherever possible, mark the price of these investments to market. Some companies often value their investments at the prices at which they were made, and ignore any fall in value.
Deferred tax assets
Sometimes companies postpone or prepay taxes on profits pertaining to a particular period. Deferred tax assets help in synchronizing the tax computations that occur due to differences in income-tax law and accounting principles.
Things to look for: Ignore if the amount is small in context of the asset size investors.
Tip:This entry does not have any monetary effect.
This is the amount due to the company from its customers or clients. It falls under the current assets category, along with cash, account receivables and loans and advances.
Things to look for: Debt turnover ratio is an indication of how much time it takes for the company to recover its dues from its customers. This is calculated as a ratio of outstanding debtors to income and is expressed in number of days. And the ratio indicates whether the company is as efficient as its peers in collecting money from its customers in a reasonable amount of time.
Tip:Look for a company that strives to keep its debtors’ days as few as possible.
Cash and bank balances
This determines the amount of cash in a company’s books. Generally , the cash component should not be too high as companies don’t typically get any substantial income out of keeping cash on their books unless some investment plans are in the pipeline.
Things to look for: Companies operating the services business tend to keep more cash in hand than manufacturing companies. So, it’s important to consider the nature of the industry while looking at this number.
Tip: Ideally, cash invested in business should return more than investments in fixed deposits or the stock markets.
Current Liabilities
This figure represents the short-term debt of the company that will be paid off within one year. It may also include the expenses incurred in the day-to-day running of a company’s operations and the amount owed to suppliers.
Things to look for: The creditors’ turnover ratio is a measure of how quickly the company pays its creditors. It is calculated as the ratio of creditors at the end of the period to income and is expressed in number of days. For Infosys, this is 40 days.
Tip: This entry includes accounts payable to suppliers, demand loans and taxes payable.
This is the amount set aside from net profits of the company in anticipation of bad debts or losses.
Things to look for: If it’s a substantial amount in the context of balance-sheet size, investors should look at the schedules attached to the balance sheet.
Tip: Can be ignored unless the number is disproportionately high.
Net current assets
This is the difference between the current assets and current liabilities of a company and is a rough and ready measure of a company’s profitability also at a very macro level. This is the money the company has to “work” its business and is called working capital.
Things to look for: The ideal current ratio, which is current assets to current liabilities, is 2:1.
Tips: Auto and fast moving consumer goods companies generally have negative working capital that shows that they first sell their goods and then pay their raw material suppliers. This works effectively for large companies that can exert major influence over suppliers.
Rachna Monga contributed to this story.
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First Published: Mon, Apr 30 2007. 12 01 AM IST