One of the biggest mistakes an investor makes is not taking time to understand their company’s financial statements. A financial statement comprises of three main statements –
In our previous article, we understood how to read an Annual Report of a company and the importance of these statements. In this article, we will focus on how to read and analyse a Balance Sheet. These statements are important in fundamental analysis.
A Balance Sheet gives us an overview of what a company owns and how much it owes to others. It tells us a business’s worth at a given time.
How to identify if a particular company is good for a short-term investment or a long-term investment? Which ratios can identify if the company has enough cash to pay its lenders? Is the company paying dividends? A Balance Sheet answers all these questions.
Here is a real example of a Balance Sheet – Dabur India Limited’s 2019-20 Annual Report.
Let’s break this down and learn how to analyse it, starting with the asset side.
Assets are what helps a company generate revenue. It includes cash, inventory, property, etc. They are important for a company to grow and survive. Having few or poor assets may cause various financial problems and difficulty. For example, cash reserves are important to meet daily needs. A company needs property, plant and equipment for manufacturing goods and services. These are basic examples of what assets are and why we need them.
Here is Dabur India’s 2019-20 asset side –
Non-Current Assets are company’s long-term investments. They help the company run its operations to support the business’ long-term goal and earn revenue.
Let’s observe the changes in these assets –
- Property, Plant and Equipment (P,P&E)
Property, Plant and Equipment are essentials for a business to function. This consists of all the office buildings, furniture, plants, etc.
In our example, P, P&E was Rs. 971.88 crores in the year 2019 and has increased to Rs. 1,060.75 crore in the year 2020. Here we can observe an increase of 9.1%. This means the company has invested in P, P&E.
Such increase in assets of a company is considered to be a positive signal in the long-term.
- Intangible Assets
This item includes company’s intangible fixed assets. Intangible assets may or may not be identifiable. Identifiable intangible assets can be sold by the company. Examples include patents, trademarks, designs, licenses, and secret formulas. Unidentifiable intangible assets cannot be physically separated from the company. For example, brand and goodwill of a company.
Goodwill represents a company’s reputation in the market. It provides economic benefits.
In our case, intangible assets of Dabur India Limited has increased from Rs. 15.37 crores in 2019 to Rs. 25.15 crores in 2020.
A total increase of 63.63%. This shows a massive growth in the market reputation of the company.
To further understand this addition, we need to refer to the footnotes for more details. Footnotes are also referred to as Notes to Accounts. They are useful to understand how the company arrived at the reported numbers. Reading these reports is the best way to stay up-to-date.
Footnotes – 6D: Other Intangible Assets
We can observe that these assets consist of brands, trademarks and computer software. Dabur India’s trademark was at Rs. 0.86 crores in 2019 which went up to 8.47 by the end of 2020. Using this information, we can observe which area is the company progressing in.
- Deferred Tax Asset
Deferred tax assets are like prepaid expenses. If a company has paid taxes in advance, they do not have to pay in future. In our case, Dabur India had no deferred tax recorded in 2019. In 2020, the company recorded Rs. 21.62 crores of deferred taxes. This is considered good as the company will have less tax obligation in the future.
Assets which will provide benefits within one year are current assets. They show the liquidity in the business and the company’s ability to pay off its current debts. For example, inventories can be sold and converted into cash within a year.
Inventories are finished products which are ready to sell. Since they can be converted into cash as soon as they are sold, they are considered as current assets.
In our case, Dabur India Limited is one of the largest Ayurvedic and Natural Health Care Company. Its inventory consists of over 250 products. We can observe an increase of 10.40% from Rs. 732.90 crores to Rs. 809.14 crores in the Balance Sheet.
It means that the company’s inventories have grown over the year. The best way to interpret this is by collecting and observing data of the past five to seven years.
- Trade Receivables
When the company sells goods on credit, they expect to receive the amount soon. Different companies offer their products on credits on different terms and conditions. These terms are set to change depending on various economic factors. We can see in our example that trade receivables has decreased by 12% approximately. There are various explanations to why trade receivables decrease –
- Changes in credit policies.
- Weak economy due to Covid-19 outbreak.
- Cash payment/recovery of goods which were previously on credit.
Along with trade receivables, one must analyse the allowance for bad debts. This is also referred to as ‘allowances for expected credit loss’ or ‘bad debt expense’.
A sharp increase indicates that the company is selling goods to riskier customers. In our example, the allowance has increased by 12.8%. Given 2020’s economic situation, we could reason the bad-debts increase to the crisis.
- Cash and Equivalents
Cash balance is important for a company to carry their day-to-day activities. They are the most liquid of all assets. Companies generally disclose what are equivalents in the footnotes to the balance sheet.
This was the asset side of a Balance Sheet. We will learn about various ratios which we can calculate to make the most of the reported data further. But before that, let’s understand the liability side.
Equity and Liability Side:
Liabilities are the funds that the company owes to others. Within liabilities, there are three subsections – equity, non-current liabilities, and current liabilities.
Here is a snapshot of Dabur India Limited’s liability side of Balance Sheet –
Equity is what the business owes to its internal investors. It is the sum left after paying all the debts. Equity share capital is also known as Here is a snapshot of Dabur’s Total Equity –
On the balance sheet, it is calculated using this formula:
Shareholder’s equity = Assets – Liability.
- Share Capital
Equity Share Capital under equity is the capital contributed by the shareholders. They earn a partial ownership in the company in exchange for this contribution.
We can see that ‘Other Equity’ went up by 15.96% and forms the major part of the Equity section. Let’s refer to the footnotes to understand the breakdown of the same.
Capital reserve, security premium and general reserves are of the same amount as last year. But we see an increase in share option outstanding account and retained earnings. Retained earnings went up by almost 18.68% which is a positive point to note.
Retained earnings is a part of net earnings or the profit a company makes. A part of profit is retained by the company to either reinvest in the business or use to pay off debt. The rest is distributed as dividends to the shareholders.
Increasing retained earnings is good, because it means the company is staying profitable.
Liabilities are the obligations on the company which need to be paid back. It is what the company owes to the outsider. Liabilities are not always bad. They help a company grow the business.
For example, raw materials bought on credit, loans from the bank, etc.
These are further divided into current and non-current liability. Let’s break it down by continuing with our same example –
Non-Current liabilities are long term commitments of a company. These liabilities are due after a year or more. Here is Dabur India’s non-current side of liabilities.
These are debt borrowed from the market in the form of loans from banks or debenture. The company’s borrowed amount has decreased by 5.25% approximately. This may be because the company paid back some of the debt and did not borrow any new loan.
- Deferred Tax Liabilities
Deferred tax liability is a tax due for the current period that a company commits to pay in the future. We can see that the deferred tax went from Rs. 8.32 crores in 2019 to 0 in 2020. This means that the company paid off the deferred amount. A decrease in deferred liability means that cash was used to settle the amount.
We had also observed a significant drop in the cash balance on the asset side of the balance sheet. It went from Rs. 23.16 crores to Rs. 2.87 crores. This transaction connects the dots of fall in cash amount and liability to a certain extent.
2. Current Liabilities
Current Liabilities are obligations which need to be paid within one year. For example, the amount owed to the supplier after a credit purchase, short term loan, etc.
Companies can also borrow funds for less than a year. They are also known as short-term borrowings. A company can go to banks or reach out money market for this type of borrowings. Short term borrowing includes trade credit, bank loans, and commercial paper, etc.
In our case, these borrowings have decreased by around 17.88%.
- Trade Payable
Trade payable works like trade receivable, but here, we owe money to the supplier. This liability has to be paid within one year to the supplier.
- Current Tax Liability
Current tax liabilities are such short-term tax obligations that an individual must pay within a year.
Balance Sheet Ratios:
Liquidity, efficiency, leverage, and rates of return ratios are 4 important performance metrics. We must calculate these ratios to understand the ongoing performance of a company.
We will learn how to calculate all the ratios in our next article. For now, let’s familiarize ourselves with these 4 categories of financial ratios with the help of this image –
The balance sheet is an invaluable piece of information for investors. It gives us a birds-eye view of the business. While analysing a balance sheet, collect the data of past 5 to 7 years and observe the trend. The same should be done with the financial ratios. It helps us get a better picture of how well the company is progressing.
Understanding its strengths and weaknesses only requires patience and analytical skills. Make the best use of the balance sheet to assess the sustainability of a business.
Pay attention to the footnotes which gives us information behind each reported figure. The assets and liabilities play an important role in decoding the quality of a business. To become an investor, you need to do a little homework before owning a share in a company.