What is a Balance Sheet and how to make money reading it?
The first question that needs to be answered is, what
is a balance sheet? A company’s accounts can be divided into three important
statements buried right in the middle of a hundred-page document we call the
set of accounts. There are a profit and loss account, a balance sheet, and
a cash flow statement. As the name suggests, the profit and loss account gives
away the net profit of an organisation during a given period and the cash flow
statement shows us where the stream of cash is coming in from and where is it
being spent.
Today we are mainly focussing on the balance sheet.
Every twelve months, the directors will prepare a balance sheet and if I have
to explain it to a layman, I would say that as such it represents you freezing
the business and taking almost a photograph of where it's at right now. It
shows the company’s assets, liabilities, and owner’s equity at a specific point
in time. Basically, a balance sheet shows what a company owns (i.e. assets),
what it owes (i.e. liabilities), and how much owners and shareholders have
invested (i.e. equity). A company always has to pay for everything they own
(i.e. assets) and they do this by either borrowing money (i.e. liabilities) or
getting money from owners and investors (i.e. equity). And so, it always has to
balance sheet always has to balance (assets= liabilities+ equity) – hence the
name ‘balance sheet’. The balance sheet gives us a snapshot of all the assets,
liabilities, debt and equity a company has at a given point of time. And so,
the companies publish their balance sheets at the beginning for the financial
year and the end, and by accessing the difference between the two it shows us
how the company performed during the year.
Now that I have used the terms- assets, liabilities,
equity and debt multiple times, its time for me to explain what they actually
mean.
Assets are essentially the resources owned by the
organisation with the help of which it creates value. In simpler terms, assets
are anything that can be used in the production of a good or a service thereby
creating economic value (i.e. generating income) for the organisation. For
example, for a newspaper company, the printing press would be considered as
their assets.
They can be classified into current assets and
non-current assets. Current assets are the assets that can be liquidated within
12 months or 1 financial year for example – debtors, stock in the inventory,
cash, etc. Non-current assets on the other hand are used for the long term in
the production of goods for example vehicles, machines, furniture etc.
Liabilities, as the name suggests, are the obligations
an organisation owes to either outside parties or even the owners. For example,
a loan taken for business operations, creditors, etc. Liabilities can be
classified into three, current, non-current, and shareholders’ funds (i.e.
equity).
Current liabilities are the ones that need to be paid
by the business within the financial year like creditors. And non-current
liabilities are to be paid over a longer period of time say- 5-10 years for
example- a loan that needs to pay over a period of 15 years. Equity is
basically what the organisation owes its owners/ shareholders and these include
the profits as well.
IMPORTANCE OF BALANCE SHEETS
Not only is a balance sheet important for the
organisation, but it is also important for all the other stakeholders of the
organisation like the shareholder, employees, the government, the community
etc. It gives the interested parties a clear picture of how the financial
health of the business is or how is it performing compared to the previous
year.
Firstly, it is helpful for the management of the
organisation. Managements need to make decisions regarding the organisations
all the time and to do so they need to access the situation of the organisation
before. They generally require details like the Company’s debt funding status,
liquidity situation assessment, trade receivables status, cash flow
availability, the investment made in other assets, and fund availability to
plan their future expansions. Therefore, the balance sheet helps the management
in calling shots based on the status of the organisation.
Another important use for the balance sheet if to the
organisations’ investors. They use the balance sheet and the other financial
statements to analyse the organisation’s financial soundness. They do this by
analysing various ratios to understand the future growth potential and the
current returns it has been generating. Based on these numbers investors or
potential investors decide if they want to be kept their investment of
increase/ decrease it in the organisation.
The balance sheet is also assessed by the banks or
financial institutions to decide if they want to lend money to the
organisation. As the balance sheet shows the current composition of debt and
equity as well as assets and liabilities, it helps them come to a conclusion
that is the organisation already over-borrowed or if it still has some scope of
borrowing.
Another important stakeholder of organisations is the
government. Not only does the government need the balance sheet for tax
calculation purposes, but they also need to look out for any malpractices or
fraudulent activities taking place in the organisation. Similarly, the stock
market regulator, SEBI needs to look out for its investors and needs to make
sure that their interests are being safeguarded and no misdeeds are being done.
Sometimes, the clients of the organisation also may
need to look the balance sheet to see if the company can provide a steady
supply and not go bust anytime soon in the future.
HOW TO READ BALANCE SHEETS
Reading about the financial strength of an
organisation just from a balance sheet generally requires a
particular amount of study and comparison, also access
to the supplementary financial report, the income report.
This analysis is known as the Financial Ratio and analysis. By
comparing this period's calculated ratios with prior periods and industry
benchmarks, allows us to spot healthy/unhealthy trends within
the financial strength of the organisation in reference
to its past and therefore the industry as a whole. Whether
the returns from the business are competitive with other investment options,
whether the corporate is becoming more or less profitable, more or
less hooked on to external funders, better or less ready
to meet its financial obligations once they become due or more
or less efficient at managing the assets of the corporate. There are various sorts
of financial ratios but they're generally grouped into 4:
Leverage Ratios, Liquidity or Solvency ratios, Operational Ratios, and
Profitability ratios.
Leverage Ratios are the ratios which calculate the
extent to which the corporate uses external debt in its capital structure
instead of equity funders. Over-reliance on external debt makes a company's
profitability susceptible to the rate of interest raises and is more
susceptible to liquidation actions by creditors during a downturn. The foremost
common leverage ratio is that the debt to equity ratio.
Liquidity/Solvency Ratios are the ratios which
calculate the company's ability to pay its debts as they become due. Some
companies might be profitable but yet unable to pay critical payments like
staff, loan repayments or rent because their money is tied up in debtors (money
owed to the company by customers) or inventory. The most common
Liquidity/Solvency Ratio is the Quick ratio.
Operational Ratios are the ratios which calculate the
efficiency of a company's management in its operations and use of assets.
Typical efficiencies affect stock turn and debtor days which measures
respectively, the quantity of stock required to
realize sales targets and the way many days it takes to
urge paid by customers. Generally, you'd not want to overstock
and you'd want your debtors to pay within the shortest
possible time.
Profitability Ratios are the ones which calculate the
return on sales and capital employed. These ratios are usually expressed
as a percentage and monitored over time periods to
spot healthy/unhealthy trends.
In conclusion, by comparing these ratios with previous
periods, commonly agreed safe operating levels and industry benchmarks help us
read about the changing financial strength/health of a company from the Balance
Sheet report.
RED FLAGS TO LOOK OUT FOR
It is common for a business to expand its line,
which increases inventory. However, if inventory goes up, but nothing
has changed within a company's offerings, it's going to mean
items aren't selling. In many industries, the longer a product
remains shelved, the larger the danger it's of becoming
obsolete or spoiling. It is simple to identify this problem by
examining the record. it's important to calculate inventory for
the year by using the ending inventory number from the previous
year's record. This amount is split by the
present year's sales. If the
amount is quite it's been in previous years, something must
be done to urge products moving at a swifter pace.
Although a hefty account receivable
figure could seem good, it's only profitable if it is
often collected. within the business world, the longer an
account goes without being paid, the more unlikely it's that the
company will see compensation. When receivables begin to mount, it's going
to be necessary to regulate the company’s collections process
and become stricter together with your credit policies.
It is acceptable to sell old
equipment that's not being utilized or that has stopped performing
effectively. However, the proceeds should never be wont to pay down
debt or be put toward short-term expenses. When this happens, it's
going to cause problems for the company's future operating
expenses. to form sure gains, losses, and disposals are getting
used correctly, it's knowing to examine the companys income
and balance sheets.
Even though a business shows a profit on
paper, it's going to still be cash poor. When
cash doesn't flow into the business, investors may start to
stress receivables aren't being collected properly, revenue is
being exaggerated, otherwise, they are struggling to pay your loans.
If net income is consistently low, they'll suffer a
cash crunch. When this happens, it's essential to spot the
cause. repeatedly, it's going to flow from to a slow month
or similar circumstances. However, if it's thanks to poor
collections efforts, it's advisable to speak together with the
customers and push for payment.
After identifying the basis of the crunch, one will have a
far better understanding of when cash will flow better. It
means you'll be required to regulate your payment schedule.
It always looks good when the company shows consistent
income from continuing operations. Investors are often leery of seeing income
from the sale of fixed assets, an outsized one-time sale, or the sale
of investments. Operating income is listed separately from non-operating income
on your earnings report. If there is a particular increase from year
to year, it's going to be necessary to focus on sources of
revenue that are solid and steady.
Many companies have "other" expenses that
are very small or inconsistent. it's normal and is
reflected within the record and income statements. However,
when these things have high values, it's a
particular red flag and wishes to be checked. In many
cases, a number of these expenses are often reclassified.
Other times, the high value could also be a one-time occurrence.
Delving into a company's financial statements will give investors great insight
into its overall performance and future. Knowing the essential red
flags will assist the investors to identify problems.
An investor should be vigilant about investigating
anything during a company’s earnings report that raises a
red flag. Both revenues and expenses are susceptible to manipulation.
Company management often has incentive to interact in manipulation
and auditors don't always catch on. Reading the earnings
report and management’s discussion of its business (together with
the record and footnotes, also because
the income statement) provides clues for vigilant investors.
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