A balance sheet is one of the most comprehensive and financial statements. Just like the rivers end up in the sea, all other major financial statements such as profit and loss (P&L) statements, cash flow statements as well as changes in equity statements end up with their balances into the balance sheet. To put it in simple terms, the balance sheet is a summary of a company’s assets, liabilities, and equity balances reported at a particular point in time, in which, assets are always equal to equity plus liabilities. Let us study those three parts of the balance sheet one by one to understand the whole picture.
Equity: What to look out for!
It’s the amount of capital that is infused into the business by its owners who can be promoters, public or FIIs and DIIs. One can see common entries like equity capital, reserves, and 'other comprehensive income' in most balance sheets. Equity capital is the capital that is infused at the time of initial public offering (IPO). Reserves form a major part of the equity. The profit after tax (PAT) number or simply net profit from the P&L statement is transferred as retained earnings to these reserves. Reserves also include statutory reserves, share warrants, hedging reserves, etc. Another interesting entry is of ‘other comprehensive income' (OCI). There are some specific entries that do not appear in the P&L statement but instead, appear directly in the equity section as OCI. For example, foreign currency translation gains or losses, pension plan gains or losses, and several others need to fulfill various conditions under accounting standards. What is important as an investor is to be watchful about OCI since companies might bypass losses into OCI so that the net profit number looks good in the books. As an analyst, huge OCI can be a red flag.
Liabilities: Is having debt good or bad?
Long-term liabilities are also referred to as borrowings or debt. Having debt in the books has its own advantages and disadvantages as well that depends upon the nature of business. Investors have a keen eye on the debt-to-equity ratio as a solvency measure for the company. For example, for a service-providing company, having a huge debt can be problematic. Since its major cost is salary, adding interest costs would penalise the profits. On the other hand, for a manufacturing company, loans can be helpful for expansion projects or buying equipment while it also increases the return on equity for the common shareholders.
Assets: Ratio analysis
To say in simpler words, equity and liabilities are the sources of finance for the assets. One can think of an asset as a resource that can be utilised to generate revenues for the company and can be converted into cash at some point in the future. And this is why return on assets (RoA) and asset turnover ratio (net sales divided by average assets) are widely used measures to analyse the efficiency of the assets. For both these ratios, it’s mostly higher the better. Trade receivables as well as cash & cash equivalents tell you a lot about the company’s liquidity position. As an investor, decreasing trade receivables and increasing cash is usually a positive sign. Although what the company plans to do with the cash is crucial to analyse.
To summarise, it is a prerequisite to understand the balance sheet in order to properly understand the functioning of any business. Hopefully, next time when you see a balance, it won’t be as intimidating as it might seem.