How to read a Balance sheet?
CA Deepak Pandey
FP&A-UNIBIC Foods | Ex-Audit Senior- TPS Thayer | Ex-Article Brahmayya & Co.,
Understanding how to read a balance sheet is crucial because it offers a quick assessment of a company's financial health, enabling informed decisions by investors, creditors, and management. It reveals vital information about liquidity, solvency, strategy, risk exposure, and operational efficiency.
Whether you're an investor, an analyst, or simply someone curious about the financial world, understanding how to read a balance sheet is an essential skill. In this article, I will break down the elements of a balance sheet and empower you with the knowledge to make informed financial decisions
A Balance sheet is the snapshot of a business at a specific point in time. It basically serves two purposes:
It shows company’s assets, liabilities and shareholders equity.
An equation to remember is Assets= liabilities+ Equity
?1??Assets:
Assets are the resources which company owns. It is divided into two categories, Current assets and non current assets
??Current assets: are the assets that a company expects to convert into cash within a year. They include:
??Non Current assets: are the long terms investments that are unlikely to be realized in cash in a near future. They usually have a high value and benefit the business for long period of time.
It generally includes :
On the contrary, If a company has a high proportion of non-current to current assets, this can be an indicator of poor liquidity, since a large amount of cash may be needed to support ongoing investments in noncash assets.
2??Property, plant and equipment:
?These are the assets with relatively long useful lives that a company is currently using in its operations. PP&E is depreciated over time and can be sold for its salvage value. If the investment in property, plant, and equipment is huge, it attracts more investors as the investment in PPE reflects the intention of long-term goals.
They include:
??Depreciation is the practice of allocating the cost of assets over the number of years. Depreciation reduces the value of property, plant, and equipment on the balance sheet as the value of assets is lowered over time due to wear and tear and the reduction of their useful life. The accumulated depreciation account shows the total amount of depreciation that the company has expensed so far in the asset’s life.
3?? Intangible assets:
They are the long term assets that lacks physical substance but are frequently very valuable. They give companies a competitive advantage. Brand recognition can sometimes give a company an authority to charge higher prices. It can also indicate quality and reliability.
Intangible assets includes
4?? Liabilities
This is what company owes to others.
??Current liabilities are the obligations that the company must pay within a next year or cycle of operation. It includes:
The relationship between current assets and current liabilities helps us to understand the liquidity of the company.
If the current assets are higher than current liabilities, the company is in the a good position to pay its short term creditors.
If not, the company can go bankrupt.
??Long term liabilities are the obligation that a company expects to pay after one year. These are debts due beyond one fiscal year. It includes
If a company's liabilities exceed its assets, this is a sign of asset deficiency and also an indicator that the company may default on its obligations and be headed for bankruptcy.
5??Stakeholders (Owners) equity:
This is the ownership claim on the assets of the company. This term refers to the amount of equity a company's owners are left with after liabilities or debts have been paid. This section of balance sheet primarily consists of common stock and retained earnings.
If we add all the resources of the company and reduce liabilities, what is left is the equity (Total Assets – Total Liabilities).
Market risk is the primary risk affecting equity funds. Market risk is the risk of loss in value of securities due to a variety of reasons that affect the entire stock market.
Negative shareholders' equity is a warning sign that a business could be facing huge financial distress. A company might have taken on too much debt or could be otherwise overspending?.
6??How to analyze a balance sheet?
We can analyze using following ratios
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Within the balance sheet, we will focus on the first 3 ratios
1?? Liquidity ratio
It measures the short term debt repayment ability of the company. Liquidity ratios are also a class of financial metrics which is used to determine a company's ability to pay off current debt obligations without raising external capital.
??Current ratio: Current assets/ Current liabilities
The current ratio is a liquidity ratio that measures a company's ability to cover its short-term obligations with its current assets. The current ratio describes the relationship between a company's assets and liabilities. For example, a current ratio of 4 means the company could technically pay off its current liabilities four times over.
A current ratio of 2:1 is considered ideal in many cases.
A ratio less than 1 means that the company can’t pay its debts. It may necessarily finance or extends the credit period of the creditors
??Quick ratio: (Cash and Cash equivalents+ Accounts receivable)/Current liabilities.
The quick ratio is a calculation that measures a company's ability to meet its short-term obligations with its most liquid assets. Generally speaking, a good quick ratio is anything above 1 or 1:1.
??Cash ratio: Cash and Cash equivalents/ Current liabilities?
It is a measure of the liquidity of a company, namely the ratio of the total assets and cash equivalents to its current liabilities. The metric calculates the ability of a company to repay its short-term debt with cash or near-cash resources, such as securities which are easily marketable.
2?? Solvency ratio:
It measures the extent to which assets of a company covers commitments for future payments, the liabilities. It also measures how well a company's cash flow can cover its long-term debt. Solvency ratios are a key metric for assessing the financial health of a company and can be used to determine the likelihood that a company will default on its debt.
??Debt to equity ratio: Total Debt/ Total Equity
The debt-to-equity ratio is a financial ratio indicating the proportion of shareholders' equity and debt used to finance a company's assets. It shows how much debt a company has compared to its assets. A higher D/E ratio means the company may have a harder time covering its liabilities.
The optimal D/E ratio varies by industry, but it should not be above a level of 2.0
??Debt ratio: Total Debt/ total assets
It measures the proportion of a company’s assets that are financed by debt. A ratio greater than 1 shows that a considerable amount of a company's assets are funded by debt, which means the company has more liabilities than assets. A high ratio indicates that a company may be at risk of default on its loans if interest rates suddenly rise.
Debt ratios of 0.4 or lower are considered better
Higher the ratio, the more debt and risk the company has
3??Efficiency ratio:
Measures the efficiency of the business to converting assets into cash. It helps in analyzing a company's ability to effectively employ its resources, such as capital and assets, to produce income. It also measures the time it takes to generate cash or income from a client or by liquidating inventory.
?? Receivables turnover ratio: Sales/ Average Account receivables
The accounts receivable turnover ratio measures the number of times a company collects its average accounts receivable balance in a specific time period. The higher the ratio, the better the business is at managing customer credit. A high AR turnover ratio generally implies that the company is collecting its debts efficiently and is in a good financial position.
A receivable turnover ratio is 7.8 means that, on average, a company will collect its accounts receivable 7.8 times per year. A higher number is better, since it means the company is collecting its receivables more quickly.
??Inventory turnover ratio: Cost of goods sold/ average inventory
It calculates the number of times a company has sold and replenished its inventory over a specific amount of time. The formula can also be used to calculate the number of days it will take to sell the inventory on hand.
Example, an inventory turnover ratio of 1.5 means that a company has sold its entire inventory 1.5 times in a given period of time. This indicates that the company is selling its inventory at a good rate and that it is managing its inventory efficiently.
?? Asset turnover ratio: Sales/ Total assets
It is a measurement that shows how efficiently a company is using its owned resources to generate revenue or sales. It shows that how many sales were generated from every penny of company assets.
For instance, an asset turnover ratio of 1.4 means you're generating Rs 1.40 of sales for every Rs of assets your business has.
Efficiency ratio can also be measured in days.
In conclusion, understanding how to read a balance sheet is an essential skill for investors, business owners, financial analysts, and anyone interested in the financial health of a company. By breaking down the key components of a balance sheet, you can gain valuable insights into a company's assets, liabilities, and equity, helping you make more informed financial decisions.
I hope that this article has provided you with a clear and insightful guide to understand and analyze a balance sheet. Remember, practice makes perfect, and the more you delve into real-world financial statements, the more proficient you will become in evaluating a company's financial position.
Have a wonderful time ahead.