Understanding and Interpreting Company Balance Sheets - with example

Have you ever prepared your personal sheet of Assets and Liabilities to calculate your financial net worth? Yes? 

Congratulations ! You already know how to prepare balance sheets. Company balance sheets are just a shade above your personal balance sheet of Assets, Liabilities and net worth...Read on..

Why Balance Sheets are needed?

A balance sheet is also known as a statement of financial position. The balance sheet, together with the income statement and cash flow statement, make up the cornerstone of any company's financial statements. 

If you are a shareholder of a company, it is important that you understand how the balance sheet is structured, how to analyze it and how to read it. The balance sheet is a key tool in learning to manage your overall risk of a company. 

A balance sheet can help you determine what a business is really worth. When reviewed with other accounting records and disclosures, it can warn of many potential problems and help you to make sound investment decisions.

What is a Balance Sheet?

A balance sheet is a snapshot of a business that shows its assets (what is has), its liabilities (what it owes), and what value is left over (the equity). Money in any balance sheet cannot exist anywhere other than these 3 buckets.

While we explain you the basic concepts of a Balance sheet, in parallel, we will show you an example from the Annual Report of Reliance Industries so that you can relate to the concepts quickly and clearly.

The Balancing Formula

A Balance sheet lists the Assets on one side and Liabilities + Shareholders Equity on the other side. And the two sides are perfectly balanced, thus giving it the name of a 'Balance Sheet'. 

The high level formula behind balance sheets is: Assets = Liabilities + Shareholders' Equity

A company has to pay for all the things it owns (assets) by either borrowing money (taking on liabilities) or taking it from investors (issuing shareholders' equity). Total assets must equal the liabilities plus the equity of the company. 

SIDE 1 : ASSETS

Have a look at the Assets portion of the Balance sheet for Reliance Industries before I explain you about each of the components inside it.

Please understand that there can be subtle variances in the balance sheet of various companies even within the same industry. the explanations given below are kept as generic as we could so that you are able to read and interpret the balance sheets of any company.

Just like your personal Assets, company Assets can be of two categories:

(A) Current Assets 

These are similar to short term investments in personal finance.

Those company assets that have a life span of one year or less are known as Current Assets. Such assets can be converted easily into cash. Because these assets are easily turned into cash, they are sometimes referred to as liquid assets.

Such asset classes typically includes:

(a) Cash and cash equivalents

(i) Cash and Cash Equivalents under the current assets section of a balance sheet represents the amount of money the company has in the bank, whether in the form of cash, savings bonds, certificates of deposit, and money invested in money market funds. It tells you how much money is available to the business immediately. 

(ii) Generally speaking, the more cash on hand the better, though excessive amounts are likely to make investors unhappy as they would rather have the money paid out in the form of a dividend to be reinvested, spent, saved, or given to charity.

(iii) A decent amount of cash-on-hand gives management the ability to pay dividends and buy back shares, but more importantly, it can provide extra wiggle-room if and when the company runs into any financial difficulties.

(iv) There are some cases where cash on the balance sheet isn't necessarily a good thing. If a company is not able to generate enough profits internally, it may borrow money from the bank, and the money sitting on its balance sheet as cash may actually be borrowed money. To find out, you will have to look at the amount of debt the company has, which is shown in its balance sheet liabilities section. 

(v) When analyzing a company balance sheet, understand that not all current assets on the balance sheet are equal. Some companies can place money in instruments such as auction- rate securities that they treat as safe cash alternatives. The market for these instruments could, in reality, dry up and it could take weeks, months, or even longer to convert them back into cash.

(vi) As an investor, it pays to be wary of exposing your portfolio to a firm that has too many questionable securities under its current assets section.

(b) Accounts receivables (Trade Receivables)

(i) Accounts receivables consist of the short-term obligations owed to the company by its clients. Companies often sell products or services to customers on credit; these obligations are considered as current assets. When a client pays, there's a transaction from accounts receivables to cash.

(ii) Accounts receivable, sometimes shortened to "receivables" or A/R, represents money that is owed to a company by its customers for products or services that it has delivered but for which it has not yet received payment.

(iii) The nature of a company's accounts receivable balance depends on the sector and industry in which it operates, as well as the particular credit policies management has set in place. Companies document their A/R on the balance sheet, as a current asset. 

(iv) Having a large A/R balance on the balance sheet seems positive. You would think every company wants a flood of future, expected cash coming their way. However, money in A/R is money that's not in the bank, which exposes the company to a degree of risk. All the talk about Non Performing Assets by the bank are a result of this risk. 

(v) Ideally, the A/R should be well diversified. If one customer or client represents more than five or 10 percent of the accounts payable, this creates exposure and might be cause for concern.

(c) Inventory

(i) The items lying in the company's inventory which can be liquidated in a span of one year are covered under this head. 

(ii) When looking at a company's current assets, you need to pay special attention to its inventory. Inventory consists of merchandise a business owns but has not yet sold. Because investors assume that inventory can be sold in the near future, turning it into cash, it is classified as a current asset. 

(iii) For certain types of businesses, inventory on the balance sheet is among the most important items you'll need to analyze because it can give you insight into what is happening with the core business in ways nothing else can.

(iv) When too much inventory remains on the balance sheet, there is a major risk of a product or products becoming obsolete. This means that the company will either be unable to sell the inventory or must reduce the price of the inventory, sometimes substantially, to sell it as there are now more attractive, newer goods on the market. 

(v) Spoilage in an inventory can occur when a product actually goes bad and cannot be sold. This is a serious concern for companies that manufacture, assemble, and distribute perishable goods.

(vi) When inventory is stolen, shoplifted, and embezzled, it is referred to as shrinkage. The more inventory a firm has on the balance sheet, the greater the chance it's going to be stolen. This is the reason that inventory-heavy companies with a lot of public access are so extraordinarily sophisticated at risk mitigation.

(B) Non-current Assets

These are company's long-term investments where the full value will not be realized within the accounting year. 

They can be further referred to as :

(a) Tangible assets

All assets such as machinery, computers, buildings and land are covered under Tangible Assets. These are physical assets which you can touch and feel. One of the most useful lines on a balance sheet the value of property, plant and equipment, or PP&E. Property, plant and equipment represents the so-called fixed assets of an enterprise. This includes the real estate, buildings, office furniture, file cabinets, computers, factories, vehicles and other tangible things that allow a company to conduct operations in pursuit of generating revenue and, ultimately, a profit. 

(b) Intangible Assets

(i) Non-current assets can also be intangible, such as goodwill, patents or copyright. While these assets are not physical in nature, they are often the resources that can make or break a company — for example the value of a brand name. 

(ii) Economic goodwill, which is frequently referred to as franchise value these days, consists of the intangible advantages a company has over its competitors such as an excellent reputation, strategic location, business connections, etc. 

(iii) While every effort should be made for businesses to carry these intangible assets at costs on the balance sheet, they are sometimes given what amounts to near arbitrarily meaningless values.

(iv) When analyzing a balance sheet, you should generally ignore the amount assigned to intangible assets or, at the very least, take it with more than a grain of salt. These intangible assets may be worth a huge amount in real life but the recorded accounting value probably doesn't approximate it to any degree of meaningful accuracy. 

Depreciation is calculated and deducted from most of these assets, which represents the economic cost of the asset over its useful life.

SIDE 2 : LIABILITIES and SHAREHOLDER EQUITY

Have a look at the Liabilities portion of the Balance sheet for Reliance Industries before I explain you about each of the components inside it.

Please understand that there can be subtle variances in the balance sheet of various companies even within the same industry. the explanations given below are kept as generic as we could so that you are able to read and interpret the balance sheets of any company.

On the other side of the balance sheet equation are the liabilities. These are the financial obligations a company owes to outside parties. Like assets, they can be both current and long-term. 

(A) Non-current Liabilities
Non-Current or Long-term liabilities are debts and other non-debt financial obligations which are due after a period of at least one year from the date of the balance sheet.

(B) Current Liabilities

These are the company's liabilities which will come due, or must be paid, within one year. This includes both shorter-term borrowings, such as accounts payables, along with the current portion of longer-term borrowing, such as the latest interest payment on a 10-year loan.

(a) Accounts payable

(i) This is the opposite of accounts receivable. It arises when a company receives a product or service before it pays for it. 

(ii) Accounts payable, or A/P as it is often shorthanded, is one of the largest current liabilities a company will face because they are constantly ordering new products or paying wholesale vendors and suppliers for services or merchandise. 

(iii) Well-Managed companies attempt to keep accounts payable high enough to cover all existing inventory. In effect, this means that the vendors are paying for the company's shelves to remain stocked.

(b) Accrued Benefits and Payroll

This item in the current liabilities section of the balance sheet represents money owed to employees as salaries and bonuses that the company has not yet paid.

(c) Short-Term and Current Long-Term Debt

(i) These current liabilities are sometimes referred to as notes payable. 

(ii) They are the most important item under the current liabilities section of the balance sheet and most of the time, represent the payments on a company's loans or other borrowings that are due in the next twelve months. 

(iii) Using borrowed funds is not necessarily a sign of financial weakness.

(C) Shareholders Equity

What is left over for the owners of the company when all debts were paid off? That amount is called the Book value or shareholder equity.

Shareholders' equity is the initial amount of money invested into a business. If, at the end of the fiscal year, a company decides to reinvest its net earnings into the company (after taxes), these retained earnings will be transferred from the income statement onto the balance sheet into the shareholder's equity account. 

This account represents a company's total net worth. (derived from the formula above)
Shareholders’ equity = Share capital [Assets - Liabilities] + Reserves + Surplus

Book Value Vs Shareholders Equity

You may feel that Assets -(minus) Liabilities must be nothing but the Book Value or Shareholder Equity. However, please note that the balance sheet concepts of book value, or net tangible assets, and shareholders' equity are not quite the same thing. To find a company's book value, you need to take the shareholders' equity and exclude all intangible items.

This leaves you with the theoretical value of all of the company's tangible assets which are those assets that can be touched, seen, and felt as opposed to things such as patents, trademarks, copyrights, and customer relationships. It is this distinction that causes book value to be referred to as net tangible assets.

How to get hold of a company's balance sheet?

1/ Annual Report

2/ Financial Portals 

You can use data aggregation services from various financial portals But my experience is that it's always better to go to the source. It is absolutely not difficult to trace the Balance sheet in an annual report.

As soon as you open the Annual Report of a company, straightaway go to the Index and look for Balance Sheets. Here is how the index page of the last Annual Report from Reliance Industries looks:

How does it compare with your Personal Finance?

In Personal Finance too, we create a list of our Assets as well as Liabilities and then subtract the two to get our actual personal financial net worth. This statement of our personal assets and liabilities as on a particular date is nothing but our personal balance sheet. For those who have read our book From the Rat Race to Financial Freedom or are ELITE subscribers, would relate this immediately to Step-2 of our Financial Freedom Planning activity, where we calculate our personal financial net worth.

Balance Sheet Exists as on a moment

Unlike other financial statements, the balance sheet cannot cover a range of dates.  In other words, it may be good as of December 31st, 2018, but it can't tell you about a period spanning from, say, December 1st through December 31st.  It is because a balance sheet lists items such as cash on hand and inventory, which change daily.  

Even in personal finance, when we write our Assets and Liabilities, we write the value of the Asset as on date and the value of Liability as on date.

Summary

Get hold of the company's Annual Report, read their Balance Sheet - and get better insights about the company you are trying to invest. 

When you go and buy stocks, you are actually buying a part of the company - and you must know your numbers before you go out shopping for a company.    ~ The Autobiography Of A Stock

Regards

Manoj Arora
Official Website