How to Read a Balance Sheet in 5 Easy Steps?

Intelligent investing is the best way to grow one’s wealth in today’s world where the conventional methods of investing money like fixed deposits, recurring deposits, etc. do not give enough rate of interest even to beat inflation.

Now, the question arises – how to do intelligent investing in stocks?

Since there is no shortcut to success, one needs to be thorough in one’s research before making an investment decision. While researching about a company’s financial health and future growth prospects, one of the best tools available to investors for fundamental analysis of a company is balance sheet.

Therefore, it is very important to learn how to read a balance sheet of a company.

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Also Read:

How to Read a Profit & Loss Statement in 5 Easy Steps?

How to Read a Cash Flow Statement in 5 Easy Steps?

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The balance sheet is prepared on a flow basis, which means that it has financial information pertaining to the company right from the time it was incorporated. It discusses how the company has evolved financially over the years.

Let us have a look and read a balance sheet of Mahindra CIE Automotive Ltd. for the twelve months ended December 31, 2017. 

We will discuss its different aspects in 5 easy steps:

 

1. Balance Sheet Equation

First of all, we must know about the balance sheet equation which is the underlying property of it. The equation is –

Assets = Liabilities + Shareholders’ Equity

This means that the assets of the company should be equal to its liabilities. This is because everything that a company owns (Assets) has to be bought either from the owner’s capital or liabilities.

This is the balance that needs to be maintained. Owners Capital is the difference between the Assets and Liabilities. It is also called the ‘Shareholders’ Equity’ or the ‘Net worth’.

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2. Understanding Different Kinds of Liabilities

The liabilities part of the balance sheet lists all the financial obligations a company owes to outside parties.

Shareholder’s Funds: Since as per the accounting principles, the owner of the business and the company are separate and have separate accounts, shareholders’ funds do not belong to the company as it rightfully belongs to the company’s shareholders’.

Therefore, from the company’s perspective the shareholders’ funds are an obligation payable to shareholders’ and are shown on the liabilities side of the balance sheet.

Non-Current Liabilities or Long-term borrowings – They are debts and other non-debt financial obligations which need to be repaid after a period of at least one year from the date of the balance sheet.

Long-term provisions – They are generally funds set aside for employee benefits such as gratuity, leave encashment, provident funds, etc.

Current liabilities – They are the company’s liabilities that need to be repaid within the time period of one year. Current liabilities include both short-term borrowings like accounts payables and the current portion of long-term borrowings like the latest interest payment on a longer-term loan like a 10 or 20-year loan.

Short-term provisions – They are similar to long-term provisions but obviously for a short-term duration.

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3. Dig Deeper

Now, after knowing about shareholders’ equity and various kinds of liabilities, one should try to read between the lines and find out relationships between various components of the different financial statements.

For example, one of the most important thing to see about any company is its debt to equity ratio (D/E ratio). This is used to measure a company’s financial leverage. It indicates how much debt a company is using to finance its assets relative to the value of shareholders’ equity.

It is calculated as follows:

Debt/Equity Ratio = Total Liabilities / Shareholders’ Equity

A high debt/equity ratio generally would mean that a company has been aggressive in financing its growth with debt. Now, this is a double-edged sword.

If a lot of debt is being taken by the company, it may result in more earnings and more growth of the company. But it will be helpful only if the increase in earnings is way more than the debt costs. Otherwise, if the cost of debt financing ends up outweighing the earnings, it may be a harmful thing for the investors of the company.

Thus, there should be a perfect balance for better profitability.

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4. Understanding Different Types of Assets

The Assets side of the balance sheet shows all the assets owned by a company. Assets are the resources held by a company helpful in generating revenues. Assets are of different types:

Non-Current Assets – These are also called fixed assets and enjoyed for long periods (beyond at least 365 days). Fixed assets (both tangible and intangible) cannot be liquidated easily.

That means, they cannot be sold and converted into cash easily. Some examples of tangible fixed assets are land, plant and machinery, vehicles, buildings, etc. Examples of intangible fixed assets are patents, copyrights, trademarks, designs etc.

Current Assets – They are the liquid assets that can be easily converted to cash. These are used to fund the daily operations of a company.

The most common current assets are cash and cash equivalents, inventories, receivables, short-term loans and advances and sundry debtors. Inventories are basically goods at various stages of production that have not yet been sold.

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5. Understanding Financial Ratios

After understanding different components of the balance sheet, let us try to learn different financial ratios which help in depicting the true picture of a company. They are more helpful when studied in comparison with previous years and other companies in the same industry.

Financial ratios are of various types. Since this article is about balance sheets, let us talk about the ratios that cover some of the balance sheet items.

Total Asset Turnover Ratio

This ratio measures the assets activity and the company’s ability to generate sales through its total assets. It is calculated by dividing the net sales by average total assets:

Total Asset Turnover = Net Sales / Average Total Assets

The higher this ratio, the better it is for a company. This is because it means that it can generate more sales with some certain level of assets. Total asset turnover ratio should be compared with other similar sized companies within the industry.

Current Asset Turnover Ratio

This ratio measures the assets activity and the company’s ability to generate sales through its current assets. It is calculated by dividing the net sales by average current assets.

Current Asset Turnover = Net Sales / Average Current Assets

Just like the total asset turnover ratio, high Current asset turnover ratio is also better for a company.

Accounts Receivable Turnover Ratio

This ratio measures the number of times accounts receivable can be turned by a company into cash. This basically indicates the liquidity of its accounts receivables. It is calculated by dividing the net sales by Average Net Receivables

Accounts Receivable Turnover (Times) = Net Sales / Average Net Receivables

When compared with previous years, the decreasing trend of this ratio shows a negative picture about the company because it would mean that the ability to turn accounts receivable into cash has become lower.

Accounts Payable Turnover Ratio

This ratio measures the number of times per year a company pays its debt to suppliers (creditors). It is calculated by dividing Cost of goods sold by Accounts payable.

Accounts payable turnover (Times) = Cost of goods sold / Accounts payable

Higher accounts payable turnover ratio indicates the ability of a company to pay its debt to creditors frequently and regularly, which is good for a company’s investors.

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Final Words

After discussing various components of the balance sheet and how to read the numbers, one should carefully analyse the risks and returns related to investing in a company.

Also, one must analyse the relationship of items on different financial statements (balance sheet, profit & loss statement and cash flow statement). The numbers of a company may not mean anything when seen alone but they make a lot of sense when compared with numbers of similar-sized peers of the same industry and last years’ comparison with itself.

So, one needs to work hard and be comfortable with all the items of the financial statements in order to reach one’s financial goals by investing in stocks.

In case you are looking to start stock market trading or investments in general, let us assist you in taking the next steps forward.