How to read a balance sheet
The primary statements of an organization’s financial performance include the balance sheet, profitability statement, and cash flow. These contain important performance indicators, and one of the most relevant parts of financial statements is the balance sheet. It provides a summary of a business at a given time in the form of the resources available to an entity and how they are funded.
The balance sheet becomes a crucial statement to understand and analyze in determining whether an organization is in good shape or in difficulty. Most often, users of financial statements tend to conclude on the performance of an organization by reading the income statement (P&L) while the fact remains that it is the balance sheet that gives a better idea of the financial position of an entity.
The income statement records only the comprehensive income and profitability of an entity. As an example, suppose a company has a turnover of 200 crore with a profit of ₹ 20 crore, which indicates that the entity has a profit of 10% and is functioning well. Now, if one has access to the information that the entity has trade receivables of 125 crore, the additional information would take the notes a little deeper, could give you vital information. Now suppose we observe that the contributions for more than 6 months are ₹ 100 crore. Your opinion of the business changes as the business has higher debt days. If you have a high number of debit days, it means your business has less cash to use.
The balance sheet summarizes the financial position of a company at a given time. It has four main sections: assets, liabilities, equity and notes.
This section contains the company’s asset accounts, which are further subdivided into – current assets and non-current assets. Current assets are assets with an accounting life of less than one year and include accounts such as accounts receivable, inventories, cash and cash equivalents, and advances. Current assets form the basis of the company’s working capital. Non-current assets, on the other hand, are assets with a useful life of more than one year and include accounts such as property, plant and equipment, land, goodwill.
This section contains liability accounts, ie amounts owed to third parties, and subdivided into – current liabilities and non-current liabilities. Current liability contributions that are payable in less than a year and include such items as accounts payable, unearned income, and the current portion of long-term debt. Current liabilities form the other end of a company’s working capital. Non-current liabilities are due with an accounting life of more than one year which includes items such as long-term debt, rental obligations
The last section is shareholders’ equity. This section summarizes the value accruing to the shareholders of the company. It includes paid-up share capital and retained earnings generated by the organization over the period.
Why is it important ?
The balance sheet is a very important financial statement for many reasons. It can be analyzed independently or in conjunction with other statements such as income statement and cash flow statement to get a complete picture of the health of a business. Some of the important financial performance indicators include:
Liquidity: Current assets must be greater than current liabilities, so that the company can cover its short-term obligations. The current ratio and the quick ratio are examples of financial measures of liquidity.
Leverage: Comparing debt to equity and debt to total capital that show the total amounts owed to external parties are common ways to assess balance sheet leverage.
Efficiency: By using the income statement in conjunction with the balance sheet, it is possible to assess the efficiency with which a company uses its assets. For example, dividing revenue by average total assets produces the asset turnover ratio to indicate how efficiently the business turns assets into revenue. This will indicate the number of times the assets are surrendered during a fiscal year. The higher the speed or number of revolutions, the better for the business.
Rate of return : It can be used to assess how well a business is generating returns. For example, dividing net income by equity produces return on equity (ROE) and dividing net income by debt plus equity gives return on capital employed (ROCE).
Ultimately, a good balance sheet that has assets rather than liabilities and should have most of the following attributes: smart working capital, positive cash flow, balanced capital structure where there is a balance between use and source assets, and assets that generate income.
(The author works with RVKS and Associates, Chartered Accountants.)