What Is Balance Sheet?
The balance sheet of a company gives us information about the assets, liabilities, and shareholders equity. Balance sheet gives us an idea about the assets and liabilities of a company, as of a specific date.
All the items defined in a balance sheet are as of a specific date.
The balance sheet gets prepared on a flow basis, which means, it has financial information about the company since it was incorporated that is to say how the company has evolved financially over the years.
How To Analyze Balance Sheet Of A Company?
If you want to know how to analyze balance sheet of a company one should be aware about the assets, liabilities, and equity, as these are components of a balance sheet given in an annual report of the company.
Let’s discuss more about income statement and balance sheet, the two most important financial statements of a company first. Let’s try to understand this through an example.
Suppose you want to set up an auto manufacturing plant yourself however you do not have enough funds and need some money for the same. You have three options to raise funds:
1: Take a loan at a fixed rate of interest from the bank or NBFC
2: Take money from your friend and make him on board as an investor/shareholder of your company
3: A mix of the above two options
Let’s say you chose the third option i.e. take some money on interest from bank and rest from your friend. Now suppose your total initial requirement is Rs 2,00,000 to setup the auto manufacturing plant.
You have decided to take a loan of Rs 100,000 from the bank and borrow the remaining Rs 100,000 from your friend. You decided to use the funds for the following purposes:
Rs 85,000 for machines
Rs 90,000 for building & other infrastructure and
Rs 25,000 for raw materials etc.
Before we move further I want you understand few important terms at this juncture:
What Is An Asset?
Here is the book definition which says, An asset is a resource with economic value that an individual, corporation, or country owns. In simple terms a useful or valuable thing.
You might have heard people saying ‘my friends are my assets’. But usually they do not know that assets are always equal to liability😂, how you will get to know later in the post.
Types of Assets, see the image below:
All the tools, machines, infrastructure, building and other things acquired by you for manufacturing are called assets. That is to say everything bought and owned by you using the money you raised, is classified as an asset.
Assets are created when funds are utilised to buy things that are going to help generate cash in the future. In above case, machines are acquired using the funds you raised and will help you generate cash in the future.
Assets further are classified into fixed, tangible & immovable assets and movable current assets. Plant and machinery will be classified as fixed, tangible and immovable assets because they are relatively immovable and have a very long life.
Whereas raw materials will be classified under movable current assets, as they have a very short life span and will be required to change at regular intervals.
What Is A liability?
In layman term, Liability means credit that’s it. Credit of an individual like loan, bills or a debt of an organization payable to banks or other lender. You can say it is a thing for which someone is responsible, especially an amount of money owed.
Types of liabilities check the image below:
As we know now that assets are brought by using funds, liabilities are the source of funds. As mentioned above, we have two sources of fund: banks and your friend. Hence the Total liability is Rs 2,00,000.
Liability, shows the company’s obligation, Any company takes up the obligation because it believes these obligations will provide economic value in the long run.
In laymen term Liability is nothing but the loan that the company has taken, and it is obligated to repay. Typical examples of obligation include short term borrowing, long term borrowing, payments due etc. Liabilities are of two types, namely current and non-current.
The most important thing to understand here is assets are always equal to liabilities.
The company’s total assets should be equal to the company’s total liabilities. Hence,
Assets = Liabilities
The equation above is also known as the balance sheet equation or the accounting equation. To be precise, above equation depicts the balance sheet’s key property, i.e. the balance sheet, should always be balanced.
In other words, the Assets of the company should be equal to the Liabilities of the company. This is because everything that a company owns (Assets) has to be purchased either from the owner’s capital or liabilities.
What Are Equity?
In layman terms equity is nothing but ownership. There are various types of equities however in stock market world it is known as shares or stock. How much you own a equity in a particular stock refers to as equity holding.
In the accounting terminology or corporate world, equity (or more commonly, shareholders’ equity) means the amount of capital contributed by the owners.
In other words the difference between a company’s total assets and its total liabilities. If a person owns 1000 shares of total 100000 shares, then he owns 1% of the company.
Owners Capital is the difference between the Assets and Liabilities. It is also called the ‘Shareholders Equity’ or the ‘Net worth’. Representing this in the form of an equation :
Shareholders equity = Assets – Liabilities
The amount you borrowed from bank needs to be repaid over the next few years and will be classified as long term liability. Where as money you raised from your friend is not a loan but an investment in your company.
Thus it is classified as shareholder’s equity and your friend will be a shareholder of the company. Equity refers to the initial investment put in by different investors/shareholders.
In above case, it would be equal to Rs 100,000 investment put in by your friend.
A company can raise more funds through equity route by issuing new shares. In such a scenario equity will increase by a proportionate amount.
Leverage is the ratio of debt to debt plus equity (debt/(debt+equity). In above case leverage is 50% (=100,000/200,000).
Hence your auto manufacturing firm is 50% leveraged. The debt/equity ratio of 1:1 or 50%:50% in this case, is also known as the capital structure of the firm. It tells us how much debt company has borrowed, compared to equity.
I hope you have got the basic idea behind assets, labilities and equity. Also keep in mind that Assets and Liabilities are part of balance sheet statement and not P&L.
The reason I told you before discussing the balance sheet statement is to make sure you have a basic understanding when you see the balance sheet on AR while we discuss.
For understanding purpose I have taken Tata Motors Limited (TML) Annual report, you can download Tata Motors Limited annual report here or even can get it from its website.
Standalone Financial statements represent the company’s standalone numbers/ financials and do not include its subsidiaries’ financials.
Whereas, the consolidated numbers include the companies (i.e. Standalone financials) and its subsidiaries financial statements.
Hence you should look through the consolidated financial statements as it represent the company’s financial position better.
Take a a look at the consolidated balance sheet of Tata Motors Group below:
As you can see in the balance sheet it contains details about the assets, liabilities, and equity. We have already understood about assets, liabilities and equity above, before knowing more under it you should know in brief about equity share capital.
Let us first understand more about the liabilities section of balance sheet rather than asset, which we will going to understand later on in the post.
The first line item in the Balance Sheet (under Equity and Liability) is the share capital (as pointed out by the green box). If you notice, there is a note number associated (orange box) with equity share capital.
They are called the ‘Schedules’ or note number related to the financial statement.
Most item will have a note number as you can see in orange box, if you go down in annual report and check the particular note number, it tells you more about how that figure has been calculated.
For example, Looking into the above statement, Tata Motors states that the equity share capital stands at 765.81 crores, To know how it gets calculated, one needs to look into the associated schedule (note number 23).
Please look at the snapshot below:
Share capital is nothing but represents the shareholders wealth, but the problem here is how can equity share capital comes under liabilities side in balance sheet which in reality is an asset (funds).
This is because equity share capital do not belong to the company it actually belongs to its shareholders.
Hence from the company’s perspective, the share capital are an obligation payable to shareholders. That is why this is shown under the liabilities side of the balance sheet.
The liabilities side of the balance sheet details all the liabilities of the company. Within liabilities, there are three sub-sections equity share capital sometime it is also called as shareholder funds, non-current liabilities, and current liabilities.
The first section under equity is the share capital. As shown in above snapshot it is Rs.765.81 crores, now to understand equity share capital assume for a moment that there is company by name XYZ.
XYZ issues 10000 shares, with each share having a face value of Rs.5 each. In this case, the share capital would be Rs.5 x 10000 = Rs.50,000/- (Face value * number of shares).
In the case of TML, the share capital is Rs.765.81 Cr (as published in the Balance Sheet), and the Face Value is Rs.2/-. as shown in notes 23 section, by the way this is also mentioned on NSE website under VWAP as shown below in snapshot taken.
You can use the FV and share capital value to calculate the number of shares outstanding. We know:
Share Capital = FV * Number of shares
Therefore,
Number of shares = Share Capital / FV
Hence in case of Tata Motors,
Number of shares = 765.81/2
= 382.905 cr shares
So above are number of shares which are outstanding right now for Tata motors limited. At the point of TML IPO, the shares were not fully subscribed, hence you can see the difference between issued and subscribed. This will continue to reflect in the BS.
The next line item on the Balance Sheet’s liability side under equity section is the ‘other equity’. Usually these are Reserves money kept by the company for specific purposes. The surplus is where all the profits of the company reside.
The reserves and surplus for TML stands at Rs.54,480.91 crores which is by the way less than previous years (2020) reserves which was at Rs.62,358.99.
This is quite obvious due to the pandemic as some part of it has been used in some specific purpose.
If we check the particular not number 24 it shows all the component under other equity.
Notice how the previous year balance sheet number is added up to this year’s number. This highlights that the balance sheet is prepared on a flow basis, adding the carrying forward numbers year on year.
The total shareholders fund is a sum of share capital and other equity and its components. Since this amount on the balance sheet’s liability side represents the money belonging to shareholders’, this is called the ‘shareholders funds’.
One not need to check what all reserves company has acquired instead just check big number to know how much it has declined or advanced in last couple of years.
This money can be used to pay dividends or repay any borrowings or loans further. So just keep in mind higher the reserves better is for the company.
Now let us move on to the liabilities section further and understand what are Non Current Liabilities and Current Liabilities.
What Is Non Current Liability In Balance Sheet?
Non-current liabilities represent the long term obligations, which the company expect to settle off not within 365 days/12 months of the balance sheet date. These obligations stay on the books for a couple of years.
Non-current liabilities gets usually settled 12 months after the reporting period.
Here is the snapshot of the non-current liabilities of TML below:
There are mainly three types of non-current liabilities;
- Borrowings
- Provisions
- Deferred Tax Liability
Let us know in brief about every type of non current liabilities TML have.
Borrowings (associated with note 26) is the first line item within the non-current liabilities. As company aspire to pay it off after some time it is called Long term borrowing.
It is one of the most important line items in the entire balance sheet as it represents the amount of money that the company has borrowed through various sources.
You do not need to go into nitty gritty as in plain language the lesser the borrowing the better it is for any company.
Having said that, you will find that there are many companies which do not have long term borrowings (debt). While it is good to know that the company has no debt, you must also question why there is no debt?
It may be because the banks are refusing to lend to the company? Or is it because the company is not taking initiatives to expand its business operations.
As in above case with TML, the borrowing have increased for the company which is obvious due to pandemic.
The next line item within the non-current liability is the ‘provisions’. Long term provisions are usually money set aside for employee benefits such as gratuity; leave encashment, provident funds etc.
The last line item within the non-current liability is ‘Deferred Tax Liability’. The deferred tax liability is basically a provision for future tax payments.
When the company foresees a situation where it may have to pay additional taxes in the future; hence they set aside some funds for this purpose.
Last but not the least is the other non current liabilities which can be government grants, employee benefit obligations, any contract liabilities.
So in totality the main point to keep in mind that Non current liabilities should be lesser and if there is increase it should be reasonable or average and not in large proportion in comparison from last couple of years.
Let us now understand in brief about current liabilities and its components in a annual report.
What Is Current Liability In Balance Sheet?
Current liabilities are a company’s obligations which are expected to be settled in lee than 365 days (within 1 year). It is quite similar to non current liabilities in terms of its components, however the term ‘Current’ is used to indicate that the obligation will be settled as soon as possible, within a year.
Where as the ‘non-current liability’ means obligations that are settled beyond 365 days.
For example, if you buy a refrigerator on EMI through credit card you usually plan to repay your credit card company within a few months. Hence, this becomes your ‘current liability’.
However, if you buy an home by seeking a 8-10 year home loan from a bank or NBFC, it becomes your ‘non-current liability’.
Below is the snapshot of TML’s current liabilities:
As you can see, there are 4 line items within the current liabilities.
Everything remains same as of non current liabilities we have covered above except the trade payables. It is also called account payable.
These are obligations payable to vendors who supply materials to the company. The vendors could be raw material suppliers, utility companies providing services, stationery companies etc.
Till now we have now gone through half of the balance sheet, which is broadly classified as the Balance sheet’s Liabilities side.
Take a look and now observe the broad numbers and compare it with last year 2020 AR.
Total Liability = Shareholders’ Funds + Non Current Liabilities + Current Liabilities
= 56,820.21 + 128,556.41 + 157,749.18
Total Liability = Rs.343,125.80 Crore
This is higher from last year liabilities, however one can consider it is a one off situation raised due to pandemic. If you check the last 4 or 5 years liabilities of TML you can get an idea that this is much higher than previous numbers.
Which means you have to wait for another quarter or half to observe the results, if you see a decline then that means it has performed up to the mark.
Now we will going to understand in brief about the assets side of balance sheet.
What Are Assets In Balance Sheet?
The Asset in a balance sheet shows us all the company’s assets (in different forms) since its inception. Assets in layman terms are the resources held by a company, which help them in generating the revenues. There are 2 kinds of assets Non-current assets and Current assets.
Let us understand few important points about both steps by step. Below is the assets side of balance sheet snapshot of TML, take a look.
What are Non-Current Assets?
In simple terms non-current assets are type of assets that have the economic benefit of over a long period of time (beyond 365 days). As an asset owned by a company is expected to give the company an economic benefit over its useful life.
Under non current assets a company have fixed assets these are both tangible and intangible in nature that the company owns, that is to say it cannot be converted to cash easily or which cannot be liquidated easily.
For example land, plant and machinery, vehicles, building etc. Intangible assets are also considered fixed assets because they benefit companies over a long period of time.
Take a look at the below snapshot taken from TML balance sheet, keep in mind these are consolidated numbers and not standalone.
As you can see in above image the first sections shows you about the tangible asset such as property, machinery or equipment’s. Tangible assets consist of assets which have a physical form. In other words, these assets can be seen or touched.
Next you see is capital work in progress (CWIP) as the name suggest it includes building under construction, machinery under assembly etc. at the time of preparing the balance sheet. Hence it is aptly called the “Capital Work in Progress”.
CWIP is the work that is not yet complete but where capital expenditure has already been incurred. Once the construction process is done, and the asset is put to use, the asset is moved to tangible assets (under fixed assets) from CWIP.
On the other hand if we talk about Intangible assets these are assets which have an economic value but do not have a physical nature. This usually includes patents, copyrights, trademarks, designs etc.
If you want you can see the notes associated with particular type of non current assets to know more. Likewise there are Intangible assets under development similar to Capital work in progress except it is talking about intangible and not tangible.
Moreover there are some investments done in equity which is known as Investment in equity accounted investees, then there are loans and advances under financial assets.
These are loans and advances given out by the company to other group companies, employees, suppliers, vendors etc.
Overall, things which a company owns for long terms non current assets, as of 2021 march Rs.2,02,534.01 crore of non current assets TML hold.
What are Current Assets?
As the name suggests current assets are those assets that can be quickly converted to cash, such assets can be used within 365 days incase if company needs urgent money. Generally, current assets are the assets that a company uses to fund and utilize its day to day operations and ongoing expenses.
Some of the most common example of current assets are cash and cash equivalents, inventories, receivables, short term loans and advances etc.
Below is Tata Motors Limited current assets as per its consolidated balance sheet for FY21 March, take a look:
As you can see in above image the first line item on the Current assets is Inventory which stands at Rs.37,456.88 Cr.
Inventory is nothing but all the finished goods manufactured by the company, raw materials in stock, goods that are manufactured incompletely and yet in process.
Inventories are goods at various stages of production and therefore have not been sold as of now. When any product is manufactured in a company, it goes through various raw material processes to work in progress to finished good.
As we have discussed above the rest line items in current assets are somewhat similar to non current assets with only difference is current assets can be used immediately as it is more easily and quickly converted to cash.
Trade Receivables sometime also referred to as Accounts Receivables represents the amount of money that the company is expected to receive from its distributors, customers and other related parties.
Cash and Cash equivalents, is one of the most liquid assets found in any company’s Balance sheet. Cash comprises of cash on hand and cash on demand.
Cash equivalents are short term, highly liquid investments with a maturity date of less than three months from its acquisition date.
We have now run through the Balance sheet’s entire Assets side, as well as balance side and in fact the whole of Balance sheet itself. Let us relook at the balance sheet in its completely :
As you can see in the above, the balance sheet equation holds for TML’s balance sheet,
Total Assets = Rs.343,125.80 Cr
Total Liabilities = Rs.343,125.80 Cr
Asset = Shareholders’ Funds (share capital) + Liabilities
So to conclude and summaries, assets are obtained by using funds and liabilities represent sources of funds. Hence assets are always equal to liabilities.
I hope now you have the basic understanding of How To Analyze Balance Sheet Of A Company In India, But this is not the end, there are other 2 financial statements you should read and understand i.e. Profit and Loss and Cash flow statement to gauge the complete knowledge about how company have performed in an financial year.
I do not want to make it a overdoes hence you can click on above link to know more about them in a detailed way.
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