The financial statements of a company are the first point of reference for potential investors and lenders to ascertain the financial health of the organization. These financial statements include three key aspects namely the balance sheet, profits and loss statement, and cash flow statement. But knowing these statements is not enough. The ability to read these statements and correctly interpret them is what helps in creating a sound portfolio or investment.
Given below is a simple way to understand various aspects of the balance sheet and what they say about the entity as a whole.
Read More: What is Equity Share Capital?
What is a balance sheet and why is it important?
A balance sheet is a record of the company’s assets and liabilities that are represented at their book values. It reflects the company’s financial position at any given date, usually the end of the financial year or a quarter. The balance sheet gives the details of the assets and liabilities of the company along with the owners’ funds.
This statement is used to calculate important ratios that can reflect the financial health of the company. Therefore, a balance sheet can be used to ascertain the relative position of the company by comparing the same not only with the previous balance sheet for a corresponding period but also by comparing the same with that of the peers. An important distinction between a balance sheet and other financial statements is that a balance sheet reflects the position of the company at any given date while the latter two are a record of the transactions throughout the financial year or any other period of consideration (like a quarter).
What are the components of a balance sheet?
The figures represented in the balance sheet are the book values or the final balances of the various assets and liabilities of the company as of the record date. While preparing a balance sheet, one has to ensure that the combined value of the owner’s equity and the total liabilities of the company have to be equal to its total assets. The detailed interpretation of each aspect of the balance sheet is mentioned hereunder.
- Shareholder’s funds
This is the first section of the balance sheet on the left side. The share capital section includes the amount of share capital as well as the preference share capital (if any) of the company. Furthermore, any accumulated reserves and surplus which includes retained earnings for the current year as well as over the years along with any other statutory reserves are also included in the shareholder’s funds. Any material change in the shareholder’s funds has a lasting impact on the company and ultimately its EPS. The amount of reserves in this category does not mean the entire amount is available for the distribution of dividends. Dividends can be distributed only out of free reserves after adhering to other regulations regarding the same.
- Liabilities
The next part of the balance sheet on the left side is the liabilities of the company. The long-term liabilities of the company are loans with a maturity of more than 1 year and include secured loans where assets are used as collateral to get such loans. The funds are utilized for the growth and expansion of the business. The current liabilities are the other part of liabilities in the balance sheet which includes the accounts payables (creditors, short-term borrowings, etc.).
- Assets
The assets of the company are shown on the right side of the balance sheet and can be classified based on the tenure for which they are held or in the form of tangible and intangible assets. The fixed assets or the non-current assets of the company are the long-term assets that are crucial for the business and can also be used as collateral for secured loans. These assets also include intangible assets like patents, The second portion of the assets is the current assets which include the accounts receivables (debtors), inventory, cash and cash equivalent, prepaid expenses, etc.
What are the important ratios to analyze to read a balance sheet?
The components of the balance sheet are used to analyze the position of the company by computing key ratios under fundamental analysis. These ratios are then compared to the industry standards as well as peers to understand the financial health of the organization. Some of the key ratios that can be computed from the balance sheet are mentioned below.
- Debt-equity ratio
The debt-equity ratio is derived by comparing the existing debt and equity capital of the company. This ratio is reviewed by lenders and potential investors before providing additional funds to ascertain the viability of such funds. There is no standard debt-equity ratio across all sectors and it can vary depending on how capital-intensive the business is. However, most experts believe that a company that is quite higher than the industry standards is a clear warning sign for potential investors.
The current ratio of the company is derived by dividing the current assets by the current liabilities of the business. The ideal current ratio in most industries is 2:1 which is considered to be a sign of a healthy entity. However, it may differ depending on the industry. When the current ratio is quite higher than the industry average, it implies that the business is not using its current assets efficiently. On the other hand, a lower current ratio will indicate that the business will have difficulty in meeting its short-term obligations and have difficulty in meeting working capital requirements.
- Quick ratio
Liquidity is the key to the smooth functioning of any business and quick ratio is the best measure of the same. The quick ratio is derived by dividing the liquid current assets (cash and cash equivalent, accounts receivables, short-term investments, etc.) by the current liabilities. The ideal quick ratio across many industries is considered to be 1:1. A company having a good quick ratio assures the investors that they can meet their current liabilities with ease.
Conclusion
The knowledge of reading balance sheets correctly can help investors and other stakeholders ascertain the true position of the company as of the balance sheet date. This helps them in better assessment of the companies’ performance with respect to its previous years as well as their peers. However, to get a complete picture of the company’s financials, it is important to review the other components of financial statements, the profit and loss statement, and the cash flow statement.
FAQs
The other ratios that can be interpreted using a balance sheet are the asset turnover ratio and the inventory turnover ratio to ascertain the efficiency in utilizing the assets of the entity and the usage of inventory respectively.
A standalone balance sheet can be used to calculate necessary ratios and reflect on the relative position by comparing it to industry standards. However, by comparing the current balance sheet with the previous ones, one can understand the material changes between the two balance sheet dates and the impact of the same on the business.
Most experts believe that the ideal, current ratio is between 1.5 to 2 depending on the nature of the industry.
ROE (Return On Equity) is calculated by dividing the net profit of the company by its equity share capital. It provides the returns generated by the company for its equity shareholders.
