We have often heard that a company must have a clean Balance Sheet which would signify a healthy financial strength. But is it really possible to read a Balance Sheet and tell whether it is a good one or not? Well the answer is “Yes”.
In this video, we will understand as to how one can read & understand a Balance Sheet to know about the company’s financial health.
A Balance Sheet consists of two parts: ASSETS AND EQUITY & LIABILITIES.
Assets are the resources owned by the company to generate some income or wealth for the company.
Assets are again divided in Non Current Assets and Current Assets.
Non Current Assets are items which help the company generate revenue & are owned for long term. Eg: Machinery, Building, Land, Long term Investments etc. Long term assets generally vary from sector to sector. For example:
A realty company will generally have more of fixed assets and Investment property than a company operating in the IT sector.
Any increase in Investments into Non Current assets spells a positive signal for a company as it nurtures creation of long term assets which indicates long term growth potential of the company.
Current Assets are those which have been acquired over a period of time and can generate revenue for shorter duration.
Eg are Inventories, Trade Receivables, Short term investments, Bank Balances etc
An inventory means the company’s raw materials, work in progress, and finished goods. Kind of Inventories vary depending on the company and the nature of the industry it is operating in. For example, a manufacturing firm will carry a large amount of Inventory, while finance or an IT firm carries almost none.
Any continuous increase in Current Assets like Inventory or Trade receivables of a company points to weakness in the efficient working of the company. As it leads to tying down of the working capital without earning any revenue on it.
Next is EQUITY AND LIABILITIES?
Equity & Liabilities shows us the owner’s share of capital contribution to the company from their own pockets known as Equities and the borrowed money which the company owes to its lenders called as Liabilities. It also shows us the Loan book of the company to run the company diligently.
So what is Equity?
Equity is the capital that the owners put into their own business. Another part of the equity is the reserves or the retained earnings, which is the part of the earnings the company has kept aside as reserves for future use. This in total forms the Shareholder’s Fund.
Liabilities are again categorized under Non Current and Current Liabilities
Non Current Liabilities are liabilities to be repaid after 1 year or more. For example Secured Loans, Long term Borrowings etc.
Company needs funds to continue its operations or do Capex to expand its business, for that the company borrows money from various sources which comes under the long term borrowings.
This is one of the most important part to be seen in a business. Too much debt will lead to higher interest expenses leading to lower profits. Borrowing also varies from Industry to Industry. A manufacturing or Realty Industry will require more borrowings than an FMCG or an I.T company.
Next is Current liabilities, they represent that part of money which the company has to repay within a year.
For example Short term Borrowing, Trade Payables etc.
We must note that reading and analyzing a balance sheet will be different for different companies working in different sectors. A view in a financial company’s balance sheet will be completely different to a realty sector or any manufacturing company.
Thus any continuous increase in short term loans and Trade payables leads to deficient outlook for the company. It makes one believe that the company can be in severe liquidity crunch.
The basic idea of the balance sheet is to provide investors an idea of the company’s financial position along with what the company owns and owes. It becomes necessary for every investor to know how to efficiently read a balance sheet and pick out crucial points from it regarding the company before deciding on Investing.
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