A balance sheet is an important source of information about a company’s financial health. It gives information about its liabilities (loans, external debt, etc) and assets (fixed assets, investments, cash, etc ). Many seasoned investors use the balance sheet as a rich source of information. The balance sheet plays a critical role in big investments such as acquisitions and mergers. Besides this, savvy investors also give high importance to the balance sheet of companies that make an Initial Public Offering (IPO). Given these factors, it is important to understand the range of information a balance sheet provides. Experts believe that understanding the balance sheet of a company gives a clear picture of how efficiently it is managed. Let us understand what exactly a balance sheet contains.
The basics
The balance sheet of a company is a financial report card of a company as at the date of publishing. A company’s assets and liabilities are shown in its balance sheet. To put it simply, it shows what a company owns and what it owes. It is a very important financial statement of a company along with the profit and loss account and cashflow statement.
Balance sheet is a financial statement prepared by professionals. It has assets on one side and liabilities on the other side. To show a true picture, assets should be equal to the liabilities. Since assets and liabilities balance each other, it is termed as ‘balance sheet’. The driving formula behind a balance sheet is
Assets = Liabilities + Shareholders’ Funds
For example, when a company raises a loan of ₹100 crore, the accountant writes ‘Loan’ under the head of liabilities and at the same time shows cash balance of ₹100 crore on the assets side.
If shareholders’ funds (or shareholder’s equity) is mentioned as ₹1,000 crore, then the accountant also shows utilisation of this money on the assets’ side. The funds could be utilized in the following manner: factory & buildings of ₹800 crore and cash balance of ₹200 crore.
Assets include all that a company owns. This includes physical assets, investments, advances, inventories, semi-finished goods and cash. The assets side has two sub-heads: current assets and non-current (or long-term) assets. Current assets include those assets that are short-term in nature. They can be monetised quickly. Other assets such as fixed assets—land, building, machinery, and capital work in progress—are mentioned under the head of non-current assets.
Liabilities too are segregated under three heads. The first is shareholders’ funds. It clearly specifies the equity capital and reserves of a company. The second is current liabilities. These include money payable in the near term. Short-term borrowings, payables such as rent, labour charges, and trade payables appear under this head. The third component is non-current liabilities. Long-term loans and long-term provisions are mentioned here.
Who prepares a balance sheet?
The balance sheet of a listed company is prepared by professionals employed in its finance and accounts department. It is made at the end of each quarter for regulatory compliance. A balance sheet is audited by internal and external auditors before presenting to shareholders. Shareholders adopt the financial accounts of a company in its annual general meeting.
Benefits of a balance sheet
Analysts and savvy investors can calculate various ratios using a balance sheet. These ratios offer some insights about the financial health of a company. For example, the debt-to-equity ratio of a company, which is arrived at by dividing loan funds by shareholders’ funds, gives an idea of the leverage of a company. Other things being the same, higher the leverage higher is the risk for shareholders. It makes comparison between two companies possible.
The balance sheet also gives an idea how a business is funded. If a company does not have much long-term capital—be it equity or debt—and a large amount of money is raised only to be used for the short-term, then it can be a risky proposition. A company that relies on short-term funds runs the risk of not being able to roll over debt.
When a company shows loans and advances given to group companies in the assets side of a balance sheet, many savvy investors dig deeper. Such loans and advances can be a red flag in some cases. Promoters may be routing funds raised by the company or cash generated in one business, to its other business ventures at a very low rate of interest.
Limitations of a balance sheet
The balance sheet does not give information about many aspects of a business. It does not specify about the sales and sales growth of a company. It does not specify profitability of a company.
Though a balance sheet gives information about the capital structure of a business—the mix of equity and debt, along with the leverage involved—it does not mention the interest expense incurred. It does not give an idea of the day-to-day operations of a company. Hence, many investors use the balance sheet as one of the tools of information when arriving at an investment decision.