How To Read The Balance Sheet

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How to Read the

When it comes to evaluating a business, understanding
the balance sheet is very important. As a financial
statement, a balance sheet reports three things – assets,
liabilities and shareholders’ equity0of
1 1 a company.
01 01
01 101 010
01 101 010 010
01 101 010 010 000
01 101 010 01 00 11
1 0 0
01 01 010 010 00 1
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01 101 010 010 00 11
0
01 101 010 010 000 11
10 0 0 0 1
10 100 100 001 1
10 1 0 1
01 000 011
00 0
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Introduction
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Understanding assets
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Understanding liabilities
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n n n n n n n n n Understanding equity
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How to Read the Balance Sheet
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Introduction
A very simple financial statement, the balance sheet gives
information about three things – the money available,
outstanding loans and the difference between these two.
T
he balance sheet is one of the most statement designed to give readers information
important financial statements for an about three things – the money available to the
investor to take into consideration. company, outstanding loans and the difference
Although this accounting statement may seem between these two.
difficult to comprehend at the first glance, it is Let’s look at a simple balance sheet of an
actually a very simple statement if you know imaginary company – ABC Limited:
what you’re looking for. Before we start discussing Bank balance = `10,000; money borrowed
how to read a balance sheet, we should first from a friend = `2500 and the difference
know what exactly a balance sheet is. between these two numbers is `7,500.
This simple balance sheet tells us that the
So, what is a balance sheet? company ABC Limited has `10,000 but has to
A balance sheet is a very simple financial repay `2500 to its friend and therefore, has a
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net amount of `7,500. To ensure that the equation is

Sounds simple? That’s all about An important balanced, we need to see the source
the balance sheet. Investors should of that asset (worth `100). Broadly,
characteristic
remember that though complicated there are only two ways through
terms, such as assets (which refers to of a balance which the company could acquire
`10,000 here), liabilities (`2,500 sheet is that it the money to purchase that asset.
owed to the friend) and shareholder’s The first method is through debt
gives financial
equity (the difference between these (which means the money needs to be
two numbers) are used, the core information repaid at some point in the future).
mathematical principle is that assets of a particular The company may have taken a bank
= liabilities + shareholder’s equity. loan. In that case, the right-hand side
moment.
And if that seems like stating the of the equation – i.e liabilities – would
obvious, it definitely is also increase by `100, thereby
In fact, the word balance in the balance sheet maintaining the balance. The second is through
has been derived from the requirement that the the company’s own funds. Perhaps, it has made
left side of the equation (assets) should be equal a profit of `100 or shareholders have given extra
to the right side of the equation (liabilities + money to the company. In either case, the right-
shareholders’ equity). hand side would still increase but this time, the
shareholders’ equity would increase, too.
The format of a balance sheet:
Assets Liabilities Shareholder’s Equity
The only exception is a case wherein the
(A) (B) (C) = (A) - (B) company used money from its own cash reserve
`10,000 `2,500 `7,500 to purchase the asset. In such a scenario, the
amount of cash with the company would go
down to the same extent as the increase in asset
Characteristics of a balance sheet: size. This transaction would not affect liabilities
An important characteristic of a balance sheet is
and shareholder’s equity portions i.e the right-
that it gives financial information of a particular
hand side of the balance sheet. This is because
moment. It’s very similar to a photograph – it
only the left-hand side is modified to the extent
only reflects things as of that instant. And that’s
of redistribution among different asset classes.
why a balance sheet is a ‘snapshot in time’. And
since the quantum of assets and liabilities can
Interpretation
vary on a day-to-day basis (or even a minute-to-
Since the principle of balance is maintained,
minute basis), it is important to keep in mind the
one look at a balance sheet should broadly tell
date of preparing the balance sheet.
you two things – how big the company is
Another important feature of a balance sheet
(which can be ascertained by looking at the
is that most transactions will not affect just one
assets) and how indebted a company is, which
side. This feature is actually the characteristic of
is in terms of the size of its liabilities. This
the current accounting system and can be best
information is also given on Value Research’s
explained with an example. If a company
website under the ‘Financial’ tab. In most cases,
purchases an asset for `100, it cannot be the
the size of the assets will be greater than the size
case that only the assets of the company
of liabilities, but when a company goes through
increased. If that were the case, it would have
difficult times, it is possible that the size of
violated the basic equation.
liabilities exceeds the asset size, thereby having
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negative net-worth. Some aviation companies shareholders are likely to lose all their money).
exemplify this possibility. As a rule of thumb, it is Now that we have covered the basics of a
better to stay away from companies having balance sheet, let us try to understand more
negative net worth, as these companies are about individual balance sheet items, comprising
likely to go through bankruptcy (in that case, assets, liabilities and shareholder’s equity.
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Understanding assets
Let’s delve deeper into the assets part of the balance sheet to
understand what it communicates and how to make use of it
T
he asset side of a balance sheet, as the held for trading purposes and expected to be
name indicates, is just a list of all the converted into cash in the normal operating
valuable items owned by a company. But cycle fall into this category. These include items
it is generally classified into two broad categories like inventory, trade receivables, etc.
– current and non-current assets.
Uses of current assets
Current assets The current assets section of a balance sheet is
In layman’s terms, the key feature of current designed to help the reader understand how
assets is that these assets can be converted into easy or difficult it is for the company to carry out
cash easily. Therefore, items like bank balances, its day-to-day operations. Since borrowing
fixed deposits, liquid funds and other short-term money is a costly and time-consuming process,
investments are usually classified as current it is important for a company to have a sufficient
assets. Besides, those assets that are primarily amount of liquid assets to conduct its day-to-day
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operations. Especially during account’s receivable goes up slightly,

Investors need
economic uncertainty when banks owing to certain seasonal fluctuations,
become more risk-averse and are to make sure but if it increases at a fast pace, it is
unwilling to give loans, having liquid that there is likely that the company is being very
assets holds more importance for a aggressive in its sales efforts, which is
sufficient cash
company. a potential cause of worry.
So, at the very least, investors for running the
need to make sure that there is company for Non-current assets
sufficient cash for running the Any asset that does not fall into the
two-three
company for two-three months. In definition of current assets is classified
fact, you can find the amount of cash months. as non-current assets. Usually, the
available with a company on the bulk of a company’s operating assets
website of Value Research. Once you search for are classified as non-current assets. Factories,
a company, the amount of cash is given on the land, plant and equipment all normally fall into
right-hand side under the table ‘Key Facts’. this category. Since they are long-term assets, it
Let’s take the example of two hypothetical is expected that they would take more time to
airline companies RedJet and Blueflight. If an sell. Therefore, it would be difficult for a company
investor checks the asset sides of these two to immediately raise money without perhaps,
companies’ balance sheets, she will realise that giving a substantial discount.
RedJet has only around `50 crore of cash, while Investors may also find that a particular asset
BlueFlight has more than `20,000 crore of cash. class may fall into both categories. For example,
So, she can be more certain about BlueFlight’s an FD which matures in the next month would
ability to continue flying because RedJet may be classified as current assets, but if the same FD
face difficulties making payments as and when matures only after five years, then it would be
they come due (fuel vendors, parking charges, classified as a non-current asset.
salaries, etc.)
Uses of non-current assets
Accounts/trade receivables: An The non-current assets give us a much better
important element to watch out understanding of a company’s business. Since
This term refers to the amount that is due from non-current assets are used for running a
the customers of a company. This situation arises company’s operations, it reflects its underlying
when a company doesn’t receive money business. For example, the type of assets owned
immediately after selling its products and by a cement-manufacturing company, such as
services. Its customers are normally given some UltraTech Cement (factories, land, mines,
time, say between one-three months, for making furnaces, etc.) would be very different from
the payment. those owned by a media company, such as
Investors have to monitor this number to intellectual property, studios, etc.
ensure that it is not going up at a very fast pace. While reading the asset side of a balance sheet
Even though giving credit is not an unhealthy can be useful for other purposes, it should not
trade practice, customers’ creditworthiness be forgotten that at the end of the day, it is still a
should be taken into account. It is okay if the simple list.
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Understanding liabilities
Insights into the liabilities part of the balance sheet to know
what it communicates and how to make use of it
“10% of the borrowers in the ground reality. Debt is the primary reason
behind companies going bankrupt. After all, if a
world use debt to get richer; company does not have any debt, it will simply
90% use debt to get poorer.” never go bankrupt.
Robert Kiyosaki As we have mentioned in the introduction,
the liabilities side of the balance sheet gives a
L
ike the asset side of the balance sheet, better understanding of how much of the total
the liabilities side is an enumeration of all assets owned by a company has actually been
the different forms of liabilities that are paid for with the company’s own money as
payable by a company. It is arguably even more against borrowed money.
important than the asset side, as the asset side Like assets, liabilities of a company are also
represents optimism, while the liability side, classified into two categories – current liabilities
more often than not, pulls a company back to and non-current liabilities.
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factories, roads, aircraft, etc.) which

Current liabilities
The current liabilities section
The activity of usually have a long lifetime, they
should ideally be funded with long-
contains the debts that are payable monitoring the
term liabilities so as to avoid the risk
by a company in the normal course liabilities should of refinancing at unfavourable
of its operating cycle and that have
to be settled in the next 12 months.
be done at conditions.
Apart from short-term borrowings, regular intervals

What non-current liabilities
this section includes portions of throughout the tell us
long-term obligations which are
payable in the near future. Short-
duration of the Paying attention to this section is
important for two reasons – (1) non-
term provisions, trade payables and investment
current liabilities, together with the
rent obligations are normally period. current liabilities, give the true picture
classified as current liabilities.
of how indebted a company is and (2)
this section, when read with the asset section
What current liabilities tell us
and considering the nature of assets and the
The study of the current liabilities section helps
proportion of assets funded by long-term
gauge immediate threats to the company’s
sources, helps us understand the stability of the
ability to function. When there are disruptions
capital structure and the degree of asset-liability
in the market environment, it is important to
mismatches if any. While mismatches can
understand the magnitude of a company’s
happen in both current and non-current
short-term obligations. Current liabilities have
portions of assets and liabilities, it would be
to be studied in conjunction with current assets
more difficult to correct long-term mismatches
to get a clearer picture of the company’s
than short-term ones.
financial position and make sure that there are
adequate assets to pay off the liabilities as and
when they arise. Companies should ideally
Investor takeaways
For investors, examining the liabilities side of
make their business plans in such a way that
the balance sheet is not a one-time exercise at
their investments mature around the same time
the time of investment. Instead, this activity of
as the liabilities come due.
monitoring the liabilities should be done at
regular intervals throughout the duration of the
Non-current liabilities
investment period. It is noteworthy that the
As the name implies, all those liabilities that are
figures are easily accessible on the website of
not classified as current liabilities are classified
Value Research. The general thumb-rule is that
as non-current liabilities. These liabilities have a
less debt is better than more debt. And of all
much longer time horizon and represent more
types of liabilities, long-term debt is preferable
stable sources of borrowing. When companies
to short-term debt.
invest in large operational assets (think of
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Understanding equity
Insights into the equity part of the balance sheet to know what it
communicates and how to make use of it
T
he final part of the balance sheet deals is equity capital. And suppliers of this capital are
with an issue that is probably the simplest residual owners of the company. This term
part of this financial statement. (residual owners) implies that if the company
Shareholders’ Equity or just Equity is all that goes bankrupt, its shareholders will get money
actually matters. Conceptually, it is the difference from the sale of assets only after all the claims of
between the assets and liabilities owned by the debt holders are fully satisfied.
company and therefore, represents the This structure underscores the basic principles
company’s net worth. of finance: the greater the risk, the greater the
But before we understand the components of expected return. Even if a company performs
Shareholders’ Equity, let’s first understand what really well, debt holders will receive only the
equity actually means. Every business needs interest (along with the principal), but
capital, which can be of two types – debt capital shareholders will see the value of their
and equity capital. Since a start-up is unlikely to investments grow manifold. The flipside of this is
have debt capital, the only capital available to it that if the business prospects don’t materialise
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and the company starts making demarcation, there is absolutely no

Investors need
losses, such losses will be borne by difference when viewed from a
shareholders first. Only if the losses to keep an eye financial perspective.
exceed the entire shareholders’ on equity
capital, the debt holders will even
without fretting Difference between these two
bear the first rupee of loss. For From an accounting perspective,
example, let’s assume that a company over its paid-up capital is considered to be
has `100 in equity and `300 in debt. components. the core capital of a company, which
If the company makes `40 in losses, means that it is necessary for running
the equity will come down to `60 (`100 - `40) the company’s operations and therefore, always
but the debt will remain at `300. But if the has to remain with the company. This is in stark
company makes a loss of `101, equity will contrast to reserves, which predominantly
become zero and debt will come down to `299. comprise retained earnings. This term, retained
earnings, refers to that portion of the company’s
Components profits (if any) earned during its previous years
Shareholders’ Equity sheds light on the total which has NOT been distributed as dividends.
amount of shareholder capital that a company And since this is not considered to be a part of
has. Broadly, it has two categories – paid-up the core capital, reserves can generally be
capital and reserves. distributed to shareholders.
Paid-up capital: Paid-up capital, as the name Investor takeaways

implies, is the amount of capital actually invested Investors need to keep an eye on equity without
in the company. While you may see some more fretting over its components. Promoters, who
complicated terms like authorised capital and tend to carry out debt-fueled expansion plans,
issued capital, investors don’t need to worry would not be able to influence Shareholders’
about them. Paid-up capital refers to the money Equity significantly, as any increase in assets
that has been infused into the company at the would result in a corresponding increase in
time of its incorporation, as well as the money liabilities. Also, any accounting changes, like
given to the company throughout its lifetime. simply shifting the money between different
The authorised capital, on the other hand, heads of shareholders’ equity, such as share
refers to the outer limit of how much capital a split, bonus shares, etc., are mere jugglery of
company is permitted to raise and this limit is numbers (You can read more about it in our
always higher or equal to that of the paid-up article “Much ado about nothing”).
capital. Although this outer limit can be And even though certain balance sheets are
increased at any point in time, it is not routinely presented in a manner where shareholders’
done, as it involves tedious procedures. equity is clubbed with liabilities, investors need
to clearly differentiate liabilities from
Reserves: All other components of Shareholders’ Equity. Please do remember that
Shareholders’ Equity are some forms of reserves. no matter what sub-classifications are used, all
Reserves can be of different kinds, such as share the money (including paid-up capital, reserves,
premium reserves, general reserves, revaluation etc.) ultimately belongs to shareholders. The
reserves, etc. What investors need to understand total Shareholders’ Equity is, in effect, the
is that though accounting standards require this ground reality.
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he balance sheet is a very of the balance sheet. It does not say
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Since it conveys the quality, it is susceptible to fudging by
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particular point in time, it has a values of various assets, which are
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investors, it is used by banks, can be very different from the
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various purposes, such as assessing limitations, the balance sheet is still
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impact of risks and so on. But at the needs to be thoroughly studied
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aware of certain inherent limitations decisions.
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How to Read the

net amount of `7,500. To ensure that the equation is

operations. Especially during account’s receivable goes up slightly,

factories, roads, aircraft, etc.) which

Apart from short-term borrowings, regular intervals

and the company starts making demarcation, there is absolutely no

Paid-up capital: Paid-up capital, as the name Investor takeaways

n n n n n n n n n useful financial statement. anything about the management

n n n n n n n n n company’s financial picture at a unscrupulous managers and the

n n n n n n n n n multitude of users. Apart from recorded using accounting rules,

n n n n n n n n n vendors, regulatory bodies, etc., for ground reality. Despite these

n n n n n n n n n creditworthiness, determining the an important document which

n n n n n n n n n same time, investors must also be before making any investment

To read more such

insightful articles, visit

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