Understanding Financial

Statements (contd)
1. Understanding Balance Sheet
2. Use of Ratio Analysis to analyse
financial statements

What is a Balance Sheet?

The balance sheet provides information on:
- what the company owns (its assets);
- what it owes (its liabilities); and
- the value of the business to its stockholders
(the shareholders' equity).
The name, balance sheet, is derived from the
fact that these accounts must always be in
balance. Assets must always equal the sum
of liabilities and shareholders' equity.

The Balance Sheet Equation

Assets = Liabilities + Shareholders' Equity is the
basic Balance Sheet equation.
The concept behind it is that assets or economic resources
must be acquired either by borrowings (liabilities) or
owners funds ( shareholders equity). This snapshot
picture is presented as of a given date. Often, this picture is
presented for two consecutive years for the same date.

Broad Asset Categories

Assets may be divided into two: Current or shortterm assets and Non-Current or long-term assets.
Current assets are assets that are usually
converted to cash within one year. Bondholders
and other creditors closely monitor a firm's current
assets since interest payments are generally made
from current assets.

Forms of Current Assets

Cash is the most basic current asset. In addition
to currency, bank accounts without restrictions,
checks and drafts are also considered cash due
to the ease in which one can turn these
instruments into currency.
Cash equivalents are not cash but can be
converted into cash so easily that they are
considered equal to cash. Cash equivalents are
generally highly liquid, short-term investments
such as government securities and money market
funds.

Forms of Current Assets (contd)

Accounts receivable represent money
clients owe to the firm. As more and more
business is being done today with credit
instead of cash, this item is a significant
component of the balance sheet.
A firm's inventory is the stock of materials
used to manufacture their products and the
products themselves before they are sold. A
manufacturing entity will often have three
different types of inventory: raw materials,
works-in-process, and finished goods.

Long-Term Assets
Long Term Assets are those tangible assets
with a useful life greater than one year.
Generally, fixed assets refer to items such as
equipment, buildings, production plants and
property. On the balance sheet, these are
valued at their cost. Depreciation is subtracted
from all except land. Fixed assets are very
important to a company because they
represent long-term illiquid investments that a
company expects will help it generate profits.

Long Term Assets (contd)

Intangible assets are non-physical
assets such as copyrights, franchises
and patents. To estimate their value is
very difficult because they are intangible.
Often there is no ready market for them.
Nevertheless, for some companies, an
intangible asset can be the most
valuable asset it possesses.

Concept of Depreciation
Depreciation is the process of
allocating the original purchase price of
a fixed asset over the course of its
useful life. It appears in the balance
sheet as a deduction from the original
value of the fixed assets and is also
shown in the income statement as an
expense.

What are liabilities?

Liabilities are obligations a company
owes to outside parties. They represent
rights of others to money or services of
the company. Examples include bank
loans, debts to suppliers and debts to
employees. On the balance sheet,
liabilities are generally broken down into
current liabilities and long-term
liabilities.

Current Liabilities
Current liabilities are those obligations
that are usually paid within the year,
such as accounts payable, interest on
long-term debts, taxes payable, and
dividends payable. Because current
liabilities are usually paid with current
assets, as an investor it is important to
examine the degree to which current
assets exceed current liabilities.

Examples of Liabilities
Accounts payable are debts owed to
suppliers for the purchase of goods and
services on an open account. Almost all firms
buy some or all of their goods on account.
Long-term debt is a liability of a period
greater than one year. It usually refers to
loans a company takes out. These debts are
often paid in installments. If this is the case,
the portion to be paid off in the current year is
considered a current liability.

Shareholders Equity
Shareholders' equity is the value of a
business to its owners after all of its
obligations have been met. This net worth
belongs to the owners. Shareholders' equity
generally reflects the amount of capital the
owners invested plus any profits that the
company generates that are subsequently
reinvested in the company. This reinvested
income is called retained earnings.

Importance of Balance Sheet

Some of the questions that a Balance Sheet can address

are the following:
Can the firm meet its financial obligations?
How much money has already been invested in this
company?
Is the company overly indebted?
What kind of assets has the company purchased with its
financing?
Ratio analysis is an important tool in the analysis of
both the Balance Sheet and Income Statement

Ratio Analysis
There are broadly three types of ratios:
Liquidity Ratios;
Leverage Ratios; and
Profitability Ratios

Liquidity Ratios

Liquidity ratios are designed to measure a

company's ability to cover its short-term
obligations such as interest payments, shortterm debts, etc. The main ratios are:
Current Ratio
Acid Test (or Quick Ratio)
Working Capital
Leverage

Current Ratio
Current Ratio =
Current Assets / Current Liabilities
While there is no fixed norm, a
benchmark norm is 1.5:1; i.e., current
assets should be 1.5 times that of
current liabilities. Comparison with the
industry average also gives useful
information.

Acid-Test or Quick Ratio

Acid-Test Ratio tries to ensure that the firm will
not have any problem in meeting its current
liabilities. Hence, current assets like inventory
which may not be easily converted into cash are
excluded from the numerator. Thus, the ratio is
calculated as
(Current Assets Inventory) / Current Liabilities
Again, comparison with industry average is useful.

Working Capital
Working Capital is simply the amount that
current assets exceed current liabilities. Here
it is in the form of the equation:
Working Capital = Current Assets - Current
Liabilities
The higher the amount, the greater is the
security to the investors that the firm will be
able to meet its financial obligations. Many
times, a company does not have enough
liquidity. This is often the cause of being over
leveraged.

Leverage Ratios
Leverage is a ratio that measures a
company's capital structure. In other words, it
measures how a company finances its
assets. Does it rely strictly on equity? Or,
does it use a combination of equity and debt?
The answers to these questions are of great
importance when assessing the firms ability
to raise more debt as well as its tendency to
go into bankruptcy. Leverage is calculated as:
Long-term Debt / Total Equity

Profitability Ratios (based on

Balance Sheet figures)
Some profitability ratios based on Income
Statement have already been dealt with in the
previous session. Here are some more that
investors find useful:
Return on assets (ROA) tells how well
management is performing on all the firm's
resources. However, it does not tell how well
they are performing for the stockholders. It is
calculated as follows:
Earnings After Taxes / Total Assets

Profitability Ratios (contd)

Return on equity (ROE) measures
how well management is doing for the
investor, because it tells how much
earnings they are getting for each rupee
of their investments. It is calculated as
follows:
Earnings After Taxes / Equity

Turnover Ratios
Turnover ratios are essentially asset
management ratios which measure how
effectively the firm is managing its assets.
The more important ratios are:
Inventory Turnover Ratio
Receivables Turnover Ratio

Inventory Turnover Ratio

This ratio is calculated as:
Cost of Sales/Average Inventory
The ratio gives an indication of how quickly
inventory gets converted into cash. Where
average inventory figure is not available, it
is calculated simply as:
(Opening Inventory + Closing Inventory) / 2

Receivables Turnover Ratio

All firms which sell on credit are worried about the
turnover of their receivables or their conversion
into cash. The ratio is calculated as: Credit
Sales/Average Receivables
This ratio further helps in the calculation of the
Average Collection Period which is simply:
365/Receivables Turnover Ratio
(Sometimes, instead of 365 days, the year is
represented by 360 days representing business
days of the year)
This is then compared with the credit period granted.

Limitations of Ratio Analysis

Ratio analysis is useful, but analysts should
be aware of the problems and make
adjustments as necessary. Some of the main
limitations are:
For diversified firms operating in different
industries, there is no industry average for
comparison purposes.

Limitations (contd)
Many firms would like to compare themselves
with industry leaders rather than industry
averages.
The true values of assets in the balance sheet
may be markedly different from the recorded
figures of cost due to inflation, etc. Hence,
comparative analysis should be conducted for
firms of the same age. Analysis of one firm over
different time periods must e done with care (time
series analysis).

Limitations (contd)
Firms may employ different accounting
practices. This will distort the results unless
suitable adjustments made.
Firms may employ window-dressing
techniques to make their financial
statements look better.