Financial Statements are the backbone of fundamental analysis and we ought to educate how to decode these statements in a series of blog posts. Financial statements include Balance Sheets, Profit and Loss Accounts, Cash Flows, and Notes to Accounts.
Through this post, we shall try and understand how to read and interpret balance sheet of an actual company. Readers may have come across such balance sheets in their 12th-grade accounts class, while an actual balance sheet also looks similar with slight changes due to different approaches taken by different companies. Ideally, while analyzing financial statements, one should go through at least 5 years of its data before making any conclusions.
Firstly, one should know where to retrieve these financial statements from. While there are many sources from which we can do so, the most reliable one is the company's annual report. The financial statements are usually in the latter part of the report. Other third-party sources like BSE/NSE websites, screener, ratestar, etc can also be used. I will link the sources in the footer of the blog
By definition, "A Balance sheet is a statement of the assets, liabilities, and capital of a business or other organization at a particular point in time, detailing the balance of income and expenditure over the preceding period". Balance Sheet shows the financial position and strength of a company
The given balance sheet is known as a vertical comparative balance sheet since it compares the data from two years and has a vertical format. Financial statements can be in consolidated form i.e. it has a combined data of all its subsidiaries or standalone i.e. it comprises data only of the parent company. For simplicity's sake, we will go through only the consolidated statements and then look at the standalone ones only if required.
As promised earlier, we shall go through the recent balance sheet (FY 2018-19) of Bata India Ltd, in order to back up the claims made by our technical analysis. We shall use Bata for further blog posts in order to do a thorough analysis of a single company.
In the first part, I shall explain the basics of a balance sheet and later on its interpretation. I have attached the images of the balance sheet, however, I request you to open one yourself from the link given below to get a comfortable view.
A Balance Sheet is made up of two parts, the assets, and the liabilities. It has a title showing the date on which the figures were calculated, the particulars column showing the items, the amount column, and the reference to notes column.
A balance sheet depends on a basic principle which states that
Assets = Liabilities + Equity
in simpler words, the assets of a company should be equal to its total equity and liabilities.
Assets
The assets can be classified into two types
- Current Assets: Assets that can be liquidated or realized within a year are known as current assets. Examples of which are clearly stated in the picture itself.
- Non-Current Assets: Assets that are not going to be liquidated or realized within a year are known as current assets.
Equity
This includes the total capital injected by its owners in the form of equity shares. Items included in other equities differ with each company and shall be confirmed through its notes to accounts. Examples are Retained earnings (old profits).
Liabilities
Similar to assets, liabilities have a similar classification
- Current Liabilities: These are the liabilities that are too be paid or written off within a year.
- Non-current Liabilities: These are the liabilities that are not going to be paid in the next financial year.
Examples of both are given in the photograph itself.
This gives a basic idea of how to read any balance sheet. However, it is necessary to know how to interpret the given items.
The first and foremost thing that you look in any balance sheet is any abnormality or significant changes in the amount from its previous year's values. One should look at major items such as changes in Non-current assets and liabilities. Here we can see that there is an increase in inventories. While this might look like a significant increase from its previous year, one has to check whether the company has sustained such an increase on a year-on-year basis. If so, then this change cannot be considered to be an abnormal one. Information such as expansions, stock pile-ups, etc should be verified through corporate announcements and investor presentations/calls to reason these abnormalities.
Similarly, we should look for out of the pattern changes in all other items as well. A seemingly alarming point in this balance sheet is that the liabilities have increased from almost null to about Rs 10,768 million. However, one should not panic seeing such an increase and dig for reasons. On looking at the notes to accounts I realized that due to recent changes in accounting standards, most of its rental agreements had to considered as lease agreements, adding up to its current and non-current liabilities. A complimentary effect is given in non-current liabilities as the "Right to use asset" to balance the equation. Hence, such a liability is not worrisome and just a transfer from its profit and loss account to the balance sheet.
Lastly, compiling the five years of data, one has to find trends and patterns for important items in order to ascertain the growth of the company. For example, steady growth in inventories and trade receivables shows that the company is consistently doing well over the years and a decline or stagnancy would tell us otherwise. A decline or consistency in its trade payable shows that the company is paying its dues on time without any defaults. Assets like intangible assets, capital work-in-progress, and liabilities like financial liabilities and provisions should also be looked at carefully. Disruption of a trend in such items can also become a reason for concern.
No significant conclusions can be made just by reading only two-year information of any company. However, through background research I have come to the conclusion that the company is asset strong and has been virtually debt-free since 2011.
To conclude, let us point out four major things that one should look for while studying a balance sheet:
1. Abnormalities: Significant changes in amounts from last year. (both increase and decrease)
2. Reason for Abnormalities: Reasons for the given changes have to be ascertained through other sources like investor calls, presentations, news pieces, notes to accounts or other significant but complementary changes seen. (For example, an increase in asset and also liabilities may show that the company has borrowed money to fund its expansion process)
3. Identify trends: Healthy trends in the balance sheet signify the strength of the company while the unhealthy ones show that the company may be heading towards a crisis.
4. Ratio Analysis: Financial ratios give us a proper picture of the strength of financial statements. A detailed blog post on ratios will be put up after studying the Profit and Loss Accounts and Cash Flow Statements.
There are no rigid guidelines to analyze a balance sheet and the approach may differ from person to person. The more balance sheets you look at the more you become an expert at analyzing them.
A piece of advice to the beginners: While you analyze the financial statements make sure that a mentor has your work checked so that they can show you various ways to interpret items and sources to find more information.
Thanks for staying this long for this blog post. Stay tuned for an update on the Profit and Loss Statment!
Sources
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