Part 1 of financial statement analysis : Balance Sheet Analysis –
In our basics of finance series, this article would help you know how to go about balance sheet analysis. But, before that lets talk about financial statement. The financial statement analysis of a company provide useful information to varied users in making economic decisions. For example, financial statements are an indispensable tool for financial analysts in making decisions on whether or not to invest in a company. Another example would be a bank which determines whether or not to provide loans to a company only after scrutinizing the financial statements.
Financial statement analysis provides an overview of the financial well-being of a company. One such financial statement is the balance sheet that discloses the financial position of a company. A company’s financial position is reflected by the amount of its assets, liabilities and shareholder’s equity. All the above mentioned elements, i.e. assets, liabilities and shareholder’s equity constitute the balance sheet. This is why, the balance sheet is also popularly known as “The Statement of Financial Position”.
The Balance Sheet equation, is given as:
ASSETS=LIABILITIES + SHAREHOLDER’S EQUITY
Where Assets refers to the means for operating a company;
Liabilities refers to the financial obligations of a company;
Shareholder’s Equity refers to the equity investment and also the retained earnings
of a company;
The equation conveys that a company’s assets are balanced by undertaking certain financial obligations and by equity investments or by using its retained earnings (ploughing back of profits).
Below is an example of a Balance Sheet:
- The ASSETS class can be divided into sub-classes such as:
- CURRENT ASSETS –These assets can be readily converted into cash
- NON-CURRENT ASSETS-These assets are not easily converted into cash. They can be both tangible as well as intangible.
- Similarly, like assets, LIABILITIES can be current as well as non-current.
- SHAREHOLDER’S EQUITYrefers to the initial amount of money invested into a business. Ploughing back results in transfer of retained earnings from the income statement onto the balance sheet into the shareholder’s equity account. This account represents a company’s total net worth.
Looking only at the balance sheet figures in isolation can be disastrous. Efficient analysis of the balance sheet requires the application of “ratio analysis”.
Ratio Analysis is a method of financial analysis that is used to ascertain a company’s operational and financial efficiency. Certain basic accounting ratios are:
These ratios reflect a company’s ability to meet its short term financial obligations. A higher liquidity ratio may be considered to be a good sign for the company, however, it may also imply that the company has too much investment in liquid assets and it is avoiding making additional or external investments, thus, hampering its profitability. Therefore, there is always a trade-off between liquidity and profitability. Some examples of liquidity ratios are-current ratio, quick ratio etc.
These ratios reflect the profitability and financial performance of a company. Usually, a higher profitability ratio is considered to be good. Higher profits ensure the long term survival of the company and it also implies that benefits trickle down to the shareholders. Some examples of profitability ratios are operating margin, return on equity etc.
These ratios reflect the financial risk of a company. Debt can be considered to be a form of leverage. Leverage magnifies outcomes. It makes good outcomes great, and bad outcomes pathetic. Higher debt ratios also implies higher risk for shareholders since they have a residual claim. Some examples of debt ratios are debt to equity ratio, debt to assets ratio etc.
OPERATING EFFICIENCY RATIOS
These ratios reflect the overall efficiency of the organisation. For example, how efficiently are the assets being utilized for generating sales. They reflect how effectively can the company utilize its resources to improve sales as well as improve shareholder’s wealth.
However, it is also important to make time-series as well as cross-sectional analysis while applying ratio analysis.
The balance sheet is an important tool to gain insights into the company. However, one must also keep in mind that a balance sheet reflects the financial position of a company at a point of time not over a period of time. Effective analysis of the balance sheet is necessary for making the right investment decisions.