The first step in the analysis of the balance sheet is the scrutiny and examination of different items of assets and liabilities and their classification into various categories. The left-hand side of the balance sheet displays capital and liabilities while the right-hand side, property, and assets. Here is a detailed balance sheet analysis that will make you more familiar with the balance sheet
Table of Contents
Balance sheet analysis
There is some essential part of the balance sheet which are essential for balance sheet analysis. Parts are
- Assets
- Current Assets;
- Fixed Assets;
- Other Non-Current Assets and;
- Intangible Assets.
- Liabilities
- Current Liabilities
- Term Liabilities
- Net Worth
- Contingent Liabilities
Most of the above topics have subtopics. You should concentrate on all of them for balance sheet analysis. It is a bit difficult to understand so we make a flow chart to make it better understandable. The following image will clear the concept of balance sheet analysis:
1. ASSETS (Balance sheet analysis)
You need to analyze assets first for balance sheet analysis. The assets of a business organization are what it owns. An asset must be i. valuable to business; ii. owned by the business; and iii. acquired at a measurable cost. An asset is any property or resource which has money value, e.g., cash, stocks, land, buildings, machinery, furniture, fixture, stock of stationery, book debts, goodwill, etc.
The assets in the balance sheet shows how the organization has used or employed its funds to acquire various things. Assets are classified into four categories;
- Current Assets;
- Fixed Assets;
- Other Non-Current Assets and;
- Intangible Assets.
1.1 Current Assets
Current assets are those assets that change their form in a short period and are ultimately get converted into cash. In other words, current assets are meant to be liquidated for cash during the normal operating cycle of a business. These assets are also called circulating assets.
In a manufacturing concern, cash is used for the purchase of raw materials and other services; the raw materials during the course of manufacture change their form into semi-manufactured goods and later finished product/stock. These stocks may be sold either for cash or on credit and when on credit, the asset takes the form of trade debts.
The trade debtors may accept bills drawn on them and the assets get converted into another form, viz, bills receivable. On maturity, these bills receivable get converted into cash in the ordinary course. The circuit which started from cash is, thus, completed and may start again in respect of similar further transactions.
Therefore, in order to qualify as a current asset, an item must be convertible into cash within the normal operating cycle of a business. For this reason, all assets of this type are known as circulating assets.
The banker attaches great significance to the total amount of current assets because it signifies the liquidity position of the customer in a short period. The larger the quantum of current assets, the greater the possibilities of the repayment of loans that are payable on demand or at short notice.
Current assets are cash in hand and in the bank, investment, stocks, book debts, bills receivables, etc. All current assets are liquid assets.
1.1.1 Cash in hand and Bank Balance
Cash in hand, as well as a bank, is the most liquid of all assets. These are also called “Quick Assets”. A larger amount of cash and bank balances ensure liquidity and quick repaying capacity of the enterprise. But such balances are non-earning assets and may affect the profitability of the concern.
Keeping large cash is not a sign of efficiency. A prudent businessman will always be careful to strike a means between liquidity and profitability. The presence of unusually large cash in hand beyond a reasonable limit should put the banker to a searching inquiry.
Because there may be window dressing in the balance sheet by showing an unusually large cash balance on the balance sheet date. This is done by some companies by withholding payments to creditors and speedy collection of debtors at the year-end.
1.1.2 Stock
Stocks are also called inventories. In the case of trading concerns, stocks will mostly represent raw materials and/or finished products. IN a manufacturing concern, stocks will comprise raw materials awaiting manufacture or processing, semi-finished products, or work-in-process and finished products for sale.
In the case of a wholesale or retail trader, stocks will indicate stock-in-trade held by him in the shop or showroom for regular handling in the course of business and also stocks, if any, held by him in godowns. In the calculation of quick ratio, this held by him in godowns., In the calculation of the quick ratio, this asset is excluded, since it is not considered highly liquid.
The valuation of the stocks may affect the profits either way. The banker, however, shall have to rely on the valuation made by the borrower, as no independent valuation by the banker is possible. Bankers will depend more or less upon the integrity, shrewdness, conservatism, prudence, and business acumen of the proprietor, partners, and directors of the concern.
Even then the banker must closely scrutinize the valuation of this item, as there is scope for manipulation of profit by changing the basis of valuation. Such a change in the valuation also distorts the ratio of stock to the cost of goods sold. The banker should ascertain from the borrower that.
- The stock of unsalable and useless goods is not included, and,
- The valuation has been made according to the principles of “raw materials valued at cost or market price whichever is lower; the stock-in process at cost; finished products at less than market value”.
The banker should also ascertain that unduly large stocks are not held and do not bear the right proportion to the sales. If the stock-sales ratio is high as compared to other concerns in the same trade or industry, the banker should enquire reasons thereof. Further, the lending bank has to verify whether the stocks are readily saleable.
1.1.3. Investment
A business enterprise invests its fund in marketable securities either.
- to employ its surplus funds not required immediately, or,
- to invest the reserves or provisions made out of the profits for specific purposes like depreciation, the redemption of debenture, etc.
The investment may either be in the form of short-term or long-term. The short-term investment is usually made in gilt-edged securities, such as government Promissory Notes, Government Stocks, savings Certificate, Treasury Bills National Prize Bonds, etc.
These securities are readily saleable and can be converted into cash immediately whenever the need arises but investment in fixed interest-bearing government security may yield ad lower return than in equity shares of a company, but the government security may be safer than company shares.
The short-term investment can also be done in the form of shares in private or public limited companies. The shares of limited companies can be classified as quoted or unquoted. The shares of private limited companies are not quoted on the stock exchange as there are restrictions on the transfer of these shares.
This is not good security for a banker and its market valuation cannot be determined. The shares of a public limited company are usually quoted on the stock exchange and an accurate valuation of these shares is thereby possible and these are sold like any other commodity through share transfer deeds. These shares are to be valued at cost price or market price whichever is lower.
Long-term investments are made if cash resources are found to be surplus on a permanent basis. Such permanent investments are sometimes made to gain control over other companies, e.g., investments made by holding companies in subsidiary companies.
A company is called a holding company that holds a majority of the shares of the subsidiary company. Such investments are not considered current assets.
Thus, only those securities like shares or debentures, which are easily marketable or saleable in the market, are deemed to be the current assets. Investments made in the subsidiary companies may not be marketable and are. Therefore, placed in the category of ‘Other Non-Current Assets’.
1.1.4 Book Debts and Bills Receivable
The amount of trade debts represents that part of credit sales that has yet to be recovered in cash. The soundness of this asset depends upon the quality or creditworthiness of the various debtors although there are practical limitations to an investigation of this kind by a banker.
The duration of each debt will also serve as a pointer in this regard. If there are a large number of debtors who have been in arrears for an unreasonably long period, such delay in realization will show slackness or inefficient management on the part of the directors. This may result in bad debts over the course of time which will add to the loss of the business.
According to the Companies Act, debts due and outstanding for more than six months are shown separately on the balance sheet. Only those debts and bills receivable which are outstanding for not more than six months are treated as Current Assets. The rest are included in the category of ‘Other Non-Current Assets’.
A banker should thoroughly scrutinize the book debts of the borrowing concern because they are valuable only if they are realizable. The number of total credit sales made. The period for which these debts have been outstanding and the amounts due should be investigated to ascertain whether a large number of debtors have been in arrears for a long time.
The period of credit granted by the borrowing concern should not be larger than the usual period of credit in that trade or industry. The credit allowed for a longer period will affect working capital. So, the credit allowed to customers should always be reasonable.
It cannot be said with certainty that all the sundry debtors will pay in full. There may be some non-realization. So, provisions for bad and doubtful debts should be made accordingly. Hence, book debts and receivables are to be valued less provisions made for bad and doubtful debts.
1.2 Fixed Assets
A fixed asset is one that is employed permanently and productively in the business in order to earn profits and is not intended to be sold or converted into cash in the ordinary course. So, there is no liquidity in the case of fixed assets. The nature and extent of fixed assets differ from business to business.
What is a fixed asset to one business may be a current asset to another and vice versa. For example, a truck may be a fixed asset for a textile mill but it will be stock-in-trade for a motor company selling trucks. Similarly, a refrigerator is a fixed asset to a retail chemist, but a current asset for the manufacturer of refrigerators.
Fixed assets are land, building, plant and machinery, furniture and fixtures, tools, and transports like a motor car, van, cycle, tempo, etc.
In case of failure of a business, the value of fixed assets remains intact but the market value is limited to the residual scrap or break-up value of the fixed assets.
Sometimes necessary repairs and replacements of the fixed assets are postponed when a deficiency of working capital is acute, rendering the fixed assets in poor condition. The banker does not expect to realize the dues by the sale of fixed assets.
The banker should, therefore, examine the following points while analyzing the fixed assets:
- How the fixed assets are valued in the balance Sheet?
- What is their current market value?
- What is their forced sale value if put to auction?
- Date of purchase in relation to valuation and cost price according to the current price level.
- If imported, whether imported on cash licenses or under credit/grant on hire purchase system.
- Whether sufficient depreciation had been provided or sufficient reserve had been created for the purpose?
- Whether it is specialized machinery suitable for a rare type of business activity?
1.3 Other Non-Current Assets
1.3.1 Land And Building
It may be a factory, a farm, a hotel, a warehouse, an office building, a block of houses, etc. The banker should ascertain their present realizable value. For this purpose, it is essential to know the type and the situation of the property, date of purchase, age of the property and the manner in which the property is maintained in case an emergency sale is necessary.
If the land is leasehold, the terms and conditions of the lease, such as the rent and the date of expiry, will be relevant. Building on leasehold land will not be worth much if the unexpired period of the lease is short and the landlord would not renew the lease except on exorbitant terms.
It is necessary to enquire whether the land and building have been charged as security against an advance. In such a case, the cost of the land and building will have to be reduced to the extent of the charge. It is also necessary to find out that the building has been insured against fire. It is essential that adequate provision for depreciation is made on the building.
1.3.2 Plant and Machinery
The age and type of machinery are important considerations. In the case of new machinery, suppliers usually erect it as a part of the bargain and guarantee its performance. In case the machinery is of a specialized nature, its marketability and value are greatly reduced.
If the machinery is subject to hire purchase, the creditor is entitled to claim it back if stipulated installments are not paid. It should be particularly investigated that no prior charge exists and reasonable depreciation is provided against these assets. It should be valued at a cost price to sell depreciation.
1.3.3 Furniture and Fixture
Furniture and fixtures may not fetch much price on a forced sale as they are usually of a specialized character and considerable expenses will be necessary before a prospective buyer can make use of them. These are to be valued at cost price less depreciation.
1.3.4 Tools
Tools are valued similarly to machinery at cost price less depreciation.
1.4 Intangible Assets
Intangible assets, also called fictitious assets, do not represent any material asset or property. They are represented by either deferred revenue expenditure or expenditure which for the sake of prudence should not be taken to carry any value.
They also include items, such as Goodwill, Patents, Trade Marks, Designs, Preliminary Expenses, Debit Balance of Profit and loss account, Discount on shares or debentures, etc. Intangible assets are non-physical and intangible in nature but have quite a long period of usefulness to the business.
Some bankers, however, make a fine distinction between intangible and fictitious assets. They classify Goodwill, Patents, Trade Marks, Design, etc., as intangible assets, as they represent some value to a going concern. They consider other items like preliminary Expenses, debts balance of profit and loss account, etc. as fictitious assets for the reason that they do not represent any value at all to the business.
Goodwill represents the amount paid by the purchaser for the reputation and connections of the business earned by the seller. Goodwill has value as long as the business is prospering and a going concern. It should be a constant endeavor to write off the value of Goodwill by spreading it over a number of years, leaving a latent Goodwill as a point of strength for the business.
Patents, Trade Marks Designs, etc., are intangible assets as in the case of Goodwill. Advance payments of royalties for Trade Marks etc. are good only so long as the business is a going concern. As soon as the business fails, these assets have no value.
Preliminary expenses represent expenditures incurred in the formation of a company. Such expenses are capitalized and appear as a debit balance on the assets side of the balance sheet to be written off from the future profit. They do not represent any assets. Although the benefit of these expenses accrues to the business, the asset is intangible.
Similarly, discounts on shares or debentures and debit balances in the profit and loss account, though shown on the asset side of the balance sheet, do not represent tangible assets. They are either deferred revenue expenditures or actual losses that are to be written off over a number of years from future profits.
The banker should carefully note that the total amount of the intangible assets are not large because they have no realizable value and the “Tangible net worth” of an enterprise is reduced by the amount of such intangible assets.
2. Liabilities (Balance sheet analysis)
For balance sheet analysis analyzing liabilities is a must. The liabilities of concern may be defined as the debts owing by a concern. These are listed on the left-hand side of the balance sheet. The liabilities of a business concern are broadly divided into two categories: i. Current liabilities ii. Term liabilities. These are external liabilities.
The owned funds comprising the share capital and various reserves which are internal liabilities to the business concern constitute the Net Worth.
There is also another category of liability known as Contingent liability.
2.1 Current Liabilities
Current liabilities otherwise known as short-term liabilities include all liabilities which are payable quickly in a short time, i.e., within a period of one year or less.
These are related to current assets in the sense that these liabilities are contracted on the cover of current assets or for the purpose of acquiring the current assets. Normally current liabilities are liquidated by conversion of current assets into cash.
2.1.1 Borrowing from banks
These are usually in the nature of short-term credit. The banker should also know the terms and conditions of the borrowings from other banks, viz, the amount, rate of interest, period of repayment, and security charged are important points for the consideration of the lending banker.
Banker thereby forms an idea of the general creditworthiness of the have been encumbered. If the advance is a term loan, it is important to know the period, the terms of repayment, and the fixed assets charged as security.
The item of bank borrowing, say, cash credits, or overdrafts, is usually taken as a current liability unless it is in the nature of a medium or ling term advance. Even in term advances, the installment, if any, payable within 12 months of the date of the balance sheet is considered a current liability.
2.2.2 Trade Creditors/Bills Payable
The creditors should be well-spread. The banker should ascertain that the amount due to the trade creditors is not too large, keeping in view the number of purchases. These accounts should view the number of purchases.
These accounts should not be overdue for periods in excess of the usual period of credit granted in the trade concerned. Otherwise, it will indicate the inability of the borrower to meet his obligation well in time. Bills payable are usually drawn by the trade creditors.
If they are drawn by persons other than the trade creditors. If they are drawn by persons other than trade creditors. If they are drawn by persons other than trade creditors, they indicate borrowings from such persons. If the amount of such borrowings is large, withdrawal of credit may put the company in financial difficulties. The company should have sufficient funds to pay its creditors.
2.2.3 Early installments against Long-term Liabilities
Term loans, deferred payment credits, debentures, and redeemable preference shares are long-term liabilities but the installments thereof, which are repayable within one year, are included in the current liabilities because their payment is to be made like other current liabilities in the immediate future.
Similarly, debentures/mortgage money or redeemable preference shares that are falling due for payment within the next twelve months are considered short terms debt and are treated as a current liability. Dividend declared in the past in respect of which dividend warrants are outstanding is obviously a current liability.
2.2.4 Other Current Liabilities
These include provision for taxation, interest on term loans, debentures and other charges due, rent, insurance, wages, salaries unpaid, etc.
The provision is meant to retain any amount by way of providing depreciation, renewals, or diminution in value of assets, or retained by way of providing for any known liability, for which the amount cannot be determined with substantial accuracy. It is a charge against profit and is to be retrained compulsorily under the companies Act.
2.2 Term Liabilities
Term liabilities are those liabilities that are payable after a period of one year from the date of the balance sheet. A higher rate of interest is payable by the organization to these creditors as they take greater and longer risks.
Term liabilities include the debts due by the borrower in the form of debenture, redeemable preference shares, term loans from financial institutions or other sources, deferred payment credits, etc., but the installments of these debts which are repayable within a year and interest accrued thereon but not paid are taken as current liabilities as stated earlier.
Debentures are borrowings made by the company from institutions and the public at large against the security of a floating charge on its assets. The points to be looked into are the terms of issue, the rate of interest, the schedule of repayment, and the charge created on the assets. The banker should also enquire about the provision made by the company regarding the redemption of the debenture.
So long as debentures are outstanding, the directors are required to certify in their annual report that the debentures are utilized by the company for the specific purpose of working capital or capital expenditure as the case may be.
The long-term borrowings of concern provide an adequate capital base for the concern. The lending banker should know the extent and terms of the long-term borrowings, such as amount, rate of interest, terms of borrowings, such as amount, rate of interest, terms of repayment, security, and period for which the loan is granted.
If the rate of interest is lower or higher than the usual rate at which long-term advances are grated to a similar unit, that may be a pointer to the creditworthiness or otherwise of the company. If repayment by installments is stipulated, it will be necessary to know whether the cash resources of the company and further accretions thereto are adequate to meet the installments as and when due.
The period for which the term advance is taken should be sufficiently long. This will enable the concern to earn profits and make repayments from its earnings over a number of years. The security offered for long-term borrowings should also be scrutinized.
3. Net Worth (Balance sheet analysis)
Apart from the liabilities due to outsiders the rest of the items on the liabilities side of the balance sheet are considered as the owned funds or the capital funds of the borrowing concern. A company’s own funds comprise mostly its share capital, general (or free) reserve, capital reserve, the premium on shares, and undistributed profits.
Capital is supplied by the proprietor in the case of a proprietorship firm, by partners in the case of a partnership firm, and by the shareholders in a company. So, capital is a liability of an organization. The profit earned by a proprietorship or partnership organization is either withdrawn by the proprietor or the partners or, retained in the business as an addition to his/their capital.
A part of the profit earned by a limited company is distributed amongst the shareholders and the balance is retained in the business under the head “Reserves”. The amount of “Reserves” is the savings of the company.
The capital employed in business by the company should be adequate considering the nature of the concern. There should be an increase in the net worth of the company’s own funds by retention in the business as a part of the profit.
The net worth includes paid-up capital of shareholders, capital reserve, general reserve, undistributed profit, and premium on shares less intangible assets if any. The capital reserve is formed out of the profits arising from the sale of its fixed assets. Revenue reserve or general reserve is created out of the profit made in the course of the company’s normal operation.
The credit balance in the profit and loss is also a part of owned funds but the reserve or provision made for a specific purpose like depreciation, bad and doubtful debts, etc., are treated as current liabilities and do not form part of the owned funds because these funds are intended to be spent for those purposes in course of time.
Out of the net profit, some amount is provided for taxation, some amount is distributed on dividends and a small residual balance remains which is the surplus of profit and loss account called undistributed profit. All these items of capital funds constitute the net worth of the business.
The amount by which the total assets exceed the total amount of liabilities (both current and term) indicates the net worth of the business. However, as the intangible assets are not realizable in cash, the more valuable criterion to judge the safety of the creditor’s funds is that of “Tangible Net Worth’ which is derived by deducting intangible assets from the Net Worth.
The owned funds or, the net worth of the borrowing concern, must be sufficient keeping in view the requirement of the business. Moreover, the long-term needs of the business should be financed by the owned or long-term liabilities. Otherwise, the business unit might experience difficulties in the payment of short-term debts.
The concept of ‘net worth’ of the borrowing concern is very significant for the creditors and the bankers because it indicates the extent of the solvency of ht borrower. The uncalled capital should also be taken into account as it strengthens the financial position of the company as, in case the company needs more funds, it can make calls on the shareholders.
Again in the event of the company’s liquidation, the uncalled share capital would bring additional cash for the benefit of the creditors.
4. Contingent Liabilities (Balance sheet analysis)
The last part of the balance sheet analysis is to analyze contingent liabilities. A contingent liability is a likely or possible liability. These liabilities do not exist at the time of the balance sheet but they may arise in the future. It may arise on the occurrence of a particular event and turn out to be an actual liability.
The total contingent liability e.g. liabilities in respect of guarantees given by the company or demand made by the government but disputed by the company in the Court, or bills discounted with banks issuance being still alive as on the date of the balance sheet, etc., have to make payment in the event of the failure of the party for whom guarantees have been given.
The banker should take note of such liabilities and ascertain whether the amount of the contingent liabilities are large in proportion to the financial resources of the business.
Wherever possible, such liabilities should be analyzed to find out which of the company being called upon to pay on account of commitments in the near future, say, within a year, it will be prudent to include such items in the figure of current liabilities.
Contingent liabilities, not actual liabilities, are shown by way of a footnote in the balance sheet.
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