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.