Fundamental Analysis

How to Understand the Balance Sheet (Part 1) – Poonit Rathore

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How to Understand the Balance Sheet (Part 1) - Poonit Rathore
How to Understand the Balance Sheet (Part 1) – Poonit Rathore

6.1 Balance Sheet Equation

The P&L account of the company tells us about the profit and loss of the company, while the balance sheet tells us about the assets, liabilities, and shareholders’ equity of the company. A P&L statement gives information about a single financial year so it can be considered a separate statement. On the other hand, Balance Sheet is a statement that shows the changes in the position of the company from its inception till now. This shows how the company has been changing financially. 

Let us have a look at the Balance Sheet of Amara Raja Batteries Limited (ARBL)-

You can see that information about assets, liabilities, and equity is given in the balance sheet. 

In the previous chapter, we talked about assets. The company has both tangible assets ie Tangible assets and intangible assets ie Intangible assets. An asset is an item that is owned by the company and has value to the company. Usually the assets we know about our- factory, machine, cash, brand, patent, etc. We will discuss these in detail further. 

Liabilities or Liability are the responsibilities of the company which it has to fulfill. The company takes on these responsibilities because it feels that it will get financial benefits from them in the future. In simple language, it is a kind of debt, that the company will have to repay in the future. Examples of liabilities are short and long-term loans, any kind of payments, etc. Liabilities or liabilities are of 2 types- 1) Current Liability and 2) Non-Current Liability. We will discuss these further. 

Usually, a company’s total assets on the balance sheet equal the company’s total liabilities. 

asset=liability

Assets = Liabilities

This equation is called the balance sheet equation or accounting equation. This equation states that the balance sheet should always be balanced. That is, assets and liabilities should be equal. This happens because the company purchases each asset either with the owner’s capital or with any liabilities. 

The difference between asset and liability is the owner’s capital, which we call Owner’s Capital. It is also called shareholders’ equity or net worth of the company. in the form of an equation 

Shareholders’ Equity = Asset-Liability

Shareholders equity = Assets – Liabilities

6.2 Shareholder Fund Information 

As we know that the balance sheet consists of two parts – Assets and Liabilities. Liability refers to the responsibilities of the company. Shareholder funds also come under liabilities in the balance sheet. You can see it in the picture below. Some people remain a little skeptical about this. 

This doubt arises because when we are talking about liability, we are actually saying what are the responsibilities of the company, while the shareholder fund shows the capital of the company. So seeing these two together in the balance sheet creates a bit of confusion as shareholder funds should actually be an asset and not a liability. 

To understand this, you have to change the way you look at the financial statements of the company. Let’s say a company is a person whose job it is to generate capital for its shareholders. Looking at it this way, you are looking at separating the shareholders of the company (which includes the promoters of the company) from the company. Looking at it from this point of view, you will understand that the company gives information about its financial condition in any financial statement. 

It also means that the shareholder’s fund is not the property of the company, it is the property of the shareholders of the company. Therefore, the company has to show the shareholders’ fund as a liability that it is going to repay later. Hence it is shown as a liability on the balance sheet. 

6.3 Liability portion of the Balance Sheet

In the liability side of the balance sheet, the company shows its liabilities in three parts – shareholders’ funds, non-current liabilities, and current liabilities. The first part is the shareholders’ fund.

To understand share capital properly, imagine a company that is issuing its shares for the first time. Suppose the name of the company is ABC and it issues 1000 shares with the face value of Rs.10 each. So the share capital is 10 × 1000 = 10000. (Face value × number of shares)

In the case of ARBL, the share capital is Rs.17.081 crore. While the face value is Rs.1. 

We can find out the total number of outstanding shares using face value and share capital value. We know

Share Capital = FV (Face Value) * Number of Shares

Hence, No. of shares = Share Capital / FV (Face Value)

Hence in the case of ARBL,

Number of shares = 17,08,10,000 / 1

= 17,08,10,000 shares

The next line item on the liabilities side of the balance sheet is “Reserves and Surplus”. Reserve is the amount that the company keeps aside for a specific purpose. Surplus is the amount where the profit of the company is shown. The amount of reserve and surplus for ARBL is Rs 1345.6 crore. Note number 3 is associated with Reserves and Surplus. Let’s see it in the picture below. 

As you can see the company has divided the total amount into 3 types of reserves. 

  1. Capital Reserve – This is the money that the company keeps for long-term projects. ARBL has not shown much amount in Capital Reserve. Although this amount belongs to the shareholders it cannot be distributed to them. 
  2. Securities Premium Reserve/Account – Whatever premium is paid on the face value of the shares of the company, the amount is kept in this reserve. ARBL has kept Rs 31.18 crore under this. 
  3. General Reserve – This is the reserve where all the profits accumulated till now (which have not been distributed among the shareholders) of the company are shown. The company uses this amount in any financial crisis. ARBL has kept Rs 218.4 crore under this. 

The next part of the balance sheet is surplus. As we have said earlier that the entire amount of profit of the year is shown in the surplus. Here you should pay attention to some things. 

  1. Last year (FY13) had a surplus of 829.8 crores in the balance sheet. In the picture below it is shown as the first line of surplus. 
  1. The profit of this financial year (FY14) which is 367.4 crores has been added to the closing balance of last year’s surplus. Here are some things to note-
    1. Note how the P&L statement relates to the balance sheet. This is pointing to one important thing and that is that all three financial statements are related to each other. 
    2. Note how last year’s balance sheet amounts have been added to this year’s amounts. This shows that the balance sheet is prepared in a flow-through manner, where the amount of the previous year is carried over to the next year. 
  2. Last year’s balance and this year’s profit together make an amount of 1197.2 crores. The company can use this amount for different things.
    1. First of all, the company puts some amount in the General Reserve, so that this amount can be used in the future. The company has kept Rs 36.7 crore for this. 
    2. After adding money to General Reserve, the company has distributed Rs 55.1 crore as dividends, on which it has to pay a Dividend Distribution Tax of Rs 9.3 crore. 
  3. After this, the company is left with a surplus of Rs 1095.9 crore. This will be the opening balance of surplus in the next year’s (FY15) balance sheet. 
  4. Total Reserves and Surplus = Capital Reserve + Securities Premium Reserve + General Reserve + Surplus for the year. This amount for FY14 works out to 1345.6 crores whereas in FY13 this amount was 1042.7 crores. 

The amount that is formed by combining share capital, reserves and surplus is the total shareholder fund. Since this amount belongs to the shareholders of the company, it is shown in the liability section of the balance sheet. 

6.4 Non-Current Liabilities

Non-current liabilities are those long-term liabilities of the company which the company is not going to fulfill within 365 days/12 months. These responsibilities are reflected in the company’s accounts for years. 

ABRL’s non-current liability is seen in this picture. 

The company has shown 3 types of non-current liabilities. Let’s take a look at them. 

Long-Term Borrowings (Related to Note 4) – This is the first line item of Non-Current Liabilities. This is the most important figure on the balance sheet because it shows all the places from where the company has taken loans. The long-term debt figure is also used to derive certain financial ratios. We will discuss this later in this module. 

Take a look at the note on long-term debt. 

It is clear from this note that here long-term borrowing means interest-free sales tax deferment (). To explain this, the company has written something just below the note, which has been highlighted in red. It seems that this is some tax incentive from the state government, which the company is going to repay in a little over 14 years. 

You will find many such companies which do not have long-term borrowings or loans. Although it is a good thing that the company has no debt, you have to ask why there is no debt. Are the banks not willing to give loans to the company or is the company not taking any steps to expand its business? We will find the answer to this question when we analyze the balance sheet. 

Remember that when the debt of the company is high, then its finance cost is also high. When we were discussing the P&L, we found this under the line item of finance cost. 

The next line item in non-current liability is Deferred tax liability. When the company arranges the amount for future tax payments, it is called Deferred Tax Liability. You should think here that what the company does so that it has to pay more tax in the future and arrangements have to be made for it now. 

This happens because depreciation is treated in a special way under the Companies Act and Income Tax. Right now we will not talk much about this but remember that Deferred Tax Liability is directly related to Depreciation. 

The last line item of non-current liability is long-term provisions. This is the amount that the company spends on the employees. This includes things like Gratuity, Leave Encashment, and Provident Fund. 

6.5 Current Liabilities

Current liabilities are those responsibilities of the company which the company has to fulfill within 365 days i.e. 1 year. Current here means that these responsibilities will be completed soon. Remember that in non-current the responsibilities are completed after 1 year. 

Let us see an example- If you buy a mobile phone on EMI (through a credit card) then it is clear that you intend to repay the loan to the credit card company in a few months. This is your current liability, but if you buy a flat and want to repay the loan to the housing finance company in 15 years, then it will be your non-current liability. 

See below for the current liabilities of ARBL

You can see that Current Liabilities has 4 line items. The first is – Short Term Borrowing. As the name suggests, it shows the need for cash that the company needs for day-to-day needs (Working Capital). Below we have displayed a portion of Note 7 explaining the meaning of short-term borrowing. 

As you can see the company has taken short-term loans from the State Bank of India and Andhra Bank as working capital. Efforts are made to keep short-term borrowings to a minimum. Here this amount is Rs 8.3 crore. 

The next line item is – Trade Payable (also called Account Payable). Here this amount is Rs 127.7 crore. This is the amount that the company has to pay to its vendors/suppliers. Such as suppliers selling raw materials, companies providing electricity and water, company providing stationery, etc. This is shown in detail in Note 8 below. 

 The next line item is other current liabilities, which here is Rs 215.6 crore. Usually, these liabilities are related to legal requirements that are not directly related to the business of the company. You can understand that in Note 9 below. 

The last line item in Current Liabilities is Short-Term Provisions (). Here it is Rs 281.8 crore. This is similar to long-term provisions. In both, things like gratuity, and provident funds have been arranged for the employees of the company. You will notice that both have the same note. 

Since Note 6 dealing with long-term and short-term provisions runs into several pages, I am not going to go into detail. If you wish, you may have a look at pages 80, 81, 82, and 83 of ARBL’s FY14 Annual Report. 

By the way, in the context of financial statements, you only need to know that both these (long-term and short-term provisions) are related to the facilities available to the employees. You can get complete information about them through the note attached to them. 

So far we have understood half of the balance sheet which dealt with the liability side. Take a look at the balance sheet once again so that you understand it properly. 

It is clean,

Total Liability = Share Holders Fund + Non-Current Liability + Current Liability

= 1362.7+143.03+633.7

Total Liability = Rs 2139.4 Crore 

Main points of this chapter

  1. A balance sheet is also called a statement of financial position. It is made in a flowing manner so that the financial position of the company can be known accurately at any given point in time. This statement shows the assets and liabilities of the company. 
  2. When the company needs money from investors or has to take loans or collect taxes, then it needs a balance sheet. 
  3. The balance sheet equation is Assets = Liabilities + Shareholders’ Equity
  4. Liability is the responsibilities or debt of the company, while share capital is the number of shares × face value
  5. Reserves means the amount that the company has kept for a specific reason, and it is to be used in the future. 
  6. Surplus is where the profits of the company are shown. It is used in both the balance sheet and P&L of the company. The dividend is given from the surplus only.
  7. Shareholders’ Equity = Share Capital+Reserves+Surplus.
  8. Non-current liability or long-term liability are those that the company does not have to pay in the next 365 days. 
  9. Deferred tax liability arises because of the special treatment of depreciation. Depreciation is treated differently in the eyes of the company’s accounts and the income tax department, hence the deferred tax liability arises. 
  10. A current liability is a responsibility that the company has to fulfill within 365 days. 
  11. Generally, long and short-term provisions cover liabilities related to employee benefits. 
  12. Total Liability = Share Holders Fund + Non-Current Liability + Current Liability. This is the amount that the company has to pay to other people. 

Poonit Rathore

My name is Poonit Rathore. I am a Blogger, Content-writer, and Freelancer. Currently, I am pursuing my CMA final from ICAI. I live in India.

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