How To Analyze A BALANCE SHEET

How To Analyze A BALANCE SHEET

What Is a Balance Sheet?

A Balance Sheet reflects a company’s financial position on a specific date showing what it owns (assets), what it owes (liabilities), and the owners’ stake (equity). Analyzing it helps assess liquidity, solvency, and overall financial health. A snapshot of a company’s financial position at a specific point in time. Shows what the company owns (assets) and owes (liabilities). Represents the company’s net worth.  Balance Sheet Equation :

$$\text{Assets}=\text{Liabilities}+\text{Shareholders’ Equity}$$

Balance Sheet – “What You Own vs What You Owe”

• Purpose: Snapshot of financial position at a specific date. Key Components:
  • Assets: Cash, inventory, property.
  • Liabilities: Loans, payables.
  • Equity: Owner’s capital, retained earnings.
• Formula: $\text{Assets}=\text{Liabilities}+\text{Equity}$
• Example: Assets INR 50L – Liabilities INR 30L → Equity ₹20L
• Insight: Shows net worth and financial stability.

Components of a Balance Sheet

Step 1: Understand the Structure

A balance sheet follows this fundamental equation: Assets = Liabilities + Shareholders’ Equity

• Assets: What the company owns (cash, receivables, inventory, plant, property, etc.)
• Liabilities: What it owes (loans, creditors, provisions, etc.)
• Equity: Owners’ capital and retained earnings

Step 2: Analyze Assets

Current Assets

• Include cash, accounts receivable, inventory, short-term investments.
• Indicate liquidity and the firm’s ability to meet short-term obligations.
• Key Ratios:
  • Current Ratio = Current Assets / Current Liabilities
  • Quick Ratio = (Current Assets – Inventory) / Current Liabilities

Non-Current (Fixed) Assets

• Include plant, machinery, property, and long-term investments.
• Check for:
  • Overstated book values vs market value
  • Depreciation adequacy
  • Asset turnover ratio = Sales / Average Total Assets

Assets – What the company owns

• Current Assets: Used within 1 year.
• Long-Term Assets: Last longer than 1 year.
• Liquidity Order:
  • Cash & Cash Equivalents
  • Marketable Securities
  • Financial Assets
  • Accounts Receivable
  • Inventory
  • Property, Plant & Equipment
  • Intangible Assets
  • Goodwill

Step 3: Analyze Liabilities

Liabilities – What the company owes

• Current Liabilities: Due within 1 year.
• Long-Term Liabilities: Due after 1 year.

Current Liabilities

• Obligations due within a year: creditors, short-term loans, outstanding expenses.
• Assess whether the company has enough liquidity to pay them off.

Non-Current Liabilities

• Long-term borrowings and deferred liabilities.
• Check the Debt-to-Equity Ratio to measure leverage.

Debt-Equity Ratio = Total Debt / Shareholders’ Equity

• A high ratio : high financial risk
• A moderate ratio: efficient leverage

Step 4: Evaluate Shareholders’ Equity

• Comprises share capital, reserves, and retained earnings.
• Indicates how much of the company is funded by owners versus lenders.
• Rising reserves and stable retained earnings signal good profitability.

Return on Equity (ROE) = Net Profit / Shareholders’ Equity

Shareholders’ Equity  : Represents net worth.

Formula: Equity=Assets−Liabilities\{Equity} = \{Assets} – \{Liabilities}Equity=Assets−Liabilities Includes retained earnings, preferred stock, treasury stock.

Step 5: Check Liquidity and Solvency

• Liquidity: Ability to meet short-term obligations (use current & quick ratios).
• Solvency: Long-term financial stability (use debt ratios).

Step 6: Trend Analysis (Year-over-Year)

Compare the balance sheet over several years to spot trends:

• Is debt increasing faster than assets?
• Are current assets growing in line with sales?
• Are reserves strengthening over time?

Step 7: Common Red Flags

• Rapid increase in receivables or inventory : weak collection or overstocking.
• Shrinking cash reserves despite rising sales : cash flow mismatch.
• High short-term borrowings : liquidity pressure.
• Declining net worth : accumulated losses or poor profitability.

Step 8: Supplement with Ratio Analysis

To get deeper insights, link balance sheet data with income statement and cash flow ratios:

• Current Ratio : Liquidity strength
• Debt-Equity Ratio : Leverage
• ROE / ROA : Profitability
• Asset Turnover : Efficiency

Income Statement : “How Much You Earned or Lost”

• Purpose: Measures profitability over a period. Key Components:
  • Revenue: Sales income.
  • Expenses: Operating, interest, tax.
  • Net Profit:
    $\text{Revenue}-\text{Expenses}$
• Example: Revenue INR 10L – Expenses INR 7L → Profit INR 3L
• Insight: Reflects business performance and efficiency.

Cash Flow Statement – “Where the Cash Comes & Goes”

• Purpose: Tracks actual cash movement. Key Components:
  • Operating Activities: Sales, payments.
  • Investing Activities: Asset purchases/sales.
  • Financing Activities: Loans, equity, dividends.
• Example: Operations ₹2L – Investing INR 1L + Financing INR 0.5L → Net Cash INR 1.5L
• Insight: Reveals liquidity and cash health.

How They’re Connected

• Net Profit from the Income Statement : Retained Earnings in Balance Sheet.  Net Profit from the Income Statement flows into the Equity section of the Balance Sheet as retained earnings.
• Cash Flow Statement starts with Net Profit: adjusts for non-cash items & working capital. The Cash Flow Statement starts with Net Profit and adjusts for non-cash items and working capital changes.
• Together, they provide a complete financial picture.Together, these statements provide a 360° view of financial health.
• A company may show profit on paper, but if cash is tied up in receivables, the Cash Flow Statement will reveal shortages — highlighting why all three reports are essential. Help investors assess company performance, Enable banks and NBFCs to evaluate creditworthiness, Support management in decision-making and financial planning, Ensure transparency for regulatory and audit compliance

• • Balance Sheet = Stability

  • Income Statement = Profitability

  • Cash Flow = Liquidity.

Quick Example Summary

A company shows profit in the Income Statement, but if cash is stuck in receivables,
➡ Cash Flow shows shortage
➡ Balance Sheet shows growing assets but low liquidity.

How to Analyze a Balance Sheet – Key Questions

• How much cash is available?
• Are there accounts receivable?
• Is there goodwill? How much?
• What are the biggest liabilities?
• Does the company have debt? What kind?
• Is there any preferred stock?
• Are retained earnings positive?
• Is there any treasury stock?

Yellow Flags to Watch For : (typically include high debt, negative equity, excessive goodwill, etc.)

Key Takeaways

• The balance sheet tells you what the company owns and owes.
• Combine it with P&L and Cash Flow Statement for a 360° view.
• Focus on liquidity, leverage, and growth trends — not just totals.
• Always compare across years and against industry benchmarks.

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