• Investor’s mindset
• Annual report reading
• P&L statement
• Balance sheet
• The cash flow
• The financial ratio
• Investment due diligence
• Equity research
• DCF primer
The Balance sheet equation
The Balance sheet contains data on the company’s assets, liabilities, and shareholders’ equity, while the P&L statement provides information on the company’s profitability. As you noted, the P&L statement discusses the profitability for the relevant financial year. Therefore, it is accurate to assert that the P&L statement is independent. The balance sheet, on the other hand, was created on a flow basis and contains financial data about the business going back to the moment of incorporation. The balance sheet, on the other hand, discusses how the company has changed financially over time, whereas the P&L discusses how the company did in a certain financial year.
The balance sheet includes information about the assets, liabilities, and equity, as you can see.
Assets were covered in the previous chapter. The firm is the owner of all assets, material and intangible alike. A resource that is under the company’s control and is anticipated to have economic value in the future is called an asset. Assets frequently include things like factories, machinery, money, names and brands, and patents. We shall examine the two different categories of assets—current and non-current—later in the chapter.
Alternatively, liability is the company’s obligation. The business accepts the requirement because it thinks it will have long-term economic benefits. Simply put, liability is the borrowing that the business has accepted and is required to repay. Borrowing for the short term, borrowing for the long term, payments that are due, etc. are common examples of obligations. There are two categories of liabilities: current and non-current. The various obligations will be covered in more detail later in the chapter.
In a standard balance sheet, the total assets and total liabilities of the business should be equal. Hence,
The balance sheet equation or accounting equation is the name given to the previous equation. The concept that the balance sheet should always be balanced is really illustrated by this equation. To put it another way, the company’s assets and liabilities should be equal. This is so because all of a company’s assets must be acquired either with capital from the owner or liabilities.
The difference between assets and liabilities is known as owners’ capital. It is also known as “Net worth” or “Shareholders Equity.” An equation for this might look like this:
Shareholders equity = Assets – Liabilities
A quick note on shareholders’ funds
As we all know, the assets and liabilities make up the balance sheet’s two main divisions. As you are aware, the liabilities are the company’s debt. The shareholders’ fund, is essential to the liabilities side of the balance sheet.
If you think about it, we are talking about liabilities here, which are the company’s obligations. On the other hand, we talk about the shareholders’ fund, which is a representation of the wealth of the shareholders. This seems really counterintuitive, don’t you think? How are shareholders’ funds and liabilities both included on the balance sheet’s “Liabilities” side? After all, the shareholder’s money is what the company’s shareholders actually own, making them an asset rather than a burden.
Now consider the financial statement while keeping this new viewpoint in mind. You will understand that the financial statements are a statement that the firm (which is a separate legal entity) publishes to inform the public about its financial health.
Additionally, this implies that the corporation does not legitimately own the funds of its shareholders, who are the true owners of the funds. Therefore, from the company’s point of view, the shareholders’ funds constitute a debt due to shareholders. The liabilities side of the balance sheet, therefore, displays this.
The liability side of the balance sheet
All of the company’s liabilities are listed on the liabilities side of the balance sheet. The shareholders’ fund, non-current liabilities, and current liabilities are the three sub-sections that make up liabilities. The funds for the stockholders are in the first segment.
Consider a hypothetical business that is issuing shares for the first time to gain an understanding of share capital. Consider that Company ABC issues 1000 shares at a face value of Rs. 10 apiece. The share capital in this scenario would be Rs. 10 x 1000 = Rs. 10,000/- (Face value X number of shares).
The share capital for ARBL is Rs. 17.081 Crs. (as stated in the Balance Sheet), and each share has an Rs. 1-value.
The number of outstanding shares can be determined using the FV and share capital value. We are aware of:
Share Capital = FV * Number of shares
Number of shares = Share Capital / FV
Hence in the case of ARBL,
Number of shares = 17,08,10,000 / 1
= 17,08,10,000 shares
Reserves and Surplus are the following line item on the liability side of the balance sheet. Reserves are often sums of money set aside by the business for particular uses. All of the company’s profits are kept in excess. For ARBL, the reserves and surplus are Rs. 1,345.6 Cr. An associated note with the reserves and surplus is note number 3.
As you can see from the memo, the corporation has allocated money to three different categories of reserves:
Capital reserves: Typically used for long-term initiatives. It is clear that ARBL does not have much at this point. The stockholders are entitled to this money, yet it cannot be given to them.
The securities premium reserve or account is where the premium over the shares’ face value or par value is kept. ARBL has a debt of Rs.31.18 billion.
All accrued corporate profits that have not yet been dispersed to shareholders are kept in the general reserve. The cash here might serve as a safety net for the business. As you can see, ARBL has general reserves worth Rs. 218.4 Cr.
The surplus is covered in the subsequent section. The gains made throughout the year are kept in the surplus, as was previously explained. There are a few noteworthy facts to consider:
As per the last year’s (FY13) balance sheet, the surplus was Rs.829.8Crs. This is what is stated as the opening line under a surplus.
The ending balance of surplus from the prior years is increased by FY14’s profit of Rs. 367.4 Crs. Here are a few things to remember:
1. Take note of the relationship between the balance sheet and the P&L statement. This draws attention to an important fact: the interdependence of the three financial accounts.
2. Take note of how the balance sheet number from last year is added to the number from this year. This demonstrates how the balance sheet is created using a flow basis and that carrying forward amounts are added year after year.
2. The total of the prior year’s balance plus this year’s profit is Rs. 1197.2 Crs. The corporation has the option of allocating this money to several uses.
A company’s initial action is to shift some funds from the excess to general reserves so they would be available for usage in the future. For this, they have transferred a little over Rs. 36.7 Cr.
After transferring to general reserves, they disbursed Rs. 55.1 crores in dividends, of which they must pay Rs. 9.3 crores in dividend distribution taxes.
The company’s closing balance is Rs.1095.9 Cr. in surplus after the necessary distributions have been made. This will serve as the starting sum for the surplus account for the next year (FY15), as you could have anticipated.
Capital reserve, securities premium reserve, general reserve, and surplus for the year are added together to form the total reserves and surplus. The FY14 figure is Rs.1345.6 Cr., compared to the FY13 figure of Rs.1042.7 Cr.
Share capital, reserves, and excess are all included in the total shareholders’ money. This sum is referred to as “shareholders funds” since it represents the money owned by shareholders on the liabilities side of the balance sheet.
Non-current liabilities are long-term debts that the corporation expects to pay off or settle after 365 or 12 months from the balance sheet date. These debts are recorded for a number of years. Liabilities that are not current are typically settled a year following the reporting period.
Here is a glimpse of Amara Raja Batteries Ltd.’s non-current liabilities.
Let’s look at each of the three categories of non-current liabilities the corporation has.
The first line item under “non-current obligations” is the long-term borrowing (connected to note 4). Given that it shows how much the company has borrowed from various sources, long-term borrowing is one of the most significant lines on the overall balance sheet.
It is abundantly evident from the note that the “Long Term Borrowings” consist of “Interest-Free Sales Tax Deferment.” The following message from the corporation explains interest-free sales tax deferment in more detail (I have highlighted the same in a red box). It appears to be some kind of state government tax incentive. The corporation intends to pay this sum over a 14-year period.
You’ll discover that many businesses don’t have long-term borrowings (debt). Although it is encouraging to learn that the business is debt-free, you must also wonder why. Is it a result of the banks’ refusal to lend money to the business?
Or perhaps it’s because the business isn’t making any efforts to grow its activities. Of course, we will discuss the balance sheet’s analytical portion later in the lesson.
Do not forget that when we examined the P&L statement, we looked at the line item “Finance Cost.” The cost of financing will also be expensive if the company has a high level of debt.
“Deferred Tax Liability” is the following line item under the non-current liability. In essence, the deferred tax liability is a reserve for future tax obligations. The corporation has set aside some money for this reason because it anticipates a scenario in which it may need to pay higher taxes in the future. Why do you believe the business would put itself in a position where it eventually had to pay higher taxes for the current year?
This occurs as a result of the distinction between the Company’s Act and Income Tax’s treatment of depreciation. We won’t discuss this point because doing so would take us away from our goal of learning how to use financial statements. But keep in mind that delayed tax duty does occur.
The “Long term provisions” is the last line item under the non-current liability. Usually, long-term provisions refer to monies set aside for employee perks like gratuities, paid time off, provident funds, etc.
Current liabilities are debts that must be repaid by a business within a year (less than 1 year). When an obligation is described as “Current,” it means that it will be paid off within a year. Considering such, it is obvious that “non-current” refers to responsibilities that are longer than a year.
Consider it this way: You certainly want to pay back your credit card company within a few months if you purchase a mobile phone on an EMI (using a credit card). Your “current liability” is now this. However, if you obtain a 15-year mortgage from a housing finance firm to purchase an apartment, the unit becomes your “non-current liability.”
As you can see, the current obligations are divided into 4 line items. The first is borrowings for a limited period of time. These are, as the name implies, short-term liabilities that the corporation often takes on to meet its daily cash needs (also called working capital requirements).
As you can see, the State Bank of India and Andhra Bank are offering these short-term loans to help with the need for working capital. It’s noteworthy to observe that just Rs. 8.3 crores are borrowed on a short-term basis.
Trade Payable, commonly known as Account Payable, is the following line item and is worth Rs. 127.7 Crs. These are debts owed to suppliers that provide goods and services to the business.
The suppliers of raw materials, service providers of utilities, stationery manufacturers, etc., could be the vendors.
“Other current obligations” is the following line item, and it is worth Rs. 215.6 Cr. Typically, “Other Current Liabilities” refer to debts owed to satisfy legal responsibilities and debts unrelated to the business’s operations.
Current liabilities’ final line item is “Short term provisions,” which totals Rs. 281.8 Cr. Long-term provisions, which deal with saving money for employee benefits like gratuities, leave encashment, provident funds, etc., are very similar to short-term provisions in this regard. It’s interesting to observe that the notes for “Short-term Provisions” and “Long term Provisions” are identical.
Note 6 fills multiple pages since it contains both long- and short-term provisions; hence, for this reason, I will not represent an extract of it.
The FY14 Annual report for Amara Raja Batteries Limited is available on pages 80, 81, 82, and 83 for those who are interested in learning more.
However, all you need to know from the viewpoint of a user of a financial statement is that these line items (short and long-term provisions) deal with the employee and associated perks. Please be aware that the linked remark should always be read carefully for complete details.
We have now examined the portion of the balance sheet known as the liabilities side or roughly speaking, half of the balance sheet.
Total Liability = Shareholders’ Funds + Non Current Liabilities + Current Liabilities
= 1362.7 + 143.03 + 633.7
Total Liability = Rs.2139.4 Cars
The Assets side of Balance Sheet
In the previous chapter, we looked at the liability side of the balance sheet in detail. We will now understand the 2nd half of the balance sheet, i.e. the Asset side of the balance sheet. The Asset side shows us all the company’s assets (in different forms) right from its inception. Assets in simple terms are the resources held by a company, which help in generate revenues.
As you can see, there are two main sections on the Asset side: Current assets as well as non-current assets. There are multiple line items (and related remarks) in both of these sections. We shall investigate each of these subheadings.
Non-current assets (Fixed Assets)
Similar to what we discovered in the previous chapter, non-current assets refer to the assets of the company from which the economic advantage is derived over an extended period of time (beyond 365 days). Keep in mind that a company expects an asset it owns to bring the company financial benefits during the course of the asset’s useful life.
You’ll see that there is a section labeled “Fixed Assets” with numerous line items under it under the non-current assets. Fixed assets are possessions of the corporation, both tangible and intangible, that are difficult to convert to cash or liquidate. Examples of fixed assets include land, equipment, cars, buildings, etc. Because they provide benefits to businesses over a long period of time, intangible assets are also regarded as fixed assets.
The first line item ‘Tangible Assets’ is valued at Rs.619.8Crs. Tangible assets consist of assets that have a physical form. In other words, these assets can be seen or touched. This usually includes plant and machinery, vehicles, buildings, fixtures, etc.
Likewise, the next line item reports the value of Intangible assets valued at Rs.3.2 Crs. Intangible assets are assets that have an economic value but do not have a physical nature. This usually includes patents, copyrights, trademarks, designs, etc.
Remember, when we discussed the P&L statement we discussed depreciation. Depreciation is a way of spreading the cost of acquiring an asset over its useful life. The value of the assets depletes over time, as the assets lose their production capacity due to obsolescence and physical wear and tear. This value is called the Depreciation expense, shown in the Profit and Loss Account and the Balance Sheet.
Every asset should be written off throughout the course of its useful life. In light of this, the company’s acquisition of an asset is referred to as a “Gross Block.” After deducting depreciation from the gross block, we can reach the “Net Block.”
Gross Block – Accumulated Depreciation equals Net Block.
It should be noted that the word “Accumulated” refers to all depreciation values since incorporation.
Remember that the corporation is reporting its Net block, which is Net of Accumulated depreciation when we see tangible assets at Rs.619.8 Crs. and intangible assets at Rs.3.2 Crs. Observe Note 10, which is related to fixed assets.
As of 31st March 2013 (FY13), ARBL reported the building’s value at Rs.93.4 Crs. During the FY14 the company added Rs.85.8Crs worth of building, this amount is classified as ‘additions during the year’. Further, they also wound up 0.668 Crs worth of building; this amount is classified as ‘deductions during the year’. Hence the current year value of the building would be:
Previous year’s value of building + addition during this year – deduction during the year
93.4 + 85.8 – 0.668
You can notice this number is highlighted in blue in the above image. Do remember this is the gross block of the building. One needs to deduct the accumulated depreciation from the gross block to arrive at the ‘Net Block’. In the snapshot below, I have highlighted the depreciation section belonging to the ‘Building’.
The building’s valuation as of the 31st of March 2013 (FY13) was Rs. 93.4 Crs., according to ARBL. Building additions totaling Rs. 85.8 crore were made by the corporation during FY14; this sum is referred to as “additions during the year.” Additionally, they ended up spending 0.668 Crs on buildings; this sum is categorized as “deductions during the year.” Consequently, the building’s current-year worth would be:
Building value from the prior year plus any additions made this year less any deductions made this year
93.4 + 85.8 – 0.668
As you can see in the figure above, this number is highlighted in blue. Do not forget that this is the building’s main block. To get to the “Net Block,” one must subtract the total depreciation from the gross block.
As of the 31st of March 2013 (FY13), ARBL had depreciated Rs. 17.2 Cr. They need to add Rs. 2.8 Cr. from FY14 and modify 0.376 Cr. as the year’s deduction. As a result, the annual total depreciation is as follows:
Deduction for the year = Previous year’s depreciation value minus Current year’s depreciation
= 17.2 + 2.8 – 0.376
Depreciation total = Rs. 19.736 billion. This is denoted in the above image by a red highlight.
Depreciation costs Rs. 19.73 Cr. and construction costs Rs. 178.6 Cr., giving us a netblock of Rs. 158.8 Cr. (178.6 – 19.73).
To determine the Total Net block number, the same operation is done for all the other tangible and intangible assets.
Capital work in progress (CWIP) and Intangible assets under development make up the following two lines under fixed assets.
At the time the balance sheet was being prepared, CWIP included machinery that was being assembled, a building that was under construction, etc. Consequently, “Capital Work in Progress” is a fitting name for it. Typically, this sum is stated in the Net block section. CWIP refers to work that isn’t finished yet but has already required capital expenditure. As we can see, CWIP for ARBL totals Rs. 144.3 Cr. The asset is moved to physical form after construction is complete and it is put to use.
‘Intangible assets under development’ is the last line item. Intangible assets are included, hence it’s comparable to CWIP. The work in the process could include trademark development, copyright filing, and patent application. This only costs ARBL 0.3 Crs, which is extremely low. The overall fixed cost of the company is calculated by adding all of these expenses.
Non-current assets (Other line items)
There are other line items under non-current assets in addition to the fixed assets.
Non-current investments are ones that ARBL makes with the long term in mind. This costs Rs. 16.07 crores. Anything could be invested in, including publicly traded equity shares, mutual funds, debentures, and minority stakes in other businesses. Here is a partial image of Note 11 that I could not fit the complete image into.
Long-term loans and advances are the next line item and the total of Rs. 56.7 crores.
These are loans and advances that the company has granted to other member companies, staff members, suppliers, vendors, and other parties.
Other Non-current Assets, which is the final line item under Non-current Assets, is worth Rs. 0.122 Cr. This also contains several other long-term assets.
Current assets are those that are quickly convertible to cash and whose consumption is anticipated by the company to occur within a year. The assets that a business uses to finance its ongoing costs and day-to-day operations are known as current assets.
Cash and cash equivalents, inventories, receivables, short-term loans, and advances, as well as various debtors, are the most prevalent current assets.
Inventory, which has a line item value of Rs. 335.0 Cr., is the first item under Current Assets. All of the company’s finished products, raw materials on hand, incompletely made products, etc. are all included in inventory. Stocks are items that are in various stages of production and have not yet been sold. Any product that is produced in a business through several raw material processes to work in progress to finished good.
As you can see, “Raw material” and “Work-in-progress” account for the majority of the inventory value.
Trade Receivables, also known as Accounts Receivables, are the next line item. This is the sum of money that the company anticipates getting from its suppliers, clients, and other relevant parties. ARBL has a trade receivable of Rs. 452.7 Cr.
The next line item is Cash and Cash equivalents, which are the assets that are thought to be the most liquid on the balance sheet of any corporation. Cash consists of cash available and cash needed. Cash equivalents are highly liquid, short-term assets with maturities of under three months from the date of purchase. This stands at Rs.294.5 Crs.
Short-term loans and advances that the company has offered are the following line item. These loans and advances must be repaid to the company within 365 days. It involves a variety of things including payments in advance for taxes (income tax, wealth tax, etc.), advances to suppliers, loans to clients, loans to workers, etc. This costs 211.9 crores of rupees. The final line on both the Assets side and the actual Balance sheet comes after this. This is the category of “Other current assets” that is referred to as “Other” because it is not important. This costs Rs. 4.3 Cr.
In conclusion, the following would be the company’s Total Assets:
Current Assets plus Fixed Assets
= 840.831 crores plus 1298.61 crores
= Rs. 2139.441 Cr., which is the precise amount of the company’s liabilities.
The balance sheet equation still applies to ARBL’s balance sheet, as you can see in the example above.
Liabilities + Shareholders’ Funds = Asset
Do not forget that we have just looked at the balance sheet and the P&L statements during the previous chapters. We haven’t done any data analysis to determine whether the figures are good or poor, though. When we examine the chapter on financial ratio analysis, we shall follow suit.
The final financial statement, the cash flow statement, will be covered in the following chapter. Before we wrap up this chapter, we must examine the numerous connections between the P&L statement and the balance sheet.
Connecting the P&L and Balance Sheet
Now let’s concentrate on the balance sheet and the P&L statement and the various ways they relate to (or have an impact on).
The line items on a typical basic P&L statement are shown on the left side of the image above. On the right side, we show some of the typical Balance Sheet components that correspond to it. You are already familiar with the meaning of each of these line items from the earlier chapters. We shall now, however, comprehend the relationship between the P&L and balance sheet line items.
Consider the Revenue from Sales first. A business has costs associated with every sale it makes. For instance, if a business decides to launch an advertising campaign to raise awareness of its goods, the campaign will cost money. The cash balance tends to drop as money is spent. Receivables (Accounts Receivables) increase in the event that the business makes a credit sale.
The acquisition of raw materials, completed items, and other comparable costs are included in operating expenses. Two things occur when a business incurs these costs to produce items. Trade payables (accounts payable) increase if the purchase is made on credit, as it always is. Second, the Inventory level is also impacted. The length of time it takes the business to sell its products determines whether the inventory value is high or low.
Companies spread the asset’s purchase price over the asset’s economic useful life whether they invest in tangible assets or in brand-building activities (intangible assets). The depreciation mentioned in the balance sheet tends to rise as a result of this. Keeping this in mind, the balance sheet is created using a flow basis. As a result, the depreciation on the balance sheet is added to each year. Please take note that the term “depreciation” used in the balance statement refers to “accumulated depreciation.”
Included in other revenue are funds received as interest income, proceeds from the sale of affiliated businesses, rental income, etc. As a result, other sources of income frequently suffer when businesses engage in investing activities.
The corporation certainly pays money to finance the debt when it takes on debt, whether it be short-term or long-term.
Last but not least, as you may remember, profit after tax (PAT) increases the company’s surplus, which is a component of shareholders’ equity.
A flow-based balance sheet, also known as a statement of financial position, shows the company’s financial situation at any given time. It is a statement that details the assets and liabilities of the business (liabilities)
A balance sheet is typically required when a business seeks investors, applies for loans, files taxes, etc.
Assets equal Liabilities plus Shareholders’ Equity in a balance sheet.
A company’s liabilities are its debts or commitments from prior transactions, and its share capital is equal to the number of shares times its face value.
Reserves are money set aside for a particular reason that a corporation plans to use in the future.
The company’s profits are kept in the surplus. The balance sheet and the P&L interact at this moment among others. Surplus funds are used to pay dividends.
Shareholder equity is calculated as Share Capital plus Reserves plus Surplus. The owners’ claim to the company’s assets is known as equity. If you flip the Balance Sheet equation, Equity = Assets – Obligations, it shows the assets that are left over after subtracting the liabilities.
Long-term liabilities and non-current obligations are anticipated to be paid off within 365 days or 12 months, respectively, of the balance sheet date.
Due to the disparity in how depreciation is handled, deferred tax liabilities are created. According to accounting books and tax books, deferred tax liabilities are the sums of income taxes that will be due in the future in relation to taxable differences.
The company’s commitments that must be paid off within 365 days or 12 months of the balance sheet date are known as current liabilities.
Both long-term and short-term provisions are often obligations that deal with issues relating to employees.
Shareholders’ Funds plus Non-Current Liabilities plus Current Liabilities equals Total Liability. As a result, total liabilities represent the total amount of debt owed by the business to third parties.
The balance sheet’s Assets side lists every asset the business has.
During their useful lives, assets are anticipated to provide economic benefits.
Assets are divided into two categories: current and non-current.
Non-current assets are anticipated to have a longer useful life beyond 365 days or 12 months.
The projected payoff period for current assets is 365 days or 12 months.
Depreciable assets are referred to as the “Gross Block.”
Gross Block – Accumulated Depreciation equals Net Block.
All assets should equal all liabilities and vice versa. The balance sheet is only deemed to be accurate at that point.
The P&L statement and balance sheets are one and the same. They are linked in numerous ways.