Balance Sheet Part – 2: Components and Examples

Balance Sheet Analysis in Detail

Now let us look at the balance sheet of XYZ Ltd. to see how it publishes it in its annual report.

Assets

Let’s look at each line item one by one:

• Non Current Assets 

The assets section starts with non-current assets, as discussed earlier, with a life of more than 1 year.

It starts with PPE, i.e., property, plant, and equipment, which are the assets of any manufacturing company. A tech company will typically have PPE as a % of total assets as a lower number than a manufacturing company.

• Capital work in progress 

It states which asset is in the construction phase.

• The Right of Use asset

It is a relatively new concept. This relates to the lease assets the company does not own but has taken on long-term leases. Earlier, the companies were not recording lease assets as they did not own those. However, with a change in accounting, they were required to report these.

• Goodwill

The next comes the goodwill. When one company acquires another, the purchase price often includes not only the value of tangible assets (like buildings, equipment, and inventory) and identifiable intangible assets (like patents or trademarks) but also the value of the acquired company's reputation, customer relationships, brand, and other intangibles that contribute to its overall value. This excess value paid to acquire a company over and above its tangible and intangible value is recognised as goodwill on the acquiring company's balance sheet.

• Investments 

Investments denote the investment in joint ventures and associate companies.

• Financial Assets 

Financial assets include the investments, loans, advances, etc., that the company has made through the excess cash available.

• Deferred Tax Assets

Deferred tax assets denote that tax has already been paid for an income yet to be generated. Hence, when the actual realisation happens, tax will not be paid.

Current Assets 

Now, let’s discuss the current assets.

• Inventory 

The first one we see here is the inventory. As we all know, inventory is the remaining unsold stocks by the year's end. These are company assets expected to be sold or converted into cash within a year.

• Current Investments 

Current investments typically consist of mutual funds and bonds easily converted into cash.

• Trade Receivables 

Trade receivables are the debtors to whom goods are sold on credit. These are also referred to as debtors of a company. 

• Cash and Cash Equivalent and Bank Balances 

It refers to the company's hard cash. Typically, while calculating a company's cash balance, we add up the cash, bank, and current investments plus a realisable portion of the non-current investments.

Now, let's move on to the other side of the balance sheet, the equity and liability side.

Equity and Liabilities 

• Equity Share Capital and Other Equity 

The equity denotes the equity share capital, and the other equity majorly constitutes the reserves and surplus. As we discussed this in detail in the last segment, we’ll move on to the next line item.

• Non Controlling Interest 

Non-controlling interest is also called the minority interest. It’s a similar concept to what we had learned in the income statement. As a recap, when we consolidate a subsidiary with less than 100% stake, accounting standards suggest consolidating by recognising it as a 100% subsidiary and later putting a plug figure that negates the effect. For, example, Starbucks is a 50% subsidiary of Tata Consumers, and all the assets and liabilities of Starbucks are added to the assets and liabilities of Tata Consumers. However, to denote the 50% ownership, a plug figure of the remaining 50% will be shown as a minority interest.

Non Current Liabilities 

In the non-current liabilities, we have borrowings that make up the major portion of most of the companies. As discussed earlier, it refers to the amount borrowed by a company in the form of loans or any other external borrowings. 

• Lease Liabilities 

Moving ahead with the lease liabilities, this is a relatively new addition to the balance sheet. This represents the assets not owned by the company but taken on lease for a longer duration and thus treated as debt. Why? Well, because it matches the basic definition of debt.

1. It has to be given back at the end of the lease term.
2. It has a fixed outflow each year, just as interest.

• Tax Liabilities 

Tax liabilities are the estimates that need to be paid later for an already realised income.

Current Liabilities 

The last segment of current liabilities shows borrowings to be paid within 1 year. These are typically working capital loans.

• Short Term Lease Liabilities

Then, we have short-term lease liabilities. That is similar to the lease liabilities discussed in the non-current liabilities section.

• Trade Payables 

The trade payables are the goods the company has taken on credit from the supplier.

Now that we have discussed all three major components of working capital, let us discuss how to calculate one.

Working capital is the sum of inventory and debtors minus the creditors. This is an essential figure as a company that is highly efficient in working capital management will typically have a lower working capital figure than an inefficient company. Managing working capital is a significant task of the company's finance department.

Relevance of Balance Sheet

Have you ever wondered why a Balance Sheet is called a “BALANCE” sheet? Because it always Balances.

Yes, that’s the ultimate truth of any transaction happening in a company. Like Newton’s law, every action has an equal and opposite reaction; similarly, every transaction has an equal and sometimes opposite and sometimes not opposite but offsetting transaction that balances the assets and liabilities.

Let's simply understand this with an example.

Suppose your business wants to install new machinery of ₹50 lakh to increase the capacity and grow the business. That’s called building an asset. It comes under the Asset Side of the Balance Sheet as a Fixed Asset.

But did any of you think about where the money is coming from? In this example, let's suppose the financing was arranged by taking a bank loan of ₹50 lakh. Now, intuitively as well, what’s a loan taken? Correct, it’s a liability.

A loan, therefore, comes under the liability side of the balance sheet.

Balance sheet as of 31st March 20XX
Liabilities	Amount [In ₹]	Assets	Amount [In ₹]
Loan	50,00,000	Machine	50,00,000
Total	50,00,000	Total	50,00,000

Hence, the Balance Sheet tallies.

You think of any transaction in a company and see that it will create either a liability of an equal amount or reduce another asset by the same amount.

Let's take a few other examples.

Suppose a company raises money through an IPO. What would its balance sheet look like?

That company must have received cash when investors subscribed to its IPO. Therefore, the Cash on the Asset side of the balance sheet went up.

On the other hand, Equity, also called Owner's Capital, is shown on the liability side and increases the company's liabilities by the same amount.

Equity, the English word, means ownership. Therefore, the investors who subscribe to the company's shares in an IPO sit on the Equity head under the Equity and Liability side of the balance sheet.

Hence, if you have heard of Warren Buffet’s advice that when you invest in a business, think like owning the company, this exactly is why he said so, as the company represents you as the owner in its Balance Sheet.

Treatment of Bonus, Split, and Right Issues in the Balance Sheet

If you have already begun your investing journey or are going to start it now, chances are that you have heard about the terms “bonus,” “split” and “rights issue.” Let’s make these terms simpler for you.

Let's start with bonus shares.

Bonus: as the name suggests, it's free! Companies satisfy the shareholders' thirst for more shares by regularly declaring bonus shares. So, let us understand why they are issued and if they benefit us as retail shareholders.

So, companies issue bonus shares to increase their share capital. Now you know what share capital means, right?

Let us consider the case of XYZ Ltd. The company had just issued bonus shares to 1:1.

Do notice how to read it in words. The company has issued 1 equity share for every 1 share held by the shareholder. So, if you hold 5 shares of XYZ Ltd as of the record date (the date announced by the company on which you hold the shares), you become eligible for bonus shares. The same term is used for dividend and rights issues. You will receive an extra 5 shares of the company for free!

Let’s look at how it impacts the financial statements of XYZ Ltd.

As you might recall, the Equity Capital in the Share Capital section is calculated as

Number of Shares Issued by the Company * Face Value

 

Snapshot of a Balance Sheet before bonus issue of 1:1

Balance sheet as of 31st March 20XX
Equities and Liabilities	Amount [In ₹]
Equity capital [80 crore equity shares * ₹1 face value]	80,00,00,000
Reserves and Surplus	1,00,00,00,000
Total	1,80,00,00,000

In the case of XYZ Ltd, it was 80 cr shares issued * 1

Now, with 1:1, 80 became approximately 160, so equity capital became 160 * 1 = 160 crore.

The company has doubled the share capital, but where did it get the amount to do so? Well, it transferred the amount from reserve and surplus. Therefore, you will notice that the company's equity, which is share capital + reserve and surplus, remains the same at ₹180 crore. 

Snapshot of a Balance Sheet after bonus issue of 1:1

Balance sheet as of 31st March 20XX
Equities	Amount [In ₹]
Equity capital [160 crore equity shares * ₹ 1 face value]	1,60,00,00,000
Reserves & Surplus	20,00,00,000
Total	1,80,00,00,000

 

Now that’s a reward. Let’s suppose you own 5 shares and get 5 for free. Doesn’t that mean just doubling the investment? Well, no! That’s impossible by just an announcement, and never fall for it. On the record date, the share price will automatically be nearly half. Why is that so? Well, to keep the investment amount of the shareholder the same as before.

Suppose you held 5 shares of XYZ Ltd at a market price of ₹5,000. That makes your investment ₹25,000.

Now, after getting the bonus 1:1, you will have 10 shares at a halved price of ₹2,500, again keeping your investment amount at ₹25,000.

Did that strike you something else? Well, it's not the share price that determines your wealth. It's also the number of shares.

Holding 10,000 shares of a penny stock at ₹2.5 will constitute the same investment as holding just 1 share of a blue chip stock at ₹25,000. Now, your return will be defined by how much percentage each of these stocks rallies. A 10% rally in both stocks would result in a gain of ₹2,500, irrespective of the quantity you hold.

Remember this. Never fall into the trap of getting into low-digit share price stocks to increase your shares. Your investment return will be determined by the fundamentals and valuations of a stock. Seems logical, right? 

Now, let’s move on to split. In a split, the treatment and result are very similar to a bonus, just that the face value changes in a split. 

Now comes the next term, the rights issue.

A rights issue is a method by which you can kill two birds with one stone. It is beneficial for both the company and the shareholders simultaneously. It’s a good corporate governance practice. [Corporate governance is a term used in the financial markets to denote the ideal practices that should be followed by the management of companies].

If a listed company wants to raise money through equity and not debt, there are two methods: to come out with an FPO or Further Public Offering. It is just like an IPO but is done by already listed companies. Both new and existing shareholders can participate here.

Next comes the right issue. Here, companies ask the existing shareholders to put money into the company, but at a discounted price from the current market price. Here, the company can raise the required amount of money, and the shareholders can increase their investment in the company at a discounted price. A win-win! In a rights issue, only existing shareholders can participate.

In terms of effect on the balance sheet. It has a similar effect to that of an IPO. The share capital, reserve, and surplus both go up. 

Balance Sheet Manipulations

You must have heard people complaining about how the company's management manipulates accounting to show the rosy picture of the company.

Well, these people have a point. When you invest in a company, you are undoubtedly at the mercy of the management. Because no matter how good an analyst you are, the management of the company is still gonna be better than you.

But how would you know whether the management is honest or not?

A simple guide to identify or at least get a hint of manipulation is determining if the company uses aggressive accounting policies.

Now, what do we mean by that?

A company can increase its revenues by showing goods sold on credit.

One thing that can happen is that the sale is legitimate, but the terms are such that they allow an extended period for the customer to pay for the goods or services.

Second and more enjoyable, what could happen is that the management shows a false sale, which means the sale is only a book entry. A sale is shown as credit; you know what happens when a good is sold on credit. It creates a debtor! Right?

Remember, this expense was fake, so this company would gradually write off some of this false entry as bad debt every year.

So, a company with high debtors is an avoid. High in such cases cannot be an absolute number but rather a ratio that tells us how many days a debtor pays back to the company on average. For that, we need another chapter on ratio analysis, which we will also cover in detail.

As you can see, in this series of financial analyses, we are building blocks with each and every chapter. Financial analysis requires understanding all the financial statements, and reading just one won't make any sense. As you learn about more statements, you can interlink them and make sense of the numbers a company reports very well.