The Study of Stock Market through Fundamental Analysis

Lesson -> The Balance Sheet

6.1 - Balance sheet equation

The P&L statement provides information about company profitability. However, the balance sheet provides information about assets, liabilities, and shareholders' equity. As you can see, the P&L statement discusses profitability for the current financial year. It is important to note that the P&L statements are standalone. The balance sheet, however, is prepared on a flow-based basis. It contains financial information about the company from the moment it was formed. The balance sheet is a financial summary of how the company has changed over time. While the P&L reports on how the company performed in a specific financial year, the balance sheet discusses how it has done.

Take a look at Amara Raja Battery Limited's balance sheet (ARBL).

The balance sheet, as you can see, contains information about assets, liabilities, equity, and other financial data.

In the previous chapter, we had already discussed assets. Assets The company owns both intangible and tangible assets. Assets are resources that the company controls and will have economic value in the future. Assets include cash, plants, machinery, and patents. The Asset is classified into Current and non-current assets. We will see these topics further in this chapter.

Liability On the other side, it is the company's obligation. Because it believes that these obligations will bring economic benefit in the long-term, the company accepts the obligation. Simply put, liability is the company's loan which it is required to repay. Examples of obligations include short-term borrowing, long-term borrowing, and payments due. There are two types of liabilities: current and non-current. Later in this chapter, we will talk about the types of liabilities.

A typical balance sheet should show that the company's total assets and liabilities are equal. This is how it works:

Assset= Liabilities

This equation is also known as the balance sheet equation or the accounting equation. This equation actually depicts the key property of the balance sheet, i.e. The balance sheet should be balanced. The assets of the company should equal the liabilities. This is because all assets owned by a company (Assets), must be purchased from the owner's capital, or liabilities.

Owners Capital is the difference between assets or liabilities. This is also known as the Shareholders equity or the Net worth'.
Asset- Liability = Shareholders

6.2 - A quick overview of shareholders' funds

The balance sheet consists of two major sections. The assets and liabilities. As you all know, the liabilities are the company's obligation. Below is a snapshot of the shareholders' fund. It is an integral part of the balance sheet's liabilities. This term can be confusing for many people.

If you look at it from one side, liabilities are the company's obligation. On the other, we will be discussing the shareholder's fund, which is the shareholder's wealth. This seems counterintuitive. How is it possible for liabilities and shareholder funds to appear on the Liabilities section of the balance sheet. The shareholder's funds are the funds of its shareholders, which is in reality an asset and not a liability.

This will help you to make sense of the financial statements. The entire company can be viewed as a single individual whose only job it is to manage its core operations and generate wealth for shareholders. This way you can see that you are actually separating shareholders (which includes the promoters) from the company. Now, let's look at the financial statement from a new perspective. The financial statement is a statement that a company publishes (which is an entity of its own) to inform the world about its financial health.

The shareholders' funds are not part of the company but belong to its shareholders. Accordingly, shareholders' funds are an obligation that the company owes to its shareholders. This is also shown on the liabilities side the balance sheet.

6.3 - The liability side of your balance sheet

The balance sheet's liabilities section details all company liabilities. There are three sections within liabilities: shareholders' fund and non-current liabilities. Current liabilities is the third. The shareholders' funds is the first.

Imagine a company issuing shares to understand share capital. Imagine Company ABC issuing 1000 shares with a face value Rs.10 per share. This would give the share capital Rs.10 x 1000 = Rs.10,000/ (Face value X amount of shares).

ARBL's share capital (as per the Balance Sheet), is Rs.17.081 crore and the Face Value is Rs.1/0. The NSE's site provided the FV value:

To calculate the number shares outstanding, I can use FV and share capital values. We know:

ARBL is an example of this.

17.08,10,000 shares / 1


Next on the Balance Sheet's liability side, is the 'Reserves & Surplus'. The company usually reserves money that is earmarked for specific purposes. Surplus is the place where all profits are located. ARBL's reserves and surplus are Rs.1,345.6 Crs. The associated note is number 3. Let's examine the same.

The note shows that the company has allocated funds to three types of reserves.

  1. Capital reservesUsually used for long-term projects. ARBL doesn't have much money here. This amount is owned by the shareholders and cannot be divided.
  2. Securities premium reserve/account- This is the place where the premium sits above and beyond the shares' par/face value. ARBL holds a reserve of Rs.31.18 Crores.
  3. Reserve general- Here are all company's accumulated profit, which has not yet been distributed to shareholders. This money can be used by the company as a buffer. ARBL's general reserves are Rs.218.4 Crores, as you can see.

Next, we will discuss the surplus. The surplus is the sum of all the profits earned during the year, as mentioned previously. A couple of interesting points to be aware of:

    1. According to the FY13 balance sheet, the surplus was Rs.829.8Crs. This is the starting line of a surplus. The image is below:

  1. Add the current year's profit of Rs.367.4 Cros to the surplus from previous years. Here are some things to note:
    1. You can see how the bottom line P&L interacts with the balance sheet. This illustrates a crucial fact: all three financial statements are closely linked.
    2. You can see how the balance sheet numbers from previous years are added up to this one. This shows that the balance sheet is prepared on an annual basis. Year on year, the carrying forward numbers are added.
  2. The sum of the previous year's profits and the balance from this year adds up to Rs.1197.2 crores. This money can be used for different purposes by the company.
    1. A company transfers money from surplus to general reserve so it can be used for future purposes. This was the purpose of close to Rs.36.7 Crore.
    2. They have transferred to general reserves and have paid Rs.55.1 crore in dividends. In addition, they must pay Rs.9.3 crore as dividend distribution taxes.
  3. After all the required apportions, the company now has Rs.1095.9 crore surplus as its closing balance. As you might have guessed, this will be the opening balance of next year's (FY15), surplus account.
  4. Total Reserves (TR) and Surplus = Capital reserve plus securities premium reserve + general reserve (GR) + surplus for the fiscal year. This compares to Rs.1042.7 Crores in FY13.

The total shareholders' fund is the sum of share capital, reserves, and surplus. This is also known as the'shareholders fund' because it represents money that shareholders have.

6.4 - Other Current Liabilities

Non-current liabilities are long term obligations that the company plans to pay off within 365 days/ 12 month of the balance sheet date. These obligations are usually kept on the books for several years. Most non-current liabilities can be settled within 12 months of the reporting period.

Here's a snapshot of Amara Raja batteries Ltd.'s non-current liabilities.

There are three types of non-current liabilities in the company. Let's examine each of them.

Long term borrowing The first line item in the list of non-current liabilities is (associated with note 4). The line item for long term borrowing, which is the total amount borrowed by the company from various sources, is one of the most important in the balance sheet. When calculating certain financial ratios, long term borrowing is one of the most important inputs. In this module we will examine the financial ratios.

Let's take a look at the note that is associated with "Long term borrowings":

It is clear from the note that the "Long term borrowings" is in the form an "interest-free sales taxes deferment". The company has provided an explanation of the note below. I have highlighted it in a red box. This appears to be a tax incentive from the state. This amount will be paid by the company over 14 years.

Many companies do not have any long-term borrowings (debt). It is great to see that there is no debt in the company, but it is also important to ask why. Are banks refusing to lend money to the company? Is it that the company isn't taking any steps to expand its business operations? We will discuss the balance sheet analysis later in this module.

Remember, we included 'Finance Costs' in the P&L statements. If the company has high debt, the finance cost will be also high.

Next is the line item in the non-current liability. Deferred tax liability. Deferred tax liability basically means that there is a provision for future taxes. They have set aside funds to cover the possibility of having to pay more taxes in the future. What makes you think that the company would place itself in a position where it will have to pay additional taxes in the future for the current year?

This is due to the differences in how depreciation will be treated according to the Company's Act and Income tax. This is not an issue we will discuss as it will distract from our goal of using financial statements. Remember that depreciation is a factor in deferred tax liability.

The non-current liability's last line item is"Long term provisions". Long-term provisions refer to money that is saved for employee benefits such as gratuity, leave encashment, and provident fund.

6.5 - The Current liabilities

Current liabilities are obligations that a company expects to settle within 365 days (less than 1 year). "Current" is used to indicate that the obligation will soon be settled or within one year. If you take the 'non-current" option, it means that obligations extend beyond 365 calendar days.

This is how you should think about it: If you purchase a mobile phone via EMI (via a card), you will likely repay your credit card company within a few weeks. This is your 'current liability. If you purchase an apartment through a 15-year home loan from a housing finance firm, this becomes your 'current liability.

Here's a snapshot of ARBL’s current liabilities:

You can see that there are four line items in the current liabilities. The first is short-term borrowings. These are short-term obligations that the company takes on to meet its cash needs (also known as working capital requirements). This extract from note 7 explains what short-term borrowings are.

As you can see, these loans are short-term loans that the State Bank of India and Andhra Bank offer to meet working capital requirements. It is worth noting that short-term borrowing is kept at a very low level at Rs.8.3Crs.

Next is Trade payable (also known as account payable) at Rs.127.7 crores. These are obligations that vendors who supply the company with goods and services must fulfill. These vendors could include raw material suppliers, utility companies that provide services, and stationery companies. Take a look at note 8, which provides more details.

Next, you will see 'Other current liabilities' at Rs. 215.6 Crs. Typically, 'Other Current Liabilities' refers to obligations related to statutory requirements or obligations that are not directly connected with company operations. Note 9 is associated with "Other current liabilities".

The last line item of current liabilities is 'Short-term provisions', which currently stands at Rs.281.8 Crore. The short term provisions are very similar to the long term provisions. They allow employees to set aside funds for benefits like gratuity, leave encashment and provident funds. The note that is associated with the 'Short term Provisions’ and the 'Long-term provisions' are identical. Take a look at these:

  • Note 6 includes both short- and long-term provisions. It is therefore very long. It is too long to reproduce. You can read the entire report on pages 80-81,82 and 83 in the FY14 Annual Report of Amara Raja Batteries Limited.

From a financial statement user's perspective, however, you only need to know that the line items (short term and long-term provisions) are about the employee and the benefits they receive. To understand the details, it is important to read the note.

Now we have seen half of the balance sheet. This is generally known as the Balance sheet's liabilities side. Let's take a look at the balance sheet again for a better perspective.

It is clear that

Total Liability = Shareholders Funds + Non-current Liabilities + Current Leabilities

= 1362.7 + 143.03 +633.7

Total Liability = Rs. 2139.4 Crs

To Summarize

  1. The Statement of Financial Position, also known as a Balance Sheet, is prepared using a flow-based method. It shows the company's current financial situation at any point in time. It shows the assets and liabilities of the company.
  2. When a business seeks investors or applies for loans, it will need a balance statement.
  3. Assets plus Liabilities plus Shareholders Equity is the balance sheet equation.
  4. From past transactions, liabilities are obligations or debts that a business has. Share capital is the amount of shares * multiplied by the current liabilities refer to the company's obligations for settlement within 365 days/12 months face value.
  5. Reserves are funds that have been set aside for a particular purpose and which the company plans to use in the future.
  6. The surplus is the place where profits are located. This is where the balance sheet interacts with the P&L. Dividends are paid from surplus.
  7. Equity = Share capital + Reserves + Surplus. Equity refers to the owner's claim on the company's assets. If you rearrange your Balance Sheet equation, Equity = Assets + Liabilities, it represents the remaining assets after subtracting the liabilities.
  8. The balance sheet date is not expected to reflect non-current liabilities and long-term liabilities.
  9. Due to the difference in how depreciation is handled, deferred tax liabilities are created. Deferred tax liabilities refer to income taxes that will be due in the future based on taxable differences according to accounting books and tax books.
  10. Current liabilities refer to the company's obligations for settlement within 365 days/12 months from the balance sheet date.
  11. Both long-term and short-term provisions in most cases are liabilities that deal with employee-related issues.
  12. Total Liability = Shareholders Funds + Non-Current liabilities + Current Liabilities. . Total liabilities are the amount that the company owes others.