How to read a company balance sheet before buying its stock?

If you are aware of the accounting procedures, you would be no stranger to a balance sheet. Even if you are not, this financial statement is among the most common documents released by a company that gives an overview of its financial position.
How to read a company balance sheet before buying its stock?

As an investor, it is beneficial for you to analyze a company’s performance before investing in its securities. For this, understanding how to interpret a balance sheet is a very helpful skill. But first, let us dig into the details of what a balance sheet is.

What is a balance sheet?

A balance sheet, also known as the position statement, tells a company’s financial position at the end of a financial year. It reports a company’s liabilities and assets. The assets side includes fixed as well as current assets. The liabilities side shows non-current and current liabilities and shareholder’s equity and reserves. An essential aspect of the balance sheet is that the assets must equal the liabilities and equity.

Why is it important to carry out a balance sheet analysis?

A balance sheet shows the company’s resources and debts, which further determines its growth potential. By carrying out a balance sheet analysis, you can enhance your chances of making profitable investments. You can also calculate financial ratios from the information gathered from such analysis. These ratios help give an insight into the firm’s liquidity, profitability, and solvency. 

Moreover, knowing a company’s financial position helps you determine the risk involved with the stock. This can help you diversify your portfolio better. Read more about portfolio diversification in our blog here.

Let us understand the process of balance sheet analysis in detail.

How to read the company balance sheet?

The new format of a company’s balance sheet is given under the Companies Act, 2013. It is a vertical format that starts with listing the liabilities and equity of the company. The second section below it mentions the assets of the firm.

Starting with the liabilities, the first major head to focus on is the shareholder’s fund. This section includes share capital details, including equity and preferred stock. It also states the reserves and surplus. This is followed by the application money received on shares that have not been allotted yet.

Below this, the subheading non-current liabilities mentions the long-term borrowings, deferred tax liabilities, long-term provisions, and any other long-term liabilities of the company. It is important to analyze this section to see the debt burden on the company. Compare it with the equity mentioned above as well as the assets to see how well-equipped the company is for meeting its financial obligations.

Further, the liabilities section also has the subheading for current liabilities. These are the short-term obligations of the company. These include short-term borrowings, trade payables, short-term provisions, and any other liabilities due within a year.

This closes the liabilities heading of the balance sheet. It is followed by the assets of the company. You must review the assets section to determine the monetary value of the resources that the company owns. This heading is divided into two subheads, namely non-current and current assets. Starting with non-current assets, it lists the fixed assets, both tangible and intangible, along with any work in progress. It further includes non-current investments, deferred tax assets, and long-term loans and advances. These long-term assets provide a solid base for the company and prove beneficial for growth in the long run.

This is followed by current assets. Some of these are trade receivables, inventory, and current investments. Another very important aspect of this is cash and cash equivalents. These determine the short-term liquidity and solvency of the company.

This concludes the details as mentioned in the format of the balance sheet. Apart from this, you must pay attention to the footnotes accompanying the balance sheet. These may contain the company’s financial obligations that have not been represented in the balance sheet or explain certain accounting policies.

We hope you will find it easier to navigate your way through the financial statement better now. Performing balance sheet analysis is a challenging task and requires expertise. We at TejiMandi can help you with this exercise. Reach out to us for any assistance.

Moving ahead, let us see some ratios that help better interpret the figures mentioned in the balance sheet.

How to do the ratio analysis based on the readings from the balance sheet?

The following ratios can be calculated to help you get a clearer picture of the position of the company:

Debt-equity ratio

The debt-equity ratio compares the amount of borrowed funds to the shareholder’s funds employed in the company. It can be calculated as:

Debt-equity ratio = Total liabilities / Shareholder’s equity

A low debt-equity ratio signals a more secure investment. This is because there is not a lot of financial burden on the company, and there is enough equity available to cover the borrowings. A high ratio can indicate financial risk, making an investment in such a company a less attractive deal.

Current ratio

This ratio determines how well-equipped the company is to meet its short-term obligations. It takes into account the current assets as well as the current liabilities. These are those liabilities that are due within a period of one year. It can be calculated as:

Current ratio = Current assets / Current liabilities

A ratio of 2:1 is considered ideal. It indicates that a company is financially sound.

In conclusion

Thorough knowledge of the balance sheet helps you analyze better and improves your judgment, enabling you to make profitable investment decisions. By reading and understanding the assets and the debts of a company, you can assess the risk involved in making investment decisions and minimize your losses considerably.

However, you do not need to do this exercise all independently. Experts at TejiMandi support your investment decisions by doing in-depth balance sheet analyses of a range of companies. We are SEBI registered investment advisors, trusted by over 10,000 investors. Head over to our website now to ensure a hassle-free capital market experience!

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