Introduction to Financial Statements

Balance sheet components: Assets

The hardest thing about the balance sheet is deciphering the vocabulary on it. Once you learn what a few things mean, the sheet is much easier to read. Before you can understand the individual accounts in each section, it is important to understand the three main sections on the balance sheet.

  • Section 1 – Assets – (these may be again classified in the balance sheet as fixed assets and current assets). But for the time being, let’s see what assets are- Assets are what the company owns. Example – land, buildings, factories, machinery, vehicles, computers, furniture, cash, bank balance in company’s account etc.. , it also includes receivable amounts from customers, tax authorities, government and other entities.
  • A company can also have fixed deposits in banks. That’s not all , it can have deposits for various purposes like rent deposit, advance given to suppliers etc , it can invest in shares, mutual funds  and bonds.. these amounts also form part of the company’s assets.
  • A company may also hold finished goods which are meant for sale. In some cases , work may be in progress. For example –,Late’s take a car factory. As on the balance sheet date, the company will have finished cars ready for sale as well as partly finished cars.  These are collectively called ‘inventories’. The value of ‘finished goods’ (Fully made cars) and ‘work-in –progress’ (partly made cars) forms part of the assets of the company.
  • Prepaid assets are another category of asset that may be seen in a balance sheet. In the course of every day operations, businesses will have to pay for goods or services before they actually receive the product. For example rent may have to be paid in advance for a year. Sometimes companies may decide to prepay taxes, salaries, utility bills,  or the interest on their debt. These would all be pooled together and put on the balance sheet under the heading ‘pre paid expenses’ or ‘pre paid assets’.By their very nature, Prepaid Expenses are a small part of the balance sheet. They are relatively unimportant in your analysis and shouldn’t be given too much attention.
  • There’s one more class of assets – intangible asset – ie, assets which appear in the balance sheet in the form of a ‘value’ but which cannot be seen , touched or felt. These include copy rights, trademarks , intellectual property, patents goodwill etc..

So that’s it for the first component in the balance sheet – Assets. Add them all up and you get the total assets owned by the company. Simple.

ASSET VALUE : MORE OF ESTIMATES AND ASSUMPTIONS

One important point to take note here is that, the value of most of the asset components discussed above as shown in the balance sheet is derived based on certain estimates and assumptions. For example – Property, plant and machinery, computers , furniture and fittings and all those equipments that the company use to operate business are accounted in the balance sheet at the purchase price in year one and in the subsequent years , a fixed rate of depreciation is charged on it and the balance is shown as the value. But in reality, nobody knows how much the company’s real estate or equipment might be worth in the open market. The fact that companies must rely on purchase price to value their assets can create some anomalies. Let’s discuss some examples here:

  • you started a company 25 years back and bought land For 25 lakhs. The land could be worth 5 or 6 crores today – but it will still be shown at 25 lakhs in the balance sheet. Since land does not wear out, depreciation is not charged on land each year.
  • In the case of machinery and other fixed assets, depreciation is charged at a fixed rate by the accountants. So , when you buy machinery worth 25 lakhs, it’s shown in the balance sheet after charging a depreciation of say, 10% or 15%. Two years down, this machinery may not have a reliazable value at all due to various reasons – for example technological obsolescence but, may still appear in the balance sheet at cost (25 lakhs) less depreciation charged (say at 15% for two years) at 18.06 lakhs.
  • A company may have intangible assets ( goodwill, intellectual property, customer base , strategic strength, brand image etc..). These are assets which exists but you cannot touch or spend. Most of these assets are ‘created’ over time and are not found on the balance sheet of the company unless an acquiring company pays for them and records them as goodwill.
  • Your company launched a major advertising campaign.All the work is done in January and the cost comes to around 25 lakhs. The accountants may now decide that the benefit from this ad campaign will benefit the company for 2 years . So they will record an expense of 12.50 lakhs in the first year and show the balance 12.50 lakhs as ‘prepaid asset’. The value of 12.50 lakhs  prepaid asset is actually an estimate since the company may receive the benefit of ad campaign for several years or the ad may not click at all !

Now it’s time to move on to the  other side of the balance sheet where we have two separate components to discuss- Liabilities and Equity.More about that in our next lesson.

have a nice day !

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Balance sheet : what is it?

  • Balance sheet is a statement that shows what a business owns and owes AT a particular point of time. (Remember, the income statement shows revenues and related expenses FOR a period of time , usually a year).
  • ALL COMPANIES are statutorily required to come out with a final statement of accounts every year. The final statement of accounts consist of the balance-sheet, the profit and loss (P&L) account, supporting schedules, the auditor’s report, a statement of accounting policies and additional notes on account. The balance-sheet and P&L account are designed to give a bird’s eye view of the state of affairs of a company.
  • Schedule VI of the Companies Act details the format and typical contents of the balance-sheet and P&L account. Companies are given the option to have their statements in either the `horizontal’ or `vertical’ format. Most companies follow the latter.
  • Companies are also given the freedom to have the figures published in thousands, lakhs or Crores of rupees depending upon the scale and magnitude of operations.
  • A typical vertical balance-sheet’s design is like this- The company gets it’s sources of funds – from shares issues, loans borrowed etc.. and applies the funds to run the business in  fixed assets, investments, stock etc..
  • Logically, at any point of time, the total of sources of funds would be equal to the total of application of funds.
  • But law in India (Companies ACT) requires companies to disclose more facts about the deployment of funds and not just a summary. So, a typical balance sheet is accompanied by schedules, notes, bifurcations, tables, disclosures.. and hence, the whole things looks complicated at  the beginning for a newbie.
  • Balance sheet is also called ‘statement of financial position’

Conclusion

The balance sheet of a company reflects it’s financial position at a particular point of time. It shows what the company owns and owes after doing business for a year. So, analysis of balance sheet of a company becomes vital for an investor. To do that, you need to know what are the components of the balance sheet . More about that in our next lesson.

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The income statement : Revenues – an important figure.

Sales or revenue is the value of all the products or services a company sold to it’s customers during a given period of time. Profits of the company are based largely on the volume of this  figure.

Why this figure is important.

More revenues means more profits. An increase in profits year on will have a positive impact in the stock price. So companies are always eager to show increased revenues in the profit and loss account. And, the ‘sales’ figure is one of the easiest figure to manipulate.

How do companies manipulate sales?

  • Method 1. Sales to related parties – The Company may sell its products to another company which may be owned by a director or any one who has substantial influence in the company.
  • Method 2. Record fraudulent sales using fake bills. For example – It was discovered that Mr. Raju of satyam computers created as many as 7,561 fake invoices during the period from April 2003 to December 2008.
  • Method 3. Very Flexible terms for payment for the buyer – by providing such a facility the company may boost up the revenues temporarily, but in the long run such arrangements  pose an increased risk of the payment never being realized!
  • Method 4. Including one time revenues like income from sale of fixed assets like unwanted machinery or scraped assets or even loan amount received in the sales figure and thus boosting the figure and profits.
  • Method 5. Companies can adjust reported net earnings simply by changing accounting policies. These tend to be quite complex and difficult to understand, but the details are going to be found in the footnotes. For example, a company may change the way it values inventory, which in turn could have a big effect on calculation of the cost of goods sold and gross profit.
  • Method 6. Converting reserve profits to income. This may also be difficult to understand for a newbie. Reserves are profits earned in the past years, kept aside for future expansion activities. Companies carrying large balance in reserves can manipulate current year outcome by simply reclassifying all or part of the reserve balance to income.

Well, i am not here to list out fraudulent practices…. that list goes on and on from least complex ones to complicated accounting tricks. The question is how to analyse a company’s quality of revenues.

HERE’S YOUR SIX POINT CHECKLIST.

  • How can a company continue to earn profits year after year? By selling more and more every year. So, the first question to be answered is – Does the company have a history of increasing revenues every year?
  • Now the second question to be answered is – Are the Revenues increasing at par or above the other competitors in the industry?
  • Does the company have a unique product-line that will sell fast? You have to invest in companies whose products and business model you understand.
  • Does the company have a unique branded product to sell? Branded products are easy to sell and if consumers love the brand, they do not mind paying a premium for its products & services. For example – Maruti. Moreover, a company with a brand value can easily diversity into other sectors and instantly become successful – For example Titan. They have diversified successfully into the eye wear and diamond jewelry sectors.
  • Take the current assets section in the balance sheet. The amount of unrealized sale from customers will be given under the head “accounts receivables” or “sundry debtors”. Check if the receivables are showing a sudden jump. Co-relate with the revenue figure and see that the revenues and receivables are growing at the same pace. For example – if you see the revenues growing moderately but receivables showing a sudden jump, that’s a red flag! You need to be careful. You have to look for company’s disclosures regarding related party transactions, sale to sister concerns , change in the assessment of customer’s ability to pay , extended payment terms offered to any particular client etc..
  • Calculate the price /sales ratio. Calculating the price/sales ratio is a simple matter of performing the maths. Let’s assume that the company we are using as an example had revenue of 300 million rupees over the last four quarters. If we take the current market capitalization of 150 million rupees and divide it by the revenue of 300 million rupees, we arrive at a P/S ratio of 0.5. As with the P/E ratio, the lower this ratio is, the better the odds that this will prove to be a good investment.

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The Income statement :Understanding Depreciation

Depreciation
One of the things that analysts and investors frequently look for while analyzing a company is the amount of depreciation written as expense in the profit and loss account. It is a term frequently used in finance that describes the loss of value over time. Depreciation is an expense; hence less of this expense would mean higher profits! Similarly, a steep rise in the depreciation would result in the company’s earnings falling below the expected levels, however profitable their operations are.
Depreciation is calculated as Cost – (minus) estimated residual value / Life of the asset. A change in any one of these measures — cost, residual value or life — will result in a change in the amount charged as depreciation.

There are also two methods of calculating depreciation – straight line method and written down value method. – a change in the depreciation policy can also bring in huge difference in the profits either positively or negatively.

As an investor you need not dig deep into this topic. What you need to understand is the following points:

  • Depreciation is an expense
  • It is a non cash expense. That is, there is no outflow of cash from the company.
  • The choices that a company makes in deciding how to amortize and depreciate — and by what amounts — will affect its overall appearance of financial health. The amounts will play probably a large part in determining the figures on the company’s balance sheet. They will also affect the profit figures on the income statement. These two documents are enormously important in determining everything from shareholder/investor returns to credit worthiness.
  • An increase in depreciation also means that the company has acquired new assets. High growth oriented companies, which are on an expansion spree may acquire lot of assets in the form of machinery and other fixed assets. So, to that extent it’s also a positive sign.
  • A fall in profits due to increased depreciation expense cannot be taken as a negative sign if the increase depreciation figure is due to acquisition of fixed assets
  • However, if the depreciation figures show material change due to factors like charging different depreciation rates or due to changes in the method of calculating depreciation etc… You may better be careful.
  • Since depreciation is an expense that depends on lot of factors, investors consider the Profit Before Deprecation and Taxes for valuation purposes.
  • Amortization and depletion are other expenses similar to depreciation that’s non cash in nature.
  • Amortization is a process that is exactly same as depreciation, for an intangible asset. We said in our earlier chapters that the business may have tangible assets like machinery or intangible assets like patents and goodwill. When tangible assets are written off at a specific rate, its called depreciation and when intangible assets are written off, it’s called amortization.
  • Depletion refers to the allocation of the cost of natural resources over time. For example, an oil well has a finite life before all of the oil is pumped out. Therefore, the oil well’s setup costs are spread out over the predicted life of the oil well.
  • Being non cash expense, these three items decreases the earnings figures of the company but helps in increasing the cash flow of the company.
  • It can also have significant effects on tax burden. The less a company claims as depreciation/amortization, the more profitable the company seems and therefore the more it will be taxed. Choosing higher depreciation amounts can provide short-term tax relief.

Where to look

The best place to find information on all this is the schedules to the balance sheet and notes to accounts in the company’s annual report or quarterly results. The schedule on ‘Significant Accounting Policies’ will give the method and rates of depreciation, along with other accounting treatment specifically followed by the company. The notes to accounts explain the accounting treatment to give us an idea of how the depreciation of that particular year has been arrived at.

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