Balance Sheet

Financial health - Balance Sheet Items

The balance sheet provides an overview of the company's financial situation at a specific time, rather than profitability over a period of time. The balance sheet includes the company's assets, liabilities and owners' or stockholders' equity. The company's assets must always equal its liabilities plus owner equity. The balance sheet helps business owners and managers maintain a firm grasp on the business's current financial situation in order to make appropriate financial decisions. For example, a lengthening receivables cycle may call for more aggressive collection practices.

This section of financials provides details of all the assets and liabilities of a company at the last date of the financial year. In Indian context, it provides details at March 31 of any given year.

Liabilities are the sources of funds, which a company has utilized to purchase all the assets it owns. The usual sources are

• shareholder’s own money (equity),

• retained earnings (profits earned but not distributed to shareholders) and

• debt (borrowings from banks and other sources)

Investments reflect the money that the company has invested in different other companies, joint venture, subsidiaries etc. which are expected to earn money for company’s shareholders.

I focus on companies, which use minimum amount of debt and create assets that keep on generating revenue for the company year after year without the need of frequent expenses to maintain these assets.

How to read balance Sheet

Shareholder's Equity/Book value

Shareholder Equity is the net worth of a company. It represents the stockholders' claim to a business' assets after all creditors and debts have been paid. Shareholder equity is also referred to as Owner's or Stockholders' Equity. It can be calculated by

Shareholder Equity = Total assets - total liabilities.

Shareholder equity usually comes from two places. The first is

• cash paid in by investors when the company sold stock;

• the second is retained earnings, which are the accumulated profits a business has held on to and not paid out to its shareholders as dividends.

It can also be calculated as

Shareholder's fund = Equity Share capital + Reserves & Surplus

Because these are the two ways a company generally creates shareholders' equity, the balance sheet is organized to show each parts' contribution.

Shareholder's equity is also known as Book Value.

Equity Share Capital

Equity Share capital is the owner's equity. It is the most permanent source of finance for the company.

Share capital consists of all funds raised by a company in exchange for shares of either common or preferred shares of stock. The amount of share capital or equity financing a company has can change over time. A company that wishes to raise more equity can obtain authorization to issue and sell additional shares, thereby increasing its share capital.

Liabilities /Borrowings

Borrowing money is one of the most effective things a company can do to build its business. But, of course, borrowing comes with a cost: the interest that is payable month after month, year after year. These interest payments directly affect the company's profitability. For this reason, a company's ability to meet its interest obligations, an aspect of its solvency, is arguably one of the most important factors in the return to shareholders.

Non-Current Liabilities

• Long Term Borrowings

Total debt includes the long term and the short debt of the company. Long term is for a longer duration, usually for a period more than 3 years like debentures.

• Deferred Tax Liabilities [Net]

• Other Long Term Liabilities

• Long Term Provisions

Current Liabilities

Current liabilities (CL) include payables within next one year and the short-term provisions

• Short Term Borrowings

Short term debt is for a lesser duration, usually for less than a year like bank finance for working capital.

• Trade/Account Payables

• Other Current Liabilities

• Short Term Provisions

Contingent Liabilities

Assets

Assets provide details of utilization of the money raised under liabilities. Assets comprise of fixed assets, investments and current assets.

Non Current Assets

Fixed Asset

Fixed assets are also knows as net Block . Fixed assets can be tangible & non-tangible assets. Fixed assets are permanent fixtures that generate revenue year after year for the company e.g. plant & machinery.

• Tangible Assets or Property, Plant And Equipment (Net PP&E)

Also Known as tangible assets:

A company asset that is vital to business operations but cannot be easily liquidated. The value of property, plant and

equipment is typically depreciated over the estimated life of the asset, because even the longest-term assets become

obsolete or useless after a period of time.

Depending on the nature of a company's business, the total value of PP&E can range from very low to extremely high

compared to total assets. International accounting standard 16 deals with the accounting treatment of PP&E.

An example of a business with a high amounts of PP&E would be a shipping company, because most of its assets would

be tied into its fleet of ships and administrative buildings. On the other hand, a management consulting firm would have

less PP&E, because a consultant would only need a computer and an office in a building to run its operations.

This item is listed separately in most financial statements because PP&E is treated differently in accounting statements.

This is because improvements, replacements and betterments can pose accounting issues depending on how the costs

are recorded.

• Long Term Assets

Long-term assets are assets that you anticipate your business will use for more than 12 months. Some of the most common long-term assets include:

Land: This account tracks the land owned by the company. The value of the land is based on the cost of purchasing it.

Buildings: This account tracks the value of any buildings a business owns. The value of the building is based on the cost of purchasing it. The key difference between buildings and land is that the building’s value is depreciated, while the value of the land is not depreciated.

Accumulated Depreciation — Buildings: This account tracks the cumulative amount a building is depreciated over its useful lifespan.

Leasehold Improvements: This account tracks the value of improvements to buildings or other facilities that a business leases rather than purchases. Leasehold improvements are depreciated as the value of the asset ages.

Accumulated Depreciation — Leasehold Improvements: This account tracks the cumulative amount depreciated for leasehold improvements.

Vehicles: This account tracks any cars, trucks, or other vehicles owned by the business. The initial value of any vehicle is listed in this account based on the total cost paid to put the vehicle in service. Vehicles also depreciate through their useful lifespan.

Accumulated Depreciation — Vehicles: This account tracks the depreciation of all vehicles owned by the company.

Furniture and Fixtures: This account tracks any furniture or fixtures purchased for use in the business. The value of the furniture and fixtures in this account is based on the cost of purchasing these items. These items are depreciated during their useful lifespan.

Accumulated Depreciation — Furniture and Fixtures: This account tracks the accumulated depreciation of all furniture and fixtures.

Equipment: This account tracks equipment that was purchased for use for more than one year, such as computers, copiers, tools, and cash registers. Equipment is also depreciated to show that over time it gets used up and must be replaced.

Accumulated Depreciation — Equipment: This account tracks the accumulated depreciation of all the equipment.

• Intangibles

An asset that is not physical in nature. Corporate intellectual property (items such as patents, trademarks, copyrights,

business methodologies), goodwill and brand recognition are all common intangible assets in today's marketplace. An

intangible asset can be classified as either indefinite or definite depending on the specifics of that asset. A company

brand name is considered to be an indefinite asset, as it stays with the company as long as the company continues

operations. However, if a company enters a legal agreement to operate under another company's patent, with

no plans of extending the agreement, it would have a limited life and would be classified as a definite asset.

While intangible assets don't have the obvious physical value of a factory or equipment, they can prove very valuable

for a firm and can be critical to its long-term success or failure. For example, a company such as Coca-Cola wouldn't

be nearly as successful were it not for the high value obtained through its brand-name recognition. Although brand

recognition is not a physical asset you can see or touch, its positive effects on bottom-line profits can prove extremely

valuable to firms such as Coca-Cola, whose brand strength drives global sales year after year.

The following accounts track long-term assets such as organization costs, patents, and copyrights. These are called intangible assets, and the accounts that track them include:

Organization Costs: This account tracks initial start-up expenses to get the business off the ground. Special licenses and legal fees must be written off over a number of years using a method similar to depreciation, called amortization, which is also tracked.

Amortization — Organization Costs: This account tracks the accumulated amortization of organization costs during the period in which they’re being written-off.

Patents: This account tracks the costs associated with patents, grants made by governments that guarantee to the inventor of a product or service the exclusive right to make, use, and sell that product or service over a set period of time. Patent costs are amortized.

Amortization — Patents: This account tracks the accumulated amortization of a business’s patents.

Copyrights: This account tracks the costs incurred to establish copyrights. This legal right expires after a set number of years, so its value is amortized as the copyright gets used up.

Goodwill: This account is only needed if a company buys another company for more than the actual value of its tangible assets. Goodwill reflects the intangible value of this purchase for things like company reputation, store locations, and customer base.

• Capital Work in Progress

Capital work in progress sometimes at the end of the financial year, there is some construction or installation going on in the company, which is not complete, such installation is recorded in the books as capital work in progress because it is asset for the business.

• Other Long-Term Assets

• Non-Current Investments

Long Term Loans And Advances

If company has provided loan & advances to other companies /entity it is tracked under non-current assets . Ensure that it makes sense to provide loan to other companies and reinvesting in own company. if not then the management is using the source company as cash cow to fund the target ( probably sick ) company.

An example of misuse of cash where in new promoters loaned the profits of Gujarat Automotive Gears limited to self at free of cost instead of taking loan from bank. It is clear sign of management not taking care of minority shareholders.

• Other Non-Current Assets

Current Assets

Current assets are usually consumed within next one year. Current assets include inventory that gets consumed and gets sold as finished product within a year, cash & similar investments kept by the company to meet day to day requirements and money due from customers (account receivables or debtors) and loans given to different parties that are expected to be received back within a year).

• Cash & bank Balance & Short-Term Investments

If the company has made some investments out of its free cash, it is recorded under it

• Accounts/Trade Receivable

Receivables include the debtors of the company, i.e., it includes all those accounts which are to give money back to the company.

• Inventory

Inventory is the stock of goods that a company has at any point of time.

• Other Current Assets

Other current assets include all the assets, which can be converted into cash within a very short period of time like cash in bank etc.

• Short Term Loans And Advances

Liquidity/Financial Health

Current Ratio

Here's a Quick Way to Tell if Your Stock Could Go Bankrupt

Current Ratio = (Current Assets / Current Liabilities)

That's it!

The ratio gives us a quick answer as to how long the company could survive should it not be able to generate free cash flow.

Take the current ratio and add the word "years" onto the end of it. Two examples:

Nvidia (NVDA): (4,050 / 986) = 4.11

Boyd Gaming (BYD): (325 / 473) = 0.69

What do these tell us? Simple. Nvidia could survive OVER 4 YEARS without generating cash flow, while Boyd Gaming would barely survive 8 months! Pretty obvious which one is a safer pick.

CR of >1 means that the company has CA which exceed CL and that the company would be able to pay off its near term liabilities by the money it would receive from current assets.

• Adding Free Cash Flow into Current Ratio

Current ratio is a good shorthand for financial health, but to really get a good feel for near-term financial health, it is imperative to add free cash flow generation to it.

Remember our personal finance example? 95% of us have jobs or some form of steady income. We are not relying on our other assets to pay our bills (liabilities).

Companies are the same way. Most generate sales revenues which are used to pay off those current liabilities, which consist of employee salaries, suppliers, benefits, debt payments, and so forth.

Their free cash flow tells us how much cash is left over after covering liabilities, and paying for maintenance or replacement of assets. In your household, if you make more than you need to spend every month, that leftover cash is your free cash flow. The concept is the same for a business.

Therefore, if a company has POSITIVE free cash flow, the current ratio should *increase* as time goes on. If it has NEGATIVE free cash flow, the current ratio will *decrease*!

Let's account for free cash flow for the prior example. To do this, I will simply add (or subtract if negative) annual free cash flow from the "Current Assets" figure. I usually take a 3 year average to smooth out any peaks or valleys - cash flow can be a bumpy line item.

Nvidia: ( (4,050 + 641) / 986) = 4.76

Boyd Gaming: ( (325 + 97) / 473) = 0.89

Since both companies have positive free cash flow, their current ratios improve. Still, Boyd is under 1 year of safety, so I would be very reluctant to consider an investment in it.

Here's a second example that illustrates the value of adding free cash flow a little more clearly:

Weight Watchers (WTW) Current Ratio: (304 / 384) = 0.79

With Free Cash Flow: ( (304 + 322) / 384) = 1.63

Weight Watchers goes from being a financial health concern at a 0.79 current ratio to being relatively safe at 1.63 because the company generates a pile of free cash flow year after year.

Summing It Up

Current ratio is a nice, simple way to quickly gauge a company's near-term bankruptcy risk. The basic ratio is valuable as a short-hand check of financial health, but adding in free cash flow gives you a more accurate view of how well the company can cover its near-term liabilities.

source

Quick Ratio

This gives you a ratio very similar to the current ratio. The usage is the same: add "years" to the ratio number to see how long a company could survive without generating positive cash flow. The rule of thumb is that anything over 1.0 is OK, and the higher the number, the better.

Why Quick Ratio instead of Current Ratio?

What both ratios are really measuring is a company's liquidity.

Liquidity, simply stated, is how fast can a company turn its assets into cash to pay off liabilities. In your own life, this is easy to illustrate. If you need a large sum of cash NOW, you can get it almost instantly by selling some stocks, but it would take you a month (or likely much more) to get cash from selling your home. Stocks are liquid assets, real estate illiquid.

Now, say an apparel retailer needed cash quickly to pay off term debt coming due. Most of its current assets can be turned to cash at full value relatively quickly. Cash is already cash, and accounts receivable are usually collectible at full price.

The one item that may not be is inventory. The retailer cannot quickly sell off its inventory of out-of-fashion items at full price. It would likely have to sell them at a deep discount to move them at all, which reduces their value on the balance sheet.

Quick ratio simply assumes the company could not immediately liquidate ANY of its inventory! Pretty drastic, but a conservative test of financial health, particularly for makers and sellers of "hard goods" that lose their value sitting on a shelf.

Putting It All Together: Adjusted Quick Ratio

Looking at a current ratio vs. quick ratio for a retailer like Express (EXPR) tells two completely different stories:

Current Ratio = (593 / 351) = 1.69

Quick Ratio = ( (593 - 343) / 351) = 0.71

Using a quick ratio, Express looks like a financial risk, with a figure well under 1.0!

But let's do some adjusting to get the "real" story. Let's start by adding in free cash flow to both ratios, as we did in the other article:

Current Ratio = ( (593 + 165) / 351) = 2.16

Quick Ratio = ( ((593 + 165) - 343) / 351) = 1.18

That looks better! Express generates a good bit of cash flow and is not really a financial risk.

Finally, I really believe the theory behind the quick ratio is a bit too dramatic. In reality, a firm could most likely liquidate most of its inventory at an appropriate discount. In this example, I've assumed a 60% discount on listed inventory value:

Final Adjusted Quick Ratio = ( ((593 + 165) - (343 * .40)) / 351) = 1.77

Conclusion

Quick ratio is an extension of the current ratio, meant to discount a firm's ability to quickly liquidate inventory at full price. It is particularly useful for firms that deal mainly in "hard goods" inventory, such as retailers and manufacturers.

While useful, the textbook definition is too conservative and can be improved by including free cash flow and discounting inventory at a percentage, instead of excluding it entirely.

Interest Coverage ratio

Interest coverage is a financial ratio that provides a quick picture of a company's ability to pay the interest charges on its debt. The "coverage" aspect of the ratio indicates how many times the interest could be paid from available earnings, thereby providing a sense of the safety margin a company has for paying its interest for any period. A company that sustains earnings well above its interest requirements is in an excellent position to weather possible financial storms. By contrast, a company that barely manages to cover its interest costs may easily fall into bankruptcy if its earnings suffer for even a single month.

The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) of one period by the company's interest expenses of the same period:

• A ratio under 1 means that the company is having problems generating enough cash flow to pay its interest expenses.

• Ideally you want the ratio to be over 1.5.

A company that barely manages to cover its interest costs may easily fall into bankruptcy if its earnings suffer for even a single month

Because interest coverage is a highly variable measure, not only between companies within an industry but between different industries, it is worthwhile to establish some guidelines for setting acceptable levels of interest coverage in particular industries.

For example, for an established utility company - a provider of power or water - an interest-coverage ratio of 2 is an acceptable standard. This fairly low minimum is justified by the consistent production and revenues that utilities tend to exhibit over the long term. Furthermore, rates for utilities may be set by governmental regulation, thereby projecting the future numerator of the interest-coverage calculation (earnings) with significant accuracy.

For more volatile industries, such as automobile manufacturing or steel production, an acceptable minimum for interest coverage is 3. Industrial companies such as these see more fluctuations in their production and consumption patterns from year to year. A greater margin of safety is therefore required to ensure the company can cover interest charges during periods when earnings are down.

An investor doing a thorough analysis of interest coverage determines how much total annual interest payments for each quarter of the past five fiscal years are covered by available earnings in each quarter. By analyzing five years of interest coverage for any company in any industry, we can gain a sense of the trend in the ratio.

At minimum, the ratio should be consistent quarter after quarter, year after year. Improving interest coverage is a positive signal of the company's overall health, and a declining pattern is a danger sign of a financial difficulty, which may be imminent or far off into the future. However, a declining ratio does not automatically mean death for the company, since a temporary change in operations can result in a blip in earnings.

For example, if a company's workers were to strike for a period of time, its interest-coverage ratio would suffer for that period. The analysis of an extended trend, over a period of at least several years, is always warranted.

Warren buffet prefers owner’s earning over net profit. Many investors like to include non-operating income while calculating interest coverage. Nevertheless, I prefer to use only operating income and avoid non-operating income while calculating interest coverage.

Some investors like to use only secured or long term debt for calculating D/E ratio. However, I prefer taking total debt for calculating D/E ratio.

Debt ratio

The name of this ratio says it all; this ratio shows how much your business is in debt, making it an excellent way to check your business’s long-term solvency. The formula is:

Total debt ratio = Total debt/Total assets

Once again, you can take these numbers from your balance sheet and plug them in. For instance, a business with $22,375 in total assets and $25,000 in total debt would have a total debt ratio of $25,000/$22,375 = 1.11:1.

This business, then, has $1.11 dollars in debt for every dollar of assets. So for this business, the total debt ratio tells us that this business is not in good health and may become really ill; for good health, the total debt ratio should be 1 or less.

The lower the debt ratio, the less total debt the business has in comparison to its asset base. On the other hand, businesses with high total debt ratios are in danger of becoming insolvent and/or going bankrupt. (You can see why lenders take such an interest in this ratio.)

Debt to Income(profit) ratio

The formula for the debt to income ratio is the applicant's monthly debt payments divided by his or her gross monthly income.

The debt to income ratio is used in lending to calculate an applicant's ability to meet the payments on the new loan. The debt to income ratio may also be referred to as the back end ratio specifically when a new mortgage is requested. The term back end ratio, or total debt to income, is used to differentiate the calculation from the housing debt ratio, also called the front end ratio.

Whether it is bonds, stocks, or any other form of investment, measuring the ability of the individual or company to remain solvent is important. For a lending institution, loans are an investment which generally comprises a very large portion of their investment portfolio. For a financial institution, calculating the debt to income ratio is similar to a potential bondholder evaluating a company's debt load before deciding to invest.

Warren Buffett will look into Debt to Earning Ratio (DER). Generally investors compare debt to equity. But Warren Buffett likes to compare Debt to Earning. Why? Because he wants to see companies which carry less debt. He likes such companies which can pay-off all of its long term debt in five years. Means, companies will DER of less than 5 are preferred.

Watch out for in balance Sheet.

• How much debt does the company have?

• How much debt does it have the current year?

• Find out debt to equity ratio. Read debt to Equity ratio above.

Preference Shares and Pledging of Shares by Promoters

Source:

1. What are the effects of redeemable preference shares on the capital of a company when these shares mature?

2. How do companies generally deal with the maturity of redeemable preference share? Do they issue fresh equity, bonus or redeem with undistributed profits?

3. So for an example, for a company that has issued 7% redeemable cumulative preference shares (worth say ₹40 cr) redeemable at par maturing in 10 years (say in March 2018), what options does a company have in order to redeem these shares? How do these options stack up in terms of preference or general practice in the industry and what will be the impact on the capital structure of the company on maturity?

The fate of the preferred shares along with their impact on capital differs from case to case depending upon the terms of each issued case of preferred shares:

• If the coupon is mentioned and is non-cumulative that would mean regular interest payments like regular debenture.

• If the coupon is cumulative, then the entire coupon can be paid at maturity

• If premium is mentioned, then preferred shares would be redeemed at a price higher than par value at maturity (Par value + Premium value)

• If no premium is mentioned, then preferred shares would be redeemed at a price equal to par value

• If it is convertible, then it would depend upon whether it is compulsory or optionally convertible. In the compulsory convertible, the company would not pay anything on maturity and would issue new equity shares, which would get same rights as existing common shares. In optionally convertible, the preferred shares subscriber might or might not choose to convert preferred shares into equity shares. If the preferred shares Subscriber decides to not convert, then the maturity amount would be paid to her without any impact on equity capital structure.

• Conversion can be fully or partially, in such cases of fully convertible all the preferred shares on maturity would be convertible into equity shares and no cash outflow. In partially convertible, then as per terms of the agreement, the preferred shares subscriber can convert part of preferred shares into equity shares and get the balance as cash from the company on maturity.

Therefore, in each case of different types of preferred shares, the final impact would be different depending upon the terms of the specific preferred shares agreement between the company and the subscriber.

1. Are these considered part of overall outstanding shares or considered as debt?

   • Preferred shares are treated as part of outstanding share capital

2. If considered as part of overall outstanding shares, what happens on the maturity of such preferred shares, does the share capital reduce by the par value of the preference shares redeemed (unless redeemed by issuing fresh equity?)

   • At maturity, the paid up share capital reduced to that extent.

3. How do companies pay back the investors holding redeemable preferred shares on maturity? What is the most preferred strategy adopted by companies to redeem such preferred shares?

   • Redemption method depends on the type of preferred shares and its terms as discussed in the previous answer.

Pledging of shares

• Is it possible for us to find out whether the proceeds received from the pledging done by the promoter are reinvested into the business i.e. a simple case of the promoter pledging the shares for investing into the busines

• I came across a news that the promoters have pledged most of their shares but the company’s stocks are still in the rally. In this case, will the proceeds of the pledged shares will come to the company as other income? And how to know that the promoter has really spent that money for business? Thanks and regards

• “Promoters, in order to raise funds for either personal or company needs, pledge their holding shares to any financial institution.

Non-banking financial institutions are more active than banks in providing such loans. Sometimes, promoters collateralize their shares for converting warrants into shares. Also, they might find share prices in the secondary market quite lucrative for fresh purchase and adopt this route for garnering funds for the consideration to be paid for the open market purchase. So there are lots of reasons why promoters pledge their shares. Generally, pledging shares is not a good sign.”

My view: The pledging of shares by the promoter won’t increase the other income. However, it should increase the interest cost in P&L, as it is a kind of loan taken by the promoter against shares collateralize with banks / non-financial institution.

I found the pledging of shares mentioned in long-term borrowing for GMR Infrastructure Limited.

• If the promoter is taking a personal loan, then I don’t think it will reflect in the balance sheet of the company.