A Layman's Guide to Balance Sheet Analysis

A balance sheet is a very important financial statement that is disclosed by a company or organization to the general public. Its analysis is a detailed study of the organization's financial potential, capabilities, and status.
BusinessZeal Staff
Last Updated: Jun 3, 2018
A balance sheet is a statement that depicts a company's current financial status. It basically depicts the assets and liabilities of the company. It can be used as a tool in order to forecast the company's income projection, growth, and development. The process of financial analysis is used to derive concrete figures about the company's revenue, assets, and liabilities. This analysis helps investors, share brokers, investment bankers, and financial institutions to check the profitability of investment for a particular company. This document is available in the annual reports of a company.

Basics of Analyzing a Balance Sheet

It must be noted that a balance sheet can be prepared by any type of business organization. The nature of financial statements depend on the form of business organization. The following are some important elements that one must thoroughly analyze before making an investment.

Assets
An asset is any property owned by the company that has monitory value and can be sold. Assets are generally divided into fixed assets and current assets. Real estate and machinery are examples of fixed assets, whereas, the bank balance and investments are examples of current assets.

Liabilities
A liability of a company is any sum of money that the company owes to other people and organizations. A loan is very prominent example of a liability. The amount of equity share capital is also an important liability, as the company raises its capital with the issue of shares. Amount of liabilities exceeding amount of assets is not a very good sign.

Return over Assets
The return over assets means the value of returns and revenue in proportion with the assets and liabilities of the company. This figure is expressed either in ratios or percentages.

Expected Payments
Often, it so happens that a customer of the company is unable to make timely payments. Such payments are charged with an interest and are included in the assets. These assets are included in the calculation of return over assets.

Credit Rating
The current credit rating, credit scores, and credit history are depicted in the final accounts. It is necessary to analyze credit rating while analyzing a balance sheet, as it reflects a company's credit worthiness and ability to raise credit for a new project.

How to Analyze a Balance Sheet

Analysis is not a very difficult task, and here is a step-by-step guide that will help you to review a given balance sheet very quickly. The procedure also describes some specific ratios which depict financial management and general cash flow of a company.

Step 1
The first step is to add the liabilities and paid-up equity share capital. The total must tally with that of the assets. After tallying, the next step is to compare the total assets with liabilities. In this comparison, do not include the amount of issued shares in the liabilities. If the total number of assets exceed the total number of liabilities, then the financial standing of the company and its performance is very good.

Step 2
The next step is to have a look at the current assets and liabilities. More current unsecured liabilities is sometimes considered to be good sign. However, if the amount of total liabilities exorbitantly exceed the asset total, then it is not a very good sign.

Step 3
The third step is a very important one, as one needs to calculate the return over assets (ROA). The ROA can be calculated very easily by dividing the net income by assets. Some companies also depict their forecasted ROA in their annual reports. The rate depends on the type of business that the company follows. For example, producer companies have a high ROA, and leasing and real estate companies have a lower one. Consultancy companies have a mammoth ROA, as they have less capital investment but a very high wage rate. It is essential to take these factors in consideration.

Step 4
This step involves special consideration for patents and copyrights. Every company invests huge amounts into research and development, which is of course rather costly. One must take into consideration the ratio between the amount invested for research, and the returns over it.

Step 5
The debt asset ratio signifies the ratio between the amounts payable in comparison to the assets of the company. This ratio can be effectively calculated by dividing the total liabilities with total assets. The lesser the liability dimension, the better is the company's performance.

Step 6
The receivables turnover ratio is a ratio between sales and accounts receivable. This ratio basically signifies the relation between the investments in sales and money receivable. The more money receivable, the better is the financial status of the company.

Step 7
The inventory turnover is another very important ratio that establishes the relationship between sales and value of inventory. This ratio is particularly important for producer companies, as it signifies the company's ability to produce goods with available assets.

Step 8
The last step is to analyze miscellaneous features of the company, such as goodwill, current projects, and credit ratings. This analysis would help you to analyze the companies activities of the near future.

While doing the analysis of a balance sheet, it is extremely important to believe your own instinct. Any exorbitant monetary figure is bound to set your brain into overdrive. Analyzing all the related elements is bound to give you the answer to exorbitant figures. For example, if you notice a bulk issue of preference shares, have a look at the major shareholders column. You are bound to see the name of financial institutions or banks in there, as the bulk issue of preference shares is actually a loan that is being given by the institution, but in the form of share application money.