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Analysis of Financial Statements - Balance Sheet

Updated on February 8, 2012

BASIC ELEMENTS OF A BALANCE SHEET

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A balance sheet shows financial conditions of an entity as of a particular date. It consists of assets (the resources of the firm), liabilities (the debt of the firm) and equity (the owners’ interest in the firm.)

To be healthy, a company must maintain a financial discipline whereby (i) current assets should be more than current liabilities, (iii) there should an appropriate blend of debt and equity, (iii) fixed assets base must be strong, and (iv) a company must have long term investment which can be liquidated at the time any financial crisis.

Packages Ltd is a healthy company. It satisfies all criteria. It currents assets are 23% more than its current liabilities, its debt and equity are in proportion of 45:55 and its fixed assets are 55 % of total assets. It has an investment of Rs.8.669 billion in non-current assets.

An analyst must tap other resources to know whether the balance sheet is cooked up or it reflects the ground realities. This may be done, as far as convenient, by asking around to customers or suppliers, visiting the plant, studying financial rating of the company and its share price in stock exchange. If prospects of the industry are good, even a weak company would prosper. So a blance sheet should be studied keeping in view economic conditions as far as these would affect the industry.

The company makes all sort of packages from paper, paperboard and plasitic
The company makes all sort of packages from paper, paperboard and plasitic

BACKGROUND OF THE COMPANY

Packages Limited was established in 1957, to convert paper and paperboard into packaging for consumer industry. Over the years, the company has expanded and now has conversion capacities of 115,000 tonnes of paper and paperboard and 13,000 tonnes of plastics for all sorts of packaging. The company is producing fine paper, packaging materials and tissues. In 2008, the company achieved a sales level of Rs.12.225 billions including 5% exports.

The company belongs to Ali Group of Industries which has setup a number of industrial plants and educational institutions of international repute. The company’s shares are listed at all Stock Exchanges in Pakistan.

WORKING CAPTIAL

Current Assets

Also called working capital, circulating assets, current assets are continuously used or replenished in ongoing operations. It forms a cycle as a company use cash for buying raw materials which are converted into finished goods and sold for cash or on credit to be collected later. The larger the cycle, the larger the funds tied up and consequently the larger the cost of the capital. So every company endure to reduce the cycle and investment thereof by resorting to ‘just-in-time inventories’, better layout of the factories and tight credit terms.

Current assets include cash at hand, bank balances, trade debtors and stocks. There are certain prudent bench marks to ascertain how much cash, trade debt or stocks a particular company should have. It depends on cash need, credit policies in line with industrial practices, lead time in procurement of raw materials and conversion time in case of finished goods inventories. A textile mill which produces fashion fabric should not have any finished goods stock as with the change in fashion, these would become obsolete. A durable goods industry such as maker of deep-freezers should pile up finished goods inventory to avail the on-coming season in summer.

Consisting land, buildingss, machinery and equipment and stores
Consisting land, buildingss, machinery and equipment and stores

Non-Current Assets

There are variations in defining non-current assets. In general, it includes all assets which are not current assets. But it would be better that the term is restricted to long-term investments in shares, bonds or un-used piece of land. These assets serve as a cushion like buffer stock and strategic stocks of foods etc.

Packages Ltd has made investments in associate concerns, in land for future projects and in bonds of stable companies.

Of these, the regulators constantly watch investments in associated companies, also called sister concerns or allied concerns. Such investments maybe a way of fund fleecing. For example, a company may pass on substantial funds to a sister concern and later may declare that concern as bankrupt. Therefore, the regulators insist that names of such companies and their operating results be disclosed as a matter of transparency.

FIXED ASSETS

Also called long term assets, fixed assets are the production base of a company. These consist of land, buildings, machinery and equipment.

While previously, the companies in general, preferred to expand vertically or horizontally, now the trend is to become leaner and smaller through out-sourcings or joint-ventures.

Current Liabilities

These represent trade credit (accounts payable), expense payable, short-term bank borrowings and others payable like taxes and dividends. Sometimes, current maturities of long term debts are also included in this category but that is just a book entry or a warning about the quantum of payments on account of liquidation of long term debt.

As stated earlier, the total current liabilities should be lesser than current assets to give a cushion to the short-term creditors.

In such a situation, the lenders feel comforatble and would not pressurize the borrow to repay the entire loan, if there is default.
In such a situation, the lenders feel comforatble and would not pressurize the borrow to repay the entire loan, if there is default.

CAPITAL STRUCTURE

CAPITAL STRUCTURE

This refers to the blend of debt and equity for financing of the assets. Some companies can afford a large debt as their products fall in the categories of necessities which have a stable demand. Others are hesitant to take debt as demand of their products is uncertain. There are many indicators which shows the extent of borrowing by a company such as D/E, TIE or DOL (These would be discussed later in some other hub.) These indicators may be compared with industrial averages.

Another way to see is the comfort level of the lenders. While commercial banks feels easy if their loans are adequately covered by inventories, the Development Banks or those providing long term loans consider fixed assets as their security. So the commercial banks watch indicators like ‘Stock Cover’ and ‘Fixed Asset Cover’. If these two bench marks fall below their expectation, they would immediately recall their total loans. When there is no response from the borrowers, the banks would go for use of leverages such as selling liquid security, pledged with them, in the market or approaching courts for the recovery of their loans. The immediate effect is an embargo on further loans from all the banks since the defaulters names are circulated by the national credit information bureau to all institutions in the banking sector. The development banks, however, would react different and would only resort to court proceeding if the clients proved as wilful defaulters.

Long Term Debt

A company must avail long term debt since it is usually much cheaper than the equity funds because of the tax shield. There are very rare cases where a company was floated without any debt.

The debts are secured by a charge on fixed assets which has many forms like (i) first charge and (ii) second charge. Sometime, a bank, while financing new equipment, insists on a first exclusive charge on the same equipment. If a bank still worries about the security of its loan, it can insist on second collaterals and stringent loan covenants which would bind the company in its operations.

Deferred Liabilities

These usually are deferred taxes and staff gratuities payable on retirements.

Shareholders' Equity

This includes initial and subsequent cash induction by the owners plus money retained in the business out of profitable operations. Of the Rs.844 million paid-up capital of Packages Ltd, only 40% was subscribed in cash while the remaining represents bonus shares. At the same time, the company has a large balance as retained earnings. It shows that the original investor has recouped its investment by 47.4 times, in the past 52 years, and still holds the share intact ( total equity of Rs.16.272 billion divided by Rs.336 million equity shares paid in cash.)

Conclusion

Balance sheet is like wealth of an individual accumulated over the time by savings year by year. It is indication of a safe and secured life all along. In case of a company, it shows solvency or ability of the company to survive in bad times due to depression in the economy or other upheavals.

A company must manage its cash so as to meet its obligations on time and also keep on investing in productive assets to compete in the market. At the same time, the funds requirement must be met prudentially and unnecessary borrowing should be avoided to ward off any attempt by the lenders to get the company liquidated through courts.

PREVIOUS HUB - Introduction

NEXT HUB - Income Statement

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    • profile image

      Mohammad 

      5 years ago

      I am very thankful for this courtesy,sire.

    • hafeezrm profile imageAUTHOR

      hafeezrm 

      5 years ago from Pakistan

    • profile image

      Mohammad 

      5 years ago

      Sir! Very beautifully, you have described techniques for analysis of the financial position of any organisation.

      Will you please,help me to tell the techniques, used to analyze the balance sheet of any Commercial bank. Specially, its deposits and advances?

    • hafeezrm profile imageAUTHOR

      hafeezrm 

      8 years ago from Pakistan

      Thanks liveforjesus for your comments.

    • liveforjesus profile image

      liveforjesus 

      8 years ago

      What you publish is super

      I am your fun

    • hafeezrm profile imageAUTHOR

      hafeezrm 

      8 years ago from Pakistan

      Thanks Rufi.

    • Rufi Shahzada profile image

      Rufi Shahzada 

      8 years ago from Karachi

      Dear Sir,

      That is such an amazing learning for me, actually I am also studying FINANCIAL MODELING and these concepts would be key to my success, Though I have studied AFS earlier, but your HUBs are constantly helping in revival of my previous studies and some new techniques and terminologies.

      Thanks a Billion Sir!

      RUFI SHAHZADA

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