Balance Sheet Analysis of a Company | Accounting

Balance Sheet Analysis in investment decision-making involves the use of the Financial Data available in Balance Sheet and Income and Expenditure statements of a Company. The objective of this analysis is to know the overvaluation or undervaluation of a share as judged by its intrinsic worth and compare it with its market price and that of the similar companies within the same industry.

The Company’s performance in terms of its physical operations is reflected in its Balance Sheet and Income and Expenditure Statements in terms of financial data.

Annual Reports:

The main components of the Annual Reports of Companies, containing Balance Sheet and Income and Expenditure data are as follows:

1. Chairman’s Speech to its Investors:

This would bring out the management views of the Company’s performance, in the backdrop of the economy and industrial growth, its plans for expansion or diversification if any, difficulties or problems faced by the Company and their plan of action to meet these challenges and the immediate future prospects of the Company etc.

2. Director’s Report:

This is a factual account of the operations of the Company during the past year and the financial results of these operations, profits or losses, the allocation of profits for depreciation, interest, taxes, dividends etc. After allocating these sums, the residual profits are ploughed back to the reserves or losses are written off. The input availability, market for the outputs, labour problems, Government policy changes with regard to them, if any, exports or imports made by the Company etc., are all presented in this report for the benefit of its shareholders.

3. Balance Sheet and Income and Expenditure Accounts:

These are accompanied by the profit allocation statement and the detailed schedules for each of the items in the accounts. The method of presenting these data varies from company to company although the contents are almost the same. These data would reflect the prima facie position of the company’s operations and the financial results of these operations.

4. Auditor’s Report:

This is a statutory report testifying the correctness of the accounts and giving their own comments on the accounting practices and proce­dures of the company. The real position of the company’s operations is known from the footnotes to the accounts and the comments of the Auditors.

They indicate the contingent liabilities, bad debts, changes in accounting practices adopted to camouflage the poor financial performance, method of providing for depreciation, provision for DRR fund and other statutory obligations, revaluation of assets if any, dividends not paid, advance calls, etc.

In fact the most vital information to be provided to Investors as per the Companies Act is contained in the footnotes. As such the analysts should examine carefully these notes and Auditors’ Report to make any correct assessment of the valuation of a share.

Market Price and Corporate Performance:

The market price of a share depends primarily on the Company’s performance, reflected in the earnings per share or cash earnings per share, dividend record and bonus payments made by the company. Besides, share price also depends on the goodwill factors which are subjective in nature such as management reputation, expansion plans, tax planning, technological set-up, reputation of collaborators and locational advantages. The management rating is subjective and is a factor contri­buting to the goodwill of the company. This goodwill also depends on the Govern­ment attitude to the management, Government policy with regard to the imports etc.

Honesty, integrity and consistency of management gives good rating for the company. The price of a share also depends on subjective factors like sentiment of the market, phase of the market such as gloom, fear, indecision, optimism and Euphoria etc.

To sum up, the market price of share depends on some fundamental factors like intrinsic value of the share, as also on subjective and goodwill factors and sentimental factors depending on the phase of the market. The intrinsic worth of the company is judged by the net present value, derived by discounting future returns of shares, book value of the share, earnings per share etc.

Analysis of Financial Position:

The following financial parameters are looked into for judging the company’s performance, as an illustration:

The above are some of the quantifiable factors derived from the Annual Accounts. But the non-quantifiable factors like goodwill and sentiment cannot be judged from the Balance Sheet data except in an indirect manner. Thus, the manage­ment policy, expansion and tax planning schemes can be known from the Chairman’s speeches, Financial Press and Directors’ Report.

Future prospects of the Company can be assessed indirectly from the hints given by the Chairman in his speech to the Investors in the General Body Meeting or in the Press conferences. Similarly, the genuineness and dependability of the accounting practices and true and factual disclosures as shown in the Auditors’ report will reflect on the management integrity, honesty and their reputation. The Balance Sheet analysis is thus an important subject in the direction of fundamental analysis of a share price which the Analysts and Investors should undertake as part of their research for identifying the shares to buy and the shares to sell.

Types of Shares in the Market:

At any stage in the economy, there are different types of industries, some startup companies, some mature and grown, some expanding into growth Industries and some showing decline in their prosperity and popularity. Some industries are seasonal, some in key or core sectors, some in export sector etc.

Similarly, in each industry there are different types of companies, some grow­ing, some stagnant and some declining. There are thus different types of companies within the same industry and different types of Industries within the Economy. A genuine investor should try to identify the potentialities of each of these groups and concentrate on growth-oriented industries or emerging Blue Chips and established Blue Chips.

Within each industry, there are some companies which are turn-around companies showing signs of emerging into Blue Chip Companies. Company cha­racteristics also vary, viz., innovative unique product companies, leaders, single product and multiproduct companies, captive demand companies, etc.

Blue Chip Companies are in simple language, growth-oriented companies showing signs of expansion, diversification, modernisation of technology and repu­tation for consistent profitability and profit margins to sustain the consistent dividend distribution, growing profits and expanding net worth. What are blue chips today may not be so after a few years. The blue chips, today are software and Information Technology Companies.

The management of these companies have got a dynamic and growth-oriented policy and have a reputation for a vision for future growth and expansion and maintain a sustained growth in assets, sales turnover and profits. Emerging Blue Chip companies are those which are turn-around companies and exhibit potentiality to grow and expand in gross block, sales and net profit. The actual Blue Chip Companies like Colgate, Hindustan Lever, SPIC, L & T etc., have a consistent record of dividend pay outs, growth in dividends, expansion and bonus from time- to-time.

The main characteristics of the Blue Chip Companies may be set out as follows:

1. These companies belong to the industry groups which are in general expanding and growing.

2. They are market leaders as in the case of Indian hotels in the Hotel Industry, ACC in Cement Industry, Bajaj Auto in Scooter Industry and Colgate in Tooth Paste Industry.

3. These Companies show capacity to diversify and grow and generate larger gross block, higher sales turnover and growing profit margins. They continuously expand the capital base in terms of debt or equity or rights etc.

4. They have purposeful tax planning and consistent modernization and expansion plans. They have the capacity to meet the emerging challenges like input or labour problems.

5. The Management outlook is dynamic and their vision is ambitious expan­sionism. They are highly aggressive leaders in the industry.

6. They have also commitments to research and development and are quick to adopt new technologies and lower costs and increase profits. They may have reputed foreign collaborators to back them up.

i. Growth Shares:

Such companies are very attractive to the long-term investors as the return to the equity shareholders in such companies are continuously expanding due to dividends, growth in dividends, net worth, bonus and rights etc. Besides in view of the consistent good performance, detailed monitoring by Investors of such companies may not be necessary. They are a good hedge against inflation and rising costs.

The investor is also benefitted by capital appreciation or capital gains and by multiplying his original investment in a short period of time. The investor has only to identify such scrips and make long-term investment in them which will ensure steady return on their investment, safety, marketability and continued capital appre­ciation, regular dividends, rights, bonus shares etc.

The examples of such growth shares which should be included in the portfolio of every investor are Bajaj Auto and Telco in automobiles, Tisco in Steel Industry, East India Hotels in Hotel Industry, CEAT Tyres and Apollo Tyres in Tyre Industry, Tata Tea in Tea Industry, Britannia in Food Industry, HLL in consumer goods category, Infosys and Pentafore in Software Technology etc.

ii. Cyclical Shares:

Other categories of shares and cyclical shares whose fortunes may depend upon the business cycle and trading like shipping, fertilisers, tea and machine tools etc. They make sometime huge profits and sometimes poor profits depending on the cycles.

iii. Defensive Shares:

Another category of companies is defensive shares whose prices are stable and do not fluctuate widely. Normally they pay regular dividends within a narrow range and have standard practices of ploughing back profits and declaration of modest dividends. These are defensive shares whose dividends are stable and profits and profitability are expanding but at a consistent and slow rate. Many plantations and Cotton Textiles come in this category.

iv. Discount Shares:

Besides there is a category of discount shares whose prices are depressed due to low profits but with a hope of higher profitability in the immediate future due to the change in the management or in Government Policies or due to new technological changes. Among the companies in this group, there may be many undervalued groups whose potentialities for growth are high and therefore they are called Turn-around Companies, or emerging Blue Chips.

The category of Blue Chips emerge out of corporate performance and can be attributed to rich parentage arising from foreign collaborators or foreign technicians, ambitious and driving promoters, unique products, special technologies, marketing strategies, management reputa­tion, etc. Pasupati Acrylon and Marmagoa Steel are some examples, which can show signs of turn-around.

Net Financial Results and Profitability:

The Company’s Balance Sheet reflects the financial position of a company at a point of time, while its Income-Expenditure Account presents the picture of its physical operations over a period of say one year. So the Balance Sheet and its Income Expenditure Statement are related closely and the combined net position of the latter is transferred to the Balance Sheet in the form of residual profits or losses shown in liabilities or assets of the company.

A study of the corporate performance over a period of time is thus possible through the Balance Sheet Analysis. The assets and liabilities in Balance Sheet and of Income and Expenditure Statement are to be studied together.

It will be seen from the proforma table on Income and Expenditure that Gross Operating Profit reflects the financial results of the Physical Operations. The Net Profits are the true residual profits after meeting the required payments of interest and taxes and providing for depreciation. But cash profits or net cash earnings include the net profit plus depreciation as the depreciation provision keeps the funds with the company only and it is only a book entry.

Corporate Performance:

The long-term investors prefer mostly companies with a solid past perfor­mance and continued good performance in future. Such companies are called growth companies, or Blue Chip Companies. Of the factors which influence the share prices, the most important one is corporate fundamentals, namely, company’s intrinsic worth, net asset value or book value.

The corporate performance is thus the single largest force, influencing share price. This is studied by the ratio analysis, funds flow analysis — namely, sources and uses of funds — and trend analysis of growth rates of important parameters like sales, gross block etc.

Corporate performance depends on a number of variables, both internal and external to the company.

The major internal factors are:

(i) Efficiency of capital use,

(ii) Productivity of total capital employed,

(iii) Growth of Gross Block and its capacity utilisation,

(iv) Sales turnover and operational efficiency,

(v) Profitability of the operations,

(vi) Return on capital employed,

(vii) Expansion plans and internal reserves built up, and

(viii) Tax planning and accounting practices etc.

All the above factors are reflected and measured in Financial Ratios, referred to below — growth rates of major assets and liabilities and operational ratios measuring the profitability and profit allocation.

1. Capital Cost Ratios:

Ex: Cost of Debt Capital/ Cost of Equity Capital

For Capital Structure Analysis — methods of Finan­cing the project.

2. Leverage Ratios:

Ex: Debt/Equity ratio or Borrowed Capital/Total Capital employed.

Long-term stability of the company — leverage en­joyed by owned Capital through borrowed funds.

3. Solvency Ratios:

Ex: Total long-term debt to total owned funds, Total liabilities to total shareholders’ equity.

Long-term solvency and Company’s Financial ability to fulfill the obligations of repayments and expenses involved.

4. Liquidity Ratios:

Ex: Current Ratio, Acid Test Ratio — Current Asset to Current Liabilities.

Company’s Financial position in the short-run and the capacity to meet short-run obligations.

5. Turnover Ratios:

Ex: Fixed Assets to Sales Sundry Debtors to Sales Inventory Turnover Ratio (cost of goods sold to total Inventory).

Efficiency of the use of Capital and operational effi­ciency in keeping high sales relative to fixed capital and management efficiency in collecting debts and keep low inventory to sales.

6. Profitability Ratios:

Gross profits to sales operating profits to sales Net profits to Equity Capital/ or to total owned funds.

Measures the profitability relative to sales, and relative to capital invested indicates the efficiency of management to generate profits against sales, or capital employed.

7. Capital Efficiency Ratios:

Gross Block/Equity Sales/Equity or Sales/ Capital employed.

Measures the efficient use of owned funds or all Capital employed.

8. Debt Servicing Ratios:

Interest payments to total ­net earnings Total debt servicing to total gross earnings.

Measures the efficiency in the use of Capital, particularly debt Capital, capacity to service Capital borrowed through earnings.

9. Profit Allocation Ratios:

Equity dividends to Net Profits All dividends to Net Profits — Tax and depreciation as % age of Gross Profits.

Management policy of dividend distribution, expansion plans, consistency in dividend distribution, bonus payments, Retention Policy etc.

10. Overall Performance of Company:

11. Comparison of Growth Rates of Gross Block, Sales, Gross Profits, etc., so as to know the efficient use of Capital and the Growth of Capital relative to sales reflecting the optimal use of capacity and profitability of operations.

12. Investor Valuation of Company:

Earnings per share, Book value per share, Net Asset value per share, Break down value of Equity Share, P/E Ratio, or payback period of Investments.

13. Management Rating:

Measured by their honesty, integrity, keeping up to schedules of project construction or fulfilling the sales target or Gross Profit margin, Consistency in dividend distribu­tion, bonus payments, expansion plans and Tax Planning.

How to Locate Emerging Blue Chips?

Research on the Companies’ operations and their financial results is necessary for locating Emerging Blue Chips. This can be done through fundamental analysis which helps us to decide what to buy and what to sell? This research has to be both on the desk and on the field. On the desk, the financial results and Balance Sheets have to be examined to locate the potentiality of companies to emerge as turn­around companies.

Prima facie, such companies, have been in losses for a year or two but due to some expected management changes leading to higher capacity utilisation or due to new projects in the last phase of completion, these companies show the potentiality for turning into profitable projects in the coming year or two.

Research on the field is to interview the officers of the companies, visit to the plant and secure the opinions of the experts, suppliers, stockists, etc. This fundamental analysis is to be supplemented by technical analysis to decide on when to buy and when to sell?

Some companies may be building up Gross Block due to expansion and diversification but sales are not rising fast enough due to low capacity utilisation. Then the company may not be making adequate profits to service investors tempo­rarily. A few companies may have both gross block and sales rising but Gross Profit margin is low due to high costs of manufacture or sale and due to inefficiency of management.

Any changes in policy to improve efficiency or improvements in technology may be expected to increase the profits and the company may be in the process of growth as a Blue Chip Company. Here are some examples of turn-around companies, or emerging Blue Chip Companies: Amar Raja Battery, Hotel Leela Venture, Wartsila Diesel etc., these are also examples of turn-around companies which have come out to be growth companies.

The expertise of the analyst lies in locating the emerging Blue Chips. Shri N.J. Yasaswy has in book “Emerging Blue Chips”, identified 177 highfliers for the year 1992-93. But these Blue Chips of yesteryears are no longer the Blue Chips of today. Similarly, there is no guarantee that the Blue Chips of today will be the Blue Chips of tomorrow. Thus for long in the eighties, Scrips like Reliance, Orkay, Century etc., were the Blue Chips. In the nineties, the Wipro, Infosys, Pentafore, Videocon, Finolex etc., took over the lead, and so on.

Established Blue Chips:

For a conservative investor, established growth stocks with an assured return are attractive. These companies are leaders in the industry, like Reliance and Raymond in the Textiles and TISCO in Steel etc. They have a strong capital base net worth, well established financial position, organised and professionalised management. They reward the investor with uninterrupted dividends, steady rise in capital values and bonus from time-to-time or rights or other privileges.

Such Companies are worth holding for long and are recommended in all the portfolios of investors. The risk of holding such scrips is low and their Betas are generally around the market Betas and their rewards are generally above average performance of the market. Investors in such Blue Chips as TELCO, Colgate, Glaxo etc., have benefitted by regular divi­dends and bonus shares.

The characteristics of established Blue Chips are as follows:

1. Management Rating:

Highly professionalized and efficient management. Reputed for honesty and integrity. Financial practices and accounting are consis­tent and dependable.

2. Gross Profit Margin:

Gross profit margin and sales turnover are high and the company captured a substantial chunk of market demand. The quality and after sales service are the strong points of the company and they are some of the leaders in the industry.

3. Dividend Record:

The company has been making continuous profits of which a reasonable dividend is declared. A prudent policy of ploughing back profits for expansion and diversification is also pursued.

4. The company’s net worth is high relative to equity and is expanding year after year. The leverage enjoyed by equity through long-term borrowings (debt) is also high. Their long-term solvency is rated high.

5. The current liquidity position is also strong. Their current assets cover their current liabilities including contingent liabilities by more than twice, and their sales management is such that inventory holding is always optimal. Their sales and distribution strategies are sound and cash efficient.

6. The company has expansion and diversification plans for future growth as reflected in the rise in net worth and gross block. Such expansion plans are accom­panied by tax planning so as to conserve resources for growth. Alternatively the company is already diversified and has still expansion plans.

7. The management has a vision for the future of the company and their policy is ambitious expansion and growth. The policies adopted are result-oriented and efficiently executed.

8. The company’s net worth is growing due to ploughed back profits and funds are available for bonus payments to satisfy the Investors from time-to-time.

9. The market price of such shares is rising consistently and steadily and any possible fall in price is small and temporary. The price fluctuations are narrow and the long-term trend of its price is upwards.

10. The company has earned a reputation for fair practices and their servicing of investors through dividends, bonus allotments, and share transfer etc., is generally rated good.