The Safal Niveshak Mastermind Module 3 | Lesson 23

Understanding the
Balance Sheet – Part 2
Module 3 | Lesson 23

Just to recap what we studied in Lesson #22, the balance sheet discloses what a
business owns and what it owes at a specific point in time. It is thus also referred to
as the statement of financial position.

The financial position of a business is described in terms of its assets, liabilities, and
equity:

Assets (A) are resources controlled by the company as a result of past events
and from which future economic benefits are expected to flow to the company
(like land, machines, plants, offices, brands, future receivables from
customers, cash, investments etc.)
Liabilities (L) represent obligations of a company arising from past events,
the settlement of which is expected to result in an outflow of economic
benefits from the company (like bank borrowings and future payment to
suppliers of raw materials etc.)
Equity (E) Commonly known as shareholders’ equity or owners’ equity ,
equity is determined by subtracting the liabilities from the assets of a
company, giving rise to the accounting equation: A = L + E or A – L = E.
Equity can be viewed as a residual or balancing amount, taking assets and
liabilities into account.

We went through the “Equity and Liabilities” side of the Balance Sheet of Hero
Motocorp for the financial year ended March 2013 (FY13) and understood the
meaning and relevance of each item therein.

In this lesson, let’s go through the Assets side of the Balance Sheet and see what lies
within.

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The Safal Niveshak Mastermind Module 3 | Lesson 23

As you can see in the snapshot above, the Assets side of the Balance Sheet is made up
of two broad categories:

1. Non-Current Assets
2. Current Assets

Let’s understand them and their constituents one by one.

I. Non-Current Assets
As the name suggests, Noncurrent Assets represent the infrastructure from which the
business operates and are not consumed or disposed within a one-year period. In
other words, these are assets that are not easily convertible to cash or not expected to
become cash within the next year.

Here is the break-up of Non-Current Assets as you see in the Balance Sheet of Hero
Motocorp –

1. Fixed Assets: Fixed Assets is a term used in accounting for assets and property
that cannot easily be converted into cash. These are assets whose future economic
benefit is probable to flow into the business, and whose cost can be measured
reliably.

Like if you own a restaurant, the machines and utensils you use to cook food, the
restaurant property, the land on which it is situated, the electrical equipments, and
the delivery vans are all fixed assets. So, fixed assets are items of value that a
company owns and will use for an extended period of time.

Fixed Assets can be further broken up into Tangible Assets, Intangible Assets, and
Capital Work-in-Progress.

As you can see from Hero Motocorp’s note on Fixed Assets below, Tangible Assets
include items like land, building, plant and equipment (which is the biggest fixes
asset as it is a manufacturing company), vehicles, office equipments, etc.

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The Safal Niveshak Mastermind Module 3 | Lesson 23

These are the type of Fixed Assets that are “tangible” – they have a physical form and
can be seen and felt.

The second category of Fixed Assets is called Intangible Assets – long-term assets
of a company that have no physical existence. As you can see in Hero’s Balance Sheet,
the biggest item under Intangible Assets is “Technical know-how / Export licenses”,
which is in fact valued even greater than the company’s plant and equipments.

You cannot touch and feel a company’s technical knowhow – like you cannot touch
and feel your personal skills and abilities, which are your intangible assets – but then
it holds tremendous relevance for the company as it is at the core of its existence.

Intangible Assets include goodwill, patents, copyrights, technical know-how,

computer software, product development cost, trademarks, and brands.

Goodwill is often the least understood item here. In simple words, Goodwill is
recognized when a business acquires another business. It represents the excess of
cost paid by the purchasing business to the purchased business over the fair value of
purchased business identifiable assets.

For instance, assume Company A acquires Company B for Rs 100 crore. The fair
value of Company B’s net assets (assets minus liabilities) equals Rs 80 crore at the
time of purchase. The difference between the cost of Rs 100 crore paid by Company A
and Rs 80 crore fair value of the assets of Company B is goodwill, which amounts to
Rs 20 crore. Goodwill here is an intangible asset and represents Company’s business

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The Safal Niveshak Mastermind Module 3 | Lesson 23

reputation, for which Company A paid Rs 20 crore more than the former’s fair value
of net assets.

Here is Tata Motors’ Balance Sheet that shows Goodwill, which was created when the
company acquired the Jaguar-Land Rover (JLR) brands.

Companies may also have intangible assets that are not recorded on their balance
sheets. These intangible assets might include management skill, valuable trademarks
and name recognition, a good reputation, proprietary products, and so forth. Such
assets are valuable and would fetch their worth if a company were to be sold.

After Tangible and Intangible Assets, the third key item under Fixed Assets is
Capital Work-in-Progress.

This represents assets that are in progress of being built and are possibly under
construction on the day the Balance Sheet is prepared, and thus the term “work-in-
progress”. Once these assets are built, they get shifted to Tangible or Intangible
Assets as the case may be.

2. Long-Term Investments: After Fixed Assets, the next type of Non-Current

Assets as you find in Hero’s Balance Sheet is “Long-Term Investments”.

These are investments that have a horizon of one year or more, are considered long-
term investments for tax purposes. These are usually made by a company in order to
secure an additional income stream or a strategic goal. Such investments can range
from anything from buying a minority stake at another company to investing in
equity shares and debt securities (for a period more than one year).

Look at Hero Motocorp’s note on Investments and you see that the company owns
bonds and NCDs (non-convertible debentures) of other companies as part of its long-
term investment portfolio.

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3. Long-Term Loans & Advances: These represent any loans and advance
payments that the company has granted to employees, suppliers, and government,
and which are to be received by the company in a period beyond one-year.

As per the relevant note on Hero’s Balance Sheet, the company has advanced some
money to buy capital assets (maybe land, machines, etc.) that is shown as capital
advances, and has also loaned money to its employees that will be returned only after
one year.

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The Safal Niveshak Mastermind Module 3 | Lesson 23

4. Other Non-Current Assets: The last type of asset under Non-Current Assets is
Other Non-Current Assets.

These are basically obligations which are not going to be paid off within the year or
operating cycle. The items here are deemed to be not important enough to warrant
identifying each amount individually and thus are termed as “others”.

II. Current Assets

Current assets are assets expected to be realized or intended for sale or consumption
in the business’s normal operating cycle, or within one year. Typical current assets
that appear on the Balance Sheet include:
Assets held primarily for trading.
Assets expected to be realized within 12 months after the balance sheet date.
Cash or cash equivalents, unless restricted in use for at least 12 months.
Debt or equity investments that are owned by a business, traded in a public
market, and whose value can be determined from price information in a
public market. Examples include treasury bills, notes, bonds, and equity
securities, such as common stocks and mutual fund shares.
Trade receivables — amounts owed to a business by its customers for products
and services already delivered are included as trade receivables.
Inventories — physical products on hand such as goods that will eventually be
sold to a business’s customers, either in their current form (finished goods) or
as inputs into a process to manufacture a final product (raw materials and
work-in-process).

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The Safal Niveshak Mastermind Module 3 | Lesson 23

Let’s understand the various Current Assets as you see in the Balance Sheet of Hero
Motocorp one by one.

1. Current Investments: As the term suggests, these are investments that a

company makes for a short period of time, largely a horizon of less than one year.

Most companies in a strong cash position have a short-term investments account on

the balance sheet. This means that a company can afford to invest excess cash in
stocks and bonds to earn higher interest than what would be earned from a normal
bank account.

2. Inventories: Inventories include items like raw materials, work-in-process

goods and completely finished goods that are considered to be the portion of a
business's assets that are ready or will be ready for sale.

Inventory represents one of the most important assets that most businesses possess,
because the turnover of inventory (conversion of raw materials into finished
products, which when sold bring in cash for the company) represents one of the
primary sources of revenue generation and subsequent earnings for the company's
shareholders/owners.

Look at Hero Motocorp’s note on Inventories and you see that the biggest item here
is “raw materials and components” that are lying with the company on the date of
preparation of the Balance Sheet. Inventories also include the two-wheelers the
company has manufactured but which have not been shipped by the Balance Sheet
date.

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Possessing a high amount of inventory for long periods of time is not usually good for
a business because of inventory storage, obsolescence and spoilage costs. However,
possessing too little inventory isn’t good either, because the business runs the risk of
losing out on potential sales and potential market share as well.

Ben Graham writes this in his book, The Interpretation of Financial Statements…

There is a tendency to consider a large inventory as a bad thing for any business.
This is not strictly true, since inventories are assets, and in general the more assets
a company has the better off it is.

Large inventories, however, often do create trouble of various kinds. They may
require substantial bank borrowings to finance them, or else absorb an undue
amount of the company’s cash.

They may lead to heavy losses in case of a decline in commodity prices (in case a
company has bought, say, a raw material at Rs 100 per tonne and the prices crash
to Rs 50 per tonne, it has to write off its inventory by that amount). Theoretically,
they could produce similar profits, but experience shows that such profits are not
nearly as large or as frequent as the inventory losses.

Finally, an abnormally large inventory suggests that a good part of the

merchandise may be unsalable and that its price may have to be drastically
reduced in order to move it.

Now the question is – how do you assess whether a company’s inventory is high or
low? Well, we will study that in the lesson on ratio analysis.

3. Trade Receivables: These represent the money owed to the company by its
customers to whom it sold goods or services on credit.

So, if a car company sells its vehicles worth Rs 10 crore to its dealers and receives
money from them in 60 days, the Rs 10 crore will show as Trade Receivables on the
Balance Sheet till the time actual payment is received by the company.

No, it’s important to note that sometimes it may happen that a few customers do not
pay up even after the company waits for the payment for the specified number of

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The Safal Niveshak Mastermind Module 3 | Lesson 23

days. These defaults are called “bad debts” and must be reduced from the total trade
receivables.

Also, to save itself from any such shock, companies usually create a “provision for
doubtful debts” to the extent of money that they are doubtful of receiving from their
customers.

In a big business that has literally hundreds if not thousands of credit customers,
some will inevitably turn out to be defaulters or go bankrupt. So the accountants
estimate what percentage of the company’s receivables will turn sour and subtract
that amount from total receivables. The result is a realistic net amount that the
company expects (crossing its fingers) to collect.

See below Hero Motocorp’s note on Trade Receivables. The company expects to
receive almost 97% of its receivables, which it has classified as “good” (see the last
row in the image below). The company has also created a small provision (Rs 9.5
crore) for doubtful receivables.

4. Cash and Cash Equivalents: As the name suggests, this is “Cash” that lies in a
company’s bank account(s), plus highly liquid short-term or temporary investments
(cash equivalents).

Cash is the most liquid asset found in a company's balance sheet. As for “cash
equivalents”, they are distinguished from other investments through their short-term
existence; they mature within 3 months whereas short-term investments are 12
months or less, and long-term investments are any investments that mature in excess
of 12 months.

Cash is a medium of exchange, a store of value and a unit of account and a business
needs to have sufficient cash in order to be able to pay its liabilities. Higher cash ratio
(ratio of cash and cash equivalents to current liabilities) suggests that the business is

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The Safal Niveshak Mastermind Module 3 | Lesson 23

liquid (i.e., it is expected not to face any difficulty in paying its very short-term
liabilities).

A business generates cash from sale of products and services, sale of assets,
borrowings from banks and other creditors and from capital contributions by its
owners. It uses cash to pay for its operating and capital expenditure, its liabilities and
in paying dividends to its owners. Information about sources and uses of cash are
presented in the statement of cash flows.

One point worth mentioning here is that Cash mentioned on the Balance Sheet is not
the “cash flow” or “free cash flow” that you may have heard or read in a company’s
research report. This Cash is what remains on the Balance Sheet date after adjusting
for all cash inflows and outflows during the period.

Also, when you are trying to assess the total cash a company has with it, it is
important to add the “Current Investments” the company owns, as these are bought
using the excess cash a company has, and can be sold whenever the company needs
hard cash.

5. Short-Term Loans and Advances: These are very much like Long-Term
Loans and Advances we discussed above, just that these are for a period less than
one-year.

As you can see in the note on Hero’s Balance Sheet, the company has advanced some
money as inter-corporate deposits, plus there are certain tax credits and advances to
vendors. The company expects to get these loans and advanced repaid back within
one year and have thus categorised them as Short-Term Loans and Advances.

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6. Other Current Assets: These are assets that do not include cash, investments,
receivables, and inventory, and can be converted into cash within one business cycle,
which is usually one year. Like you can see in Hero’s Balance Sheet, it has shown the
interest that has accrued (earned but not received) on its investments as part of
Other Current Assets.

How to Analyze the Balance Sheet

We have till now understood the meaning and relevance of various components of
the Balance Sheet.

Now the question is – How do you analyze the Balance Sheet to study whether it is
improving or worsening?

Broadly, the Balance Sheet tells about a company’s liquidity, financial strength, and
efficiency. But how do you assess all that?

One insightful Balance Sheet analysis is a “common-size analysis” that investigates

the different items as a percentage of a common figure. For assets, using Total Assets
as the denominator and every other category as a numerator item helps look at it in
percentage terms. Once these figures are calculated, you can compare them over time
for a single company.

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For instance, an increase in Trade Receivables over time could indicate a firm is
having trouble collecting cash from its customers. A large, sudden drop in prepaid
expenses could also indicate the company is in a cash crunch and trying to cut
corners by not paying for as many items in advance. This same analysis can be used
to compare the subject firm to its rivals.

The second important way to analyze a Balance Sheet is by way of ratio analysis,
which will help you investigate the liquidity (the ability to cover short-term liabilities
with short-term assets), solvency (the ability to finance long-term debt with profits)
and how shareholder capital is being managed.

We will study ratio analysis in Lesson #26. For now, you can download this
excel and see how a common-size analysis of a Balance Sheet is done.

The biggest benefit of a common-size analysis is that it can let you identify large or
drastic changes in a firm’s financials. Rapid increases or decreases will be readily
observable, such as a rapid drop in reported profits during one quarter or year.

Like in the case of Hero Motocorp, as you will see in the excel, Trade Receivables
have risen sharply over the past the three years – from 1% of Total Assets in FY11 to
3% in FY12 and 7% in FY13.

This is concerning as Hero’s customers (dealers) are taking a longer time to pay for
products. Given that Hero has a safe Balance Sheet and good cash generation, this
won’t impact the company much, but for a lot of small and mid-size companies,
customers delaying payments can cause a big trouble.

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A common-size Balance Sheet analysis can also give insight into the different
strategies that companies pursue. For instance, one company may be seeing a rise in
Trade Receivables as it is allowing its customers easy payment terms. On the other
hand, its competitor may be seeing stable or falling Receivables as it maintains a
tight control over its patents, which is a good sign.

The Bottom Line

As we’ve studied from the analysis of various components of a Balance Sheet, it
comes out clear that this statement is a powerful indicator of a business’s health.

The Balance Sheet tells you in a snap how much money a company owes – and
whether that amount has increased or decreased over the previous year(s) – and how
big are the borrowings in comparison to the owner’s equity/shareholders’ finds.

Still, the Balance Sheet is a static indicator. That is, it doesn’t tell much about the
future of the business and particularly about future income, but rather more about
where the company has been and how well it did getting to where it is now.

Also, although it is in theory useful to have a summary of the values of all the assets
owned by an enterprise, these values frequently prove elusive in practice. For
example, the value of land, machines, investments, and inventories as mentioned in
the balance sheet may not be their true value.

Finally, many kinds of things have value and could be construed, at least by the
layperson, as assets. Not all of them can be assigned a specific value and recorded on
a balance sheet, however. For example, proprietors of service businesses are fond of
saying, “Our assets go down the elevator every night.”

Everybody acknowledges the value of a company’s “human capital” – the skills and
creativity of its employees – but no one has devised a means of valuing it precisely
enough to reflect it on the balance sheet. Accountants do not go to the opposite
extreme of banishing all intangible assets from the balance sheet, but the dividing
line between the permitted and the prohibited is inevitably an arbitrary one.

Still, as it comes out clear, the Balance Sheet is a remarkable statement that a value
investor must not miss reading and analyzing. While we will discuss this in detail in
subsequent lessons, value investors typically look for the following in a Balance
Sheet:

Composition of assets, liabilities, and owners’ equity (lots of inventory and

little cash can be a bad sign)
Trends (increasing debt, decreasing owner’s equity — also bad)
Quality (do stated values reflect actual values?)

Each of these examinations should be done with an eye toward what the figure
probably should be for a company in that line of business. A company like Nestle or
Hindustan Unilever, with frequent small cash sales, shouldn’t have a large Trades
Receivable balance. A retailer should have sizeable inventories, but they shouldn’t be
out of line for the industry or category. A high debt compared to equity is normal for

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a power company which is setting up huge capacities, but again it should not be out
of sync with the industry.

To determine whether Balance Sheet numbers are in line, you need to apply
specifically defined ratios to the numbers. Ratios serve to draw comparisons among
companies and their industry. By doing so, they show whether performance is better
or worse than industry peers. Because many financial analysis ratios involve items
found outside the Balance Sheet, mostly on the Income Statement, the discussion of
ratio analysis is deferred to Lesson #26.

In the meanwhile, here are two videos where I explain the Assets side of the Balance
Sheet that I’ve discussed above.

Video 1 | Video 2
In the next lesson, I would take you through the analysis of Income Statement.

Exercise
Download the FY12 and FY13 annual reports of Hindustan Unilever and Suzlon
Energy, and create the common-size Balance Sheet (consolidated) as per this excel
format (for three years – FY11, FY12, and FY13).

Then, visit the Mastermind Forum via this link and share your observations on
the changes in the following:

1. Total Borrowings (Long and Short Term)

2. Trade Receivables
3. Inventories
4. Shareholders’ Funds
5. Cash

If you have any questions on the Balance Sheet analysis, please post here.

Further Reading
Financial Statement Analysis ~ Martin Fridson
Intermediate Accounting For Dummies ~ Maire Loughran

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