Balance Sheet Analysis Of A Company

 

Balance Sheet — Key Terms

Assets (what the company owns)

• Current Assets – convertible to cash within a year (cash, receivables, inventory, prepaid expenses)
• Non-Current/Fixed Assets – long-term holdings (property, plant, equipment, intangibles like patents/goodwill)
• Inventory – goods held for sale or production
• Accounts Receivable – money owed by customers

Liabilities (what the company owes)

• Current Liabilities – due within a year (accounts payable, short-term debt, accrued expenses)
• Non-Current Liabilities – long-term debt, deferred tax liabilities, bonds payable
• Accounts Payable – money owed to suppliers

Equity (owners’ stake)

• Share Capital – funds raised by issuing shares
• Retained Earnings – cumulative profits kept in the business (not paid as dividends)
• Reserves – funds set aside for specific purposes

Core identity: Assets = Liabilities + Equity

Important Ratios for Assessment

1. Liquidity Ratios (short-term solvency)

• Current Ratio = Current Assets / Current Liabilities
• Quick Ratio = (Current Assets − Inventory) / Current Liabilities

2. Solvency/Leverage Ratios (long-term financial risk)

• Debt-to-Equity = Total Liabilities / Shareholders’ Equity
• Debt Ratio = Total Liabilities / Total Assets

3. Efficiency Ratios (how well assets are used)

• Asset Turnover = Net Sales / Total Assets
• Inventory Turnover = Cost of Goods Sold / Average Inventory
• Receivables Turnover = Net Credit Sales / Average Accounts Receivable

4. Profitability Ratios (using balance sheet + income statement)

• Return on Assets (ROA) = Net Income / Total Assets
• Return on Equity (ROE) = Net Income / Shareholders’ Equity

5. Valuation Ratios

• Book Value per Share = (Total Equity − Preferred Equity) / Shares Outstanding

Here’s the same balance sheet and ratios in Rupees (₹):

Item	Amount (₹)
Cash	20,000
Accounts Receivable	30,000
Inventory	50,000
Total Current Assets	1,00,000
Property, Plant & Equipment	1,50,000
Total Assets	2,50,000
Accounts Payable	25,000
Short-term Debt	15,000
Total Current Liabilities	40,000
Long-term Debt	60,000
Total Liabilities	1,00,000
Shareholders’ Equity	1,50,000

• Current Ratio = ₹1,00,000 / ₹40,000 = 2.5
• Quick Ratio = (₹1,00,000 − ₹50,000) / ₹40,000 = 1.25
• Debt-to-Equity = ₹1,00,000 / ₹1,50,000 = 0.67
• Debt Ratio = ₹1,00,000 / ₹2,50,000 = 0.40
• Asset Turnover = ₹3,00,000 / ₹2,50,000 = 1.2
• Inventory Turnover = ₹1,80,000 / ₹45,000 = 4.0
• ROA = ₹30,000 / ₹2,50,000 = 12%
• ROE = ₹30,000 / ₹1,50,000 = 20%

Key Parameters to Check Before Buying a Share

1. Valuation Ratios

• P/E Ratio (Price / Earnings per Share) – how much you pay per ₹1 of earnings; compare to industry average
• P/B Ratio (Price / Book Value per Share) – price relative to net asset value
• PEG Ratio (P/E / Earnings Growth Rate) – valuation adjusted for growth

2. Profitability

• ROE (Return on Equity) – how efficiently the company uses shareholder money
• ROCE (Return on Capital Employed) – returns generated on all capital, debt + equity
• Net Profit Margin – Net Income / Revenue

3. Financial Health / Risk

• Debt-to-Equity Ratio – too high means high financial risk
• Current Ratio / Quick Ratio – ability to meet short-term obligations
• Interest Coverage Ratio (EBIT / Interest Expense) – can the company comfortably pay interest on its debt

4. Growth Trends

• Revenue Growth (YoY, 3–5 yr CAGR)
• EPS Growth – consistent earnings growth over time
• Promoter/Management shareholding trend – increasing stake is a positive signal, declining stake can be a red flag

5. Cash Flow Quality

• Operating Cash Flow – should be positive and ideally growing, not just paper profits
• Free Cash Flow – cash left after capital expenditure, shows real financial flexibility

6. Dividend (if income-focused)

• Dividend Yield – Dividend per Share / Share Price
• Payout Ratio – % of profit paid as dividends (very high payout may limit reinvestment)

7. Qualitative Factors

• Industry outlook and competitive position (moat)
• Corporate governance and management track record
• Regulatory or litigation risks

Quick sanity checks people often skip:

• Compare all ratios against industry peers, not in isolation
• Look at 5-year trend, not just one year’s snapshot
• Check for red flags: rising debt, falling margins, frequent auditor changes, promoter pledging shares

Typical Healthy Benchmarks (India context)

Valuation

• P/E Ratio: Lower than or close to industry average (varies by sector — IT ~20-30x, banks ~10-20x, FMCG ~40-60x)
• P/B Ratio: < 3 is generally reasonable; < 1 can mean undervalued or troubled
• PEG Ratio: ≤ 1 is considered fairly valued relative to growth; > 2 often overvalued

Profitability

• ROE: > 15% is considered good; > 20% is excellent
• ROCE: > 15%, and ideally ROCE > cost of capital
• Net Profit Margin: Varies by sector, but consistently positive and stable/improving is the key signal, not an absolute number

Financial Health

• Debt-to-Equity: < 1 is healthy; < 0.5 is conservative/strong; > 2 is risky (capital-intensive sectors like infra/power run higher)
• Current Ratio: 1.5 – 3 is healthy; below 1 signals liquidity stress; too high (> 3) can mean idle assets
• Interest Coverage Ratio: > 4-5x is safe; below 2x is a red flag

Growth

• Revenue Growth (3-5yr CAGR): > 10-15% annually is considered strong growth
• EPS Growth: Should track or exceed revenue growth — shows improving efficiency, not just top-line expansion
• Promoter Holding: > 50% generally shows strong commitment; rising trend is positive; falling or heavy pledging is a red flag

Cash Flow

• Operating Cash Flow: Should consistently be positive and roughly track or exceed net profit — if profit is high but OCF is low/negative, earnings quality is questionable
• Free Cash Flow: Positive and growing; negative FCF for a few years is only okay for high-growth/expansion-stage companies

Dividend

• Dividend Yield: 1-3% is typical for growth companies, higher (4%+) for mature/value stocks
• Payout Ratio: 20-50% is generally sustainable; > 70-80% may limit reinvestment in growth (except utilities/mature businesses)

Quick red-flag checklist

• Debt rising faster than revenue
• Net profit growing but operating cash flow flat/declining
• Promoter pledging shares increasing
• Frequent auditor resignations
• ROE/ROCE trending down over 3+ years

These are general guardrails, not fixed rules — capital-intensive sectors (infra, telecom, power) naturally run higher debt and lower margins than asset-light sectors (IT, FMCG), so always benchmark against industry peers, not just these numbers in isolation.

Balance Sheet & Ratio Analysis

A reference guide to key balance sheet terms and the financial ratios used to assess a company's health, illustrated with a worked example in Indian Rupees (₹).

1. Key Balance Sheet Terms

Assets — what the company owns

● Current Assets: Assets expected to be converted to cash within one year — cash, accounts receivable, inventory, prepaid expenses.

● Non-Current (Fixed) Assets: Long-term holdings such as property, plant & equipment, and intangible assets like patents or goodwill.

● Inventory: Goods held for sale or used in production.

● Accounts Receivable: Money owed to the company by its customers for goods or services already delivered.

Liabilities — what the company owes

● Current Liabilities: Obligations due within one year — accounts payable, short-term debt, accrued expenses.

● Non-Current Liabilities: Long-term obligations such as long-term debt, bonds payable, and deferred tax liabilities.

● Accounts Payable: Money the company owes to its suppliers.

Equity — the owners' stake

● Share Capital: Funds raised by the company through the issue of shares.

● Retained Earnings: Cumulative profits kept in the business rather than distributed as dividends.

● Reserves: Funds set aside from profits for specific future purposes.

 

Core identity:  Assets = Liabilities + Equity

Balance Sheet Red Flags to Watch For

1. Debt-Related Warning Signs

• Debt-to-Equity ratio rising sharply year-on-year
• Short-term debt used to fund long-term assets (mismatch signals liquidity stress)
• Frequent new borrowings even when profits are reported as growing
• Interest coverage ratio falling below 2x

2. Liquidity Stress

• Current Ratio below 1 (current liabilities exceed current assets)
• Quick Ratio well below 1, especially alongside high inventory
• Cash & cash equivalents shrinking sharply quarter-on-quarter

3. Receivables & Inventory Red Flags

• Accounts Receivable growing much faster than Revenue — could mean sales are being “pushed” or not actually collected
• Inventory piling up faster than sales growth — may indicate unsold stock or demand slowdown
• Rising receivable days / inventory days over several quarters

4. Asset Quality Issues

• Large or unexplained “Other Assets” or “Miscellaneous Expenditure” — often used to hide losses
• Goodwill forming a very large % of total assets (from overpaying in acquisitions) — future write-down risk
• Frequent asset revaluations that boost book value without real cash backing

5. Equity Red Flags

• Repeated equity dilution (frequent new share issues) — dilutes existing shareholders without proportional growth
• Reserves declining or turning negative — signals accumulated losses eating into net worth
• Promoter shareholding falling steadily, especially combined with high pledging of shares

6. Contingent Liabilities

• Large contingent liabilities (mentioned in notes, not the main balance sheet) relative to net worth — pending litigation, guarantees, disputed taxes that could materialize into real liabilities

7. Related-Party Red Flags

• Large loans/advances to related parties or group companies — money leaving the business through non-transparent channels
• Unusual or opaque related-party transactions in the notes

8. General Structural Warning Signs

• Total Liabilities growing faster than Total Assets over time (deteriorating net worth)
• Negative working capital (Current Liabilities > Current Assets) persisting for multiple years
• Frequent changes in auditors or qualified/adverse audit opinions

Rule of thumb: one red flag in isolation may be explainable, but 2-3 appearing together (e.g., rising debt + rising receivables + falling promoter holding) is a strong signal to avoid or investigate deeply before investing.