EVER so often, I have been posed the question, "How does one go about reading a balance sheet"? The answer could be as easy or as complicated as the answer to "How do you drive an automobile?"
As in the case of driving, there is a learning process which incorporates some basic know how....in much the same way, a certain know how is involved in analysing a balance sheet.
However beyond a point it is a question of developing one's own style and approach to analysing a balance sheet.This attempt (or any attempt for that matter) to enumerate the steps involved in reading a balance sheet can only initiate a novice into the process.
Beyond a point every reader would have to evolve his own style and approach much as a driver of an automobile (once he has gone beyond the stage of Successfully putting the automobile into motion and controlling it) soon develops his own "touch".
Fusion of science and art
Reading a balance sheet is a science and an art and the dexterous reader is one who blends the two well. Undue reliance on the textbook and measurement approach could lead to the same judgmental erors that statisticians find so irksome: the spurious co-relation (Research over the last twenty years indicate a positive co-relation between the fertility of tribal women in Papua New Guinea and rainfall in the hilly
regions of Haiti). On the other hand, an approach which ignores the ratios and measurements and
relies only on reading "in between the lines" is like playing a game of poker without looking at one's cards.
Anatomy and dissection of a Balance Sheet
1. Notice of AGM :
The discerning reader would look closely at the "explanatory statements to the special resolutions that are sought to be passed at the AGM. Largely, the explanatory statements are drafted in non-legal language giving the rationale or background to special resolution(s) sought to be passed at the AGM.
Cues
- Look out for anything out of the ordinary in the explanatory statement since this is an area where far reaching changes are often couched.
2. Director's report :
This is the management's encapsulation of the company's performance for the year/period under review. The Director's report is comprised of the issues that the report is statutorily required to cover such as answers to the qualifications made by the auditors in their report, the report on technology absorption,
recommendation of dividend payout, retirement and proposed appointment of Directors and Auditors, a separate statement on the salaries, age, qualification and previous employment of employees drawing remuneration above a certain amount etc.
Cues
* A proper reading of the Directors report will set the "mood" to the analysis of the balance sheet.
* A lot of inferences can be drawn on the ethos and the values of the company' management from the
non-statutory areas covered by the Directors report. A report that sticks to the bare statutory issues is
also reflective of the management's attitude to its shareholders.
* There is more than meets the eye in the case of Auditors retiring at the AGM and not seeking re-appointment.(I have yet to come across an Auditor who is in the retirement business).
* Look out for changes in directors. These could be the first signals of a management shift.
3. Statement of sources and application of funds (the Balance sheet) :
In the good old days there was in voguc the "Horizontal Form" of the Balance sheet with the. right
handside depicting the assets of the company (now application of funds) and the left hand side the
liabilities (now sources of funds). The excess of the assets over the liabilities represented the shareholder's funds (net worth).
Cues
* Net worth - this basically indicates the size of the company in terms of the wealth that jt owns
"Reserves to Equity" ratio which indicates the inherent "Reserves: Strength of the company. However
"revaluation resources" and "share premium which are not in the nature of "earnings ploughed back"
need to be excluded.
* Debt/Equity ratio: A very high or a very low Debt/Equity ratio are both not very positive indicators. Ahigh Debt/Equity ratio, (say beyond 1:5 for most industries) would signify heavy borrowings which would then need to be analysed in respect of the uses of the borrowed funds- Has the money gone to fund losses, to fund working capital or to build assets?
* A very low gearing (Debt/Equity ratio) could indicate either a very passive management which is not making the shareholders funds work hard enough or could indicate a situation where costly Equity funds have been used, in lieu of cheaper Debt funds to fund the company's business which once again would not be very "healthy for the company in the long run.
* Quick ratio: Current Assets (except loans and advances)/current liabilities (except tax provision). This ratiodoes remain one of the important indicators of the short term solvency and liquidity of the company.
* Fixed assets: Look out for hidden resources say, in the form of Land/Building not currently in use by the company (say residential premises) where the book value is substantially below the current market value. Likewise watch out for intangible assets such as Goodwill and assets taken on Hire Purchase which are, strictly speaking not owned by the company, as yet.
* Investments : In case of investments in quoted instruments, the difference between the market value and the book value would represent hidden profit/losses which need to be considered.
* Loans and advances: Large loans given to group companies or subsidiaries etc. could indicate diversion of company's funds into uses which may not be generating suitable returns.
* Miscellaneous expenditure (to the extent not written off or adjusted): This head is increasingly
becoming the favorite playground for the creative accountant where expenses with debatable future
value (such as launch advertising or research expenses) are parked.
Hence this head would also merit closer scrutiny by astute balance sheet readers.
4. Notes to accounts
This most ignored and "skipped over part of the Balance Sheet is often the most interesting. Within the notes to accounts, there are the mandatory areas" which has to be covered as also the special elucidations/qualifications to the accounts that the management deems necessary.
The Art of reading a Balance Sheet
Having come to grips with the science, it is now the time for the reader to graduate to the Art. This is largely a function of time and "Balance Sheet Hours" (like "Flying Hours"). It is the art of reading in between the lines, the art of juxtaposing a comment here with a figure there and inferring the "Big Picture", the art of developing industry perspectives thereby adding much more meaning to the Balance Sheet figures and so on and so forth.
It is the art developing your own "Golden Rules to reading a Balance Sheet".
Here are some:
- Reading Balance Sheets is all about reading the unwritten.
- Other things being equal, favour the Balance Sheet with the least number of colour photographs.
- A Balance Sheet which fails to conjure up an image of the Company has failed to make its point.
- Be wary of Balance Sheets with blown up photographs of Directors and Presidents; it does reflect a bloated Corporate ego.
- A Balance Sheet is a Historical Document; one cannot see the Future through a rear view mirror.
- A Abridged Balance Sheet to a savvy reader is what the game of "Cut Throat" is to a Bridge Player.
To cap up this piece here's an experiment conducted in 90's by a Swedish Tabloid (and as reported in an issue of TIME Magazine)):
Five leading analyst were given S 16,000 each and a one eyed chimpanzee was given five darts to stick on a list of companies. Two months down the line the chimp's picks made a profit of $ 270 against $ 240 of his closest human rival.
So apart from attempting to read Balance Sheets, do eat more bananas and close one eye while throwing dart.
