Let's see What Balance sheet is all about

Readers, i have always had this idea or the interest of writing an article telling how to read financial statements. But i have doubtful how these kind of articles would be received. That has long stopped me from writing such articles. Finally, i just thought of giving it a shot.

Balance sheet is one of the three key financial statements an investor should go through before making an investment in any company. The other 2 - Income statement (Profit and Loss statement) and Cash flow statement are equally important as well. These three financial statements along with the Annual reports are very good sources of information. But, i am sure many people don't even have a look into them before buying a share. Today, we will see how to read a balance sheet.

As a sample, i have taken Pantaloon Retail and this is a random pick. The recent balance sheet is not available for most the of companies yet and hence we will take the FY 08 numbers. For FY 08, Pantaloon made a sale of 5866 crore and a net profit of 20.8 crore.

The basic theme behind the Balance sheet is this ---> Assets = Equity + Liabilities.
As the name points out things must balance out at any point of time. For ex, if the company increases the liabilities by issuing a debt, the liabilities increases. At the same time, the cash that came in will increase the Assets as well.

The below picture is not clear. I request the readers to click on the picture to view it clearly.

Current Assets - This will contain items that is meant to be used up shortly by the business. It is also indicative of item that can be turned into cash in one business cycle - often termed as an year.

Cash, Cash Equivalents and Short term investments - This is exactly how much amount that the company has to meet it's immediate needs. This does not necessarily mean the company has them in physical cash. For Ex - Pantaloon has a cash of around 297 crore, but it is not necessary it is hot cash. They are mostly very liquid investments. In most cases, that could lie in a FD account. The short term investments of 91 crore could be anything like a bond or any fairly low risk investment. In all, the company has around 389 crore of money that is fairly liquid and can be made available in little amount of time.

Accounts Receivable - This section gives the amount that the company is expecting to collect for which it has already sold the goods. A company like pantaloon can book and report a sale as soon as the product is out of the store, but there are chances that it will never receive the money for it.

What one should see here is how the total receivables moves with respect to the sales. If the total receivables moves much faster than the sale that the company is reporting, it clearly indicates that the company is boosting sales by giving loose credit. When there are loose credit, there are high chances that there are higher defaults as well.

In case of pantaloon, the sales rose by around 84% and 70% in the last 2 years. In the same period, the total receivables rose by 100% and 110% respectively. Clearly, the rise in receivables out paces the sales growth. But, it is not at an alarming level. One should worry if the receivables growth is around double the sales growth.

Inventories - Inventories need not necessarily be the final product. It could be raw materials, partially finished goods and finished goods. In case of a retailer like Pantaloon, we can safely assume that most of the inventory is finished goods.

Inventories are really really important for manufacturing and retail companies because they will clearly tell you how good and how fast the company is in selling stuff. Investors should always take the inventory number with a grain of salt. Unsold gold ornament from a Gold retailer may be worth much more than what is quoted in the balance sheet. But, what about an apparel retailer who sells some seasoned clothes ? It would be worth only for peanuts one or two seasons later.

Why did i said inventory number is very important for a retailer and for a manufacturing company? Because they soak in the capital that the company needs to run the business. If i can sell stuff worth 10 rupees 10 times a year and if my competitor does it only 5 times, i cam certainly at an advantage. Moreover, the success of these companies would depend on how fast the company is in selling stuff. It is here that Inventory turnover comes in handy. Inventory turnover = Cost of Revenue (from Income statement) / Inventory (from balance sheet).

In case of pantaloon retail, the inventory turnover is 2.8, where as for kouton retail it is only .81 and for Trent it is 2.6. Well this clearly says why Pantaloon is at the helm. However, it has a long way to go in terms of inventory turnover which can be a lot better. Look at Wal mart whose size of business is so huge. It has a inventory turnover ratio of 8.8.

Non current Assets - Unlike, the current assets, non current assets are the ones that cannot be converted into cash immediately or in one business cycle. They are not liquid assets. Manufacturing companies will have more of these non current assets. They include things like Land, Factory building, retail outlet, machinery...

PP & E - This constitutes the Property, Plant and the equipments. This will give you a clear idea as to how capital intensive the business is. There is nothing wrong in a company being capital intensive. A steel major or a cement major is prone to be capital intensive. But, you should check if the company makes out enough money from the assets.

Pantaloon's PP&E net is almost 29% of total assets, where as it is 7.7% for Koutons retail and 16% for Trent. Clearly Pantaloon is capital intensive when compared to the other two. But. let's see how much sales the company generates out the PP&E assets. The Sales of PRIL is 3 times its PP&E assets, where as it is 11 times for Koutons retail and 4 times for Trent. Clearly, Koutons scores well in this parameter. Koutons is less capital intensive and also makes the most out the PP&E assets it has. But, one should remember as the size grows, for a retailer the PP&E assets increases very much and it is tough to be lean. Wal mart's PP& E assets make up almost 80% of its total assets and the sales is just 3 times the PP&E assets. Sounds PRIL is more in the path of Walmart ?

Long term investments - As said before, this is not as liquid as cash and might be worth more or less that what is quoted. If there is substantial amount of this Long term investments one should dig deeper. For ex - PRIL says it has almost 720 crore in Long term investments. Thats not a small number. A peep into the annual reports will tell you that these are mostly the % stakes that the company holds in other subsidiaries and joint venture companies.

When i started writing this article, i never thought it would take these many pages or so much of my time. But, i guess you will find it useful. We will go over the other two parts - Liabilities and Equity in the days to come.

To contact the equity analyst on this story: Arun Gopalan in Chennai at Arun@hbjcapital.com