As the current financial year draws to a close, analysts and experts will start looking and dissecting financial statements of different companies.
Hrishi K: Hello and welcome to another episode of NSE Presents: Invest – O- Cast (An exclusive investor podcast) Powered by Moneycontrol. My name is Hrishi K and I am your host and this podcast is all about getting your money to make better investments for you in the new financial year.
As the current financial year draws to a close, analysts and experts will start looking and dissecting financial statements of different companies. They will talk about Balance sheets, Incomes statements and Cash flow statements.
They will discuss assets and Liabilities, and Financial ratios, and how much should the company get from its clients, and how much it owes its creditors. This got me thinking. When these experts discuss all these statements, it’s important for us to understand what they are talking about.
One of the most important statements is a balance sheet. A balance sheet tells you how effectively a company can deploy its resources, and how effectively it can manage its resources. It offers a quick snapshot of the financial health of a company. This statement helps potential investors decide whether this is a company worth investing in to.
I realized that I needed a lot more info on balance sheets, and all of you know what I do when I have to increase my knowledge in finance. That’s right. I call up my producers at Moneycontrol and ask them to set me up with a guest who can bridge the financial lacunae.
And that is why today’s podcast is all about helping investors understand the balance sheet.
National Stock Exchange (NSE) with the help of Invest – O- Cast (An exclusive investor podcast) Powered by Moneycontrol is committed to break the limitations of geographic boundaries and reach investors across the country. Today’s podcast is all about helping investors understand the role that a balance sheet plays in making decisions on investing in a company. Our guest for today is going to tell us what to look out for in one, and how Balance Sheets can help us understand a lot about the company.
Let’s say hello to our guest for today: Anil Lamba. A practising Chartered Accountant, Anil is a bestselling author, financial literacy activist, and an international corporate trainer. He also holds degrees believe it or not in Commerce, Law and a Doctorate in Taxation.
Anil’s financial training programs are held internationally, with a client list exceeding 1,000 large and medium sized corporations spread across several countries including India, the USA, Europe, Russia, Africa, the Middle-East and the Far-East.
Welcome to the show Anil. We are so glad you could fit us into your busy schedule.
Anil Lamba: Thank you Hrishi, pleasure to be here with you.
Hrishi K: So what’s the big deal about a balance sheet? Can you explain, in a nutshell, why is it so important that investors should know about balance sheets?
Anil Lamba: I think a balance sheet is at much neglected statement. Most people understand they look at the ‘Profit Loss Account’ I think too much emphasis is placed in profit and loss account whereas a critical statement is balance sheet. Why should one look at a balance sheet? Same question why should a doctor look at a blood test report and why should a cardiologist look at an ECG, same reason if you want to know health of the organization you have got to look at balance sheet. So Balance sheet is very very important.
Hrishi K: So now let’s break it down what are the most important factors or components that one should search for in a balance sheet?
Anil Lamba: Well first one should then be clear what a balance sheet is. I think everyone knows one side of the balance sheet list out ‘liabilities’ and the other side ‘assets’, but what do this indicate liabilities actually indicates where ‘the money has come from’ and the assets tell you ‘what you did with the money’. So typically a balance sheet each side may have numerous numbers but typically money comes from 2 sources owners contribute and outsiders contribute. What owners contribute is ‘Capital’ and what outsiders contribute is called ’Loan’. Actually both are loan, one is the loan from owner and the other is the loan from the outsider and because both are actually loans both are classified as liabilities. And both give you in 2 ways, outsiders give you loan in cash, outsiders give you loan in kind, so even the creditors appear in the liability side. Owners contribute in 2 ways, they contribute money which is called capital and the reward for that is whatever profit the business earns belongs to the owners but rarely do the owners take all the money home. A portion of the money is paid to the owners as dividend, the profit that they leave behind is an additional contribution of the owner. So sources come from 2 ways owners and outsiders both give you direct and indirect. It goes into 2 avenues. Business needs money for the creation of infrastructure that appears on the asset side heading called ‘Fixed Assets’. And one should make sure that they don’t exhaust the money while they create infrastructure because you need a continuous supply of something known as ‘Working Capital’. So working capital in a balance sheet on the asset side is represented by something known as ‘Current Assets’ after buying land and building, plant, machinery you need to buy and maintain inventories of raw materials. Since money doesn’t come in everyday but expenses happen every day and business has to hold on in certain amount of cash and business also demands that you keep spending, keep buying material, keep hiring people, keep making a product that get cost to yourself and some brilliant customers comes say that I am buying it from you and I am going to pay you month, 2 months, 3 months later, you have got to fund your customers also. So money goes into 2 areas goes towards creation of infrastructure goes to supply of ‘Working Capital’ and working capital have 3 components ‘inventory, cash and debtors’. This in a nutshell one on one on what a balance sheet.
Hrishi K: Fair enough, what we should search for in a balance sheet?
Anil Lamba: Now, if one has to understand the health of a business two things are critical, a business will survive if these 2 things happen and a business will fail if any of these 2 things get violated. I have these 2 golden rules of good finance management. These are not standard rule these are mine but you bring me any sick company’s balance sheet and I will tell you which are the 2 rules that is violated. The first rule says as I just now told you liabilities are sources and assets are uses. First rule says you must understand none of the sources are ‘free’. Now everyone understands loan comes at a cost. Unfortunately very often people think that owner’s money is free and usually who thinks like this, very often the owners themselves. Whereas the truth is no money is free and the owner’s money is the most expensive source of money. The most expensive source of money is the owner’s money, so debt free companies which proudly go around strutting, we are debt free are the ones using the most expensive money. Now your business can only be justified, business can only be survive because the sources on the liability said they have deployed to create assets on the asset side and the assets hopefully poses and ability to earn. So number one every business person, every investor should know what money cost a company and then you got to make sure where you deploy and earn for you at least equal to cost of capital. Now everyone understands my earnings should exceed the cost of production, the cost of people, the cost of selling and the cost of admin, what many people don’t understand the profit left behind should be equal to or greater than the cost of capital. So the first thing to look at in a balance sheet is this and second thing is the most critical thing that your sources again can be reclassified as, initially I told you classify them as owners and outsiders. Now you can reclassify these sources as long term sources and short term sources. Owner’s money is a long term source both ways and outside long term loan is a long term source but the creditors and those liabilities which will mature within a year are short term sources. Similarly, assets can be divided into long term assets and short term assets. What a long term asset means those assets don’t bring my money back, why do you bring that back because we did not buy the assets for trading purposes. For a manufacturing company a land, a building, a machine is bought for use for years together. However working capital is a short term use, its a cycle. Money invested in a working capital goes through a cycle and come back every few months. So now you have classified your sources as long term sources and short term sources, you classified your uses as long term uses and short term uses. Now the rule for a healthy company is a healthy organization should use the long term funds for acquiring long term assets, they should use short money to buy short term assets, there is no harm if you use long term funds and buy short term assets but don’t ever use short term sources to acquire long term assets. And it is not funny how many companies are doing that and therefore most business failures in the world are undisputed fact. 90-95% businesses that fail in the world fail due to bad finance management and out of that 90-95% I think a 90% fail because they use short term money for long term purposes. So this is critical. I wrote a LinkedIn post sometimes back but if there was a graveyard of failed companies. You know the tombstone in front of many would have read: “Here lays a company that give you short term money for long term purposes.”
Hrishi K: Very graphically put. A lot us don’t come from financial backgrounds and we take it that people listening to this pod cast on MoneyControl.com need not necessarily come from that kind of a background. Is there a dummies guide to read a balance sheet? An easy way to read a balance sheet?
Anil Lamba: I think what I just now gave you were that. 2 things you look at it, see what the business is earning, see what the money is costing them, the earnings have to exceed the cost. And if it doesn’t exceed the cost it means somebody is not getting paid and who is that somebody? That somebody is the owner. And why is he not getting paid? Either they think it is free and therefore they deployed into the area which they should not have deployed it but folks the paradox is that, the business is run in one objective never to forget that and that is to make profit and profit for whom? For the owner, so when the owner doesn’t make money it is a matter of time that the owner will decide that shut down this business.
Hrishi K: You are listening to National Stock Exchange (NSE) presents Invest – O- Cast (An exclusive investor podcast) Powered by MoneyControl. We committed to break the limitations of geographical boundaries and reach investors across the country. Anil Lamba is with us on the show today telling us why it is important for investors to understand balance sheets and interpret them. A lot of us find it easier to look at a Profit and Loss statement. Because if we look at the last line, we know if the company made money or didn’t. What does a balance sheet tell us in terms of the financial condition of the company? Does it actually tell us if the company is in a healthy financial condition just expand that a little bit?
Anil Lamba: Yeah, so a balance sheet can absolutely indicate whether a company is healthy or not. When I said a little while back you must classify sources into long term and short term. Now the people who are going to standing on your door step asking for the money to be paid are the short term length. Similarly assets are short term and long term. Short term assets will bring the money back in the short term period, long term assets can’t because you did not buy them for sale and you bought them for use. So the short term liabilities are the ones which have to be paid back in the short period. The short term assets are the ones where the money will come back in the short period. So when people come knocking in your doors ‘can I have my money back’, so at that time you should make sure that the doors available to you on the assets side where you can go knocking, ‘can I have my money back’ so I can pay my short term liabilities and this will not happen if the short term assets are less than short term liabilities. And when the short term assets are not enough to meet short term liabilities then organizations are forced to sell the long term assets to pay short term liabilities. That can only happen when you are ready to shut down. You can’t sell your building, you can’t sell your machinery, you are not into pay a current liability or a creditor for materials and the companies are forced to do that at times and one single ratio can make sure this will not happen so that is a ratio called ‘Current Ratio’. The short term assets on the asset side are called current assets, short term liabilities are called current liabilities and the ratios between the 2 is called Current Ratio. And the norm is healthy organizations must maintain a current ratio of 2:1. If an organization can make sure that the current ratio is 2:1 everything else falls into place ultimately the balance sheet has to balance. Now this logic is also if liabilities have to be paid the short term assets can be used but all short term assets cannot be used, why? Because inventory is also a part of short term assets. An inventory cannot be liquidated at will, so if you exclude the inventory from the short term assets, what is left are called liquid assets. And the ratio between the liquid assets and current liabilities should be minimum 1:1. If one understands these 2 ratios, ‘Current Ratio’ 2:1, ‘Liquid Ratio’ 1:1, if these 2 are maintained I think most of the things will automatically fall into place.
Hrishi K: What red flags do we look out for in a balance sheet Anil? You have told us how to find out if a company is healthy or not through a balance sheet but there have to be red flags which will tell us there is something wrong in the company.
Anil Lamba: Exactly! Number 1 if you find that short term sources are more than short term uses. Then they won’t be able to pay off. Second ratio is red flag is on and the current ratio is below 2:1. Third red flag is if the liquid ratio is below 1:1 and then there are more because if you have less of debt and more of equity makes you very very safe but that needs you take in a large amount of expensive of money. That means you have to earn. The threshold level of earning has to be much much much higher. On the flip side if you have too much debt that can also make you risky, so the tradeoff between debt and equity. Some another one is ‘Debt Equity’ but that gets little technical. But if you say for dummies then these are the 3 things.
Hrishi K: Ok, so here’s my last question for you. You’ve told us so much about balance sheets. How often should an investor look at a balance sheet?
Anil Lamba: I don’t think so the investor should look at it very often. Investor should definitely look at a balance sheet while taking the wide decision. Having purchased neither does the investor have access to a balance sheet very often. Even if he wants to look at it every second day how can he? Because he will not be able to but the management should look at balance sheet maybe at least once a month. Investor annually or quarterly balance sheet if you glance at them that’s good enough, that is to decide you should stay invested or you should be getting out. So investor cannot do much more they don’t have access to internal accounts of the organizations to look at it more frequently in that.
Hrishi K: Well, this has been a very powerful Invest-O-Cast podcast when it comes to taking the plunge into hardcore financial analysis. It’s been really interesting and I feel a lot smarter after talking to Anil Lamba. We’ve all learned so much about this financial statement called a ‘Balance Sheet’ and all the information it gives us.It’s now time for ‘Wisdom in the Bank’, the segment on this show that does a quick recap of all the points that our guest has spoken about.
- Factors you should search for in a balance sheet: sources of money, cost of capital, working capital, current ratio liquid or quick ratio.
- In a dummies guide to a balance sheet reduce it to 2 numbers on each side. Long term sources and short term sources. Long term usage and short term usage, just like a blood report tells us about the medical condition of a person. The balance sheet tells us about the financial condition of a company.
- Investors should take a look at a balance sheet before investing. Management needs to look at a balance sheet very very often and frequently.
Anil it’s been an absolute pleasure having you on the show. Thank you once again for coming on our show, and elaborating on a topic that we have heard a lot of people speak about but never really understood. You’ve made these concepts really simple to understand. That is amazing. It’s not a skill a lot of finance guys have and I want to compliment you.
Anil Lamba: Thank you Hrishi, Thank you!Pleasure.
Cheers! And that is a wrap on our show NSE presents Invest-o-cast! I am your host Hrishi K for NSE Presents: Invest – O- Cast (An exclusive investor podcast) Powered by MoneyControl. To know more about our podcast, log on to moneycontrol.com and visit the podcast section. In case you would like us to address any of your investment queries on our show do write into us at: firstname.lastname@example.org. You can also reach out to us on Twitter @moneycontrolcom or Facebook @moneycontrol.com; do remember to use #nseinvestocastThank you for listening!