Fundamental Analysis Basics: How to Read a Balance Sheet Report in Stocks?

Fundamental analysis is the foundation of analysing the financial health of any company. If you are planning to invest in stocks of any company, mastering fundamental analysis is a step in the right direction.One of the most vital elements of fundamental analysis is reading the balance sheet report of the companies. Before making any long-term investment in stocks, it is essential to correctly analyse and read the balance sheet of the company you are interested in.So, how do you read a company balance sheet? While balance sheet analysis is a skill that you develop with time, there are a few essential things you should know about in the beginning. Here are some points that will ensure that you get the basics right-

Before learning about how to read and analyse balance sheets, it is essential first to know what it is.In simple words, the balance sheet provides a detailed overview of the company's assets and liabilities, along with the equity held by shareholders. It offers excellent insights into any company's financial worth - its debt to asset ratio, debt-to-equity (D/E) ratio, etc.Along with other financial reports, like cash flow statements and income statements, the balance sheet can help people make better and smarter investment decisions.

Companies use their ‘assets’ to carry out day-to-day business operations. These ‘assets’ can either be equity (capital infused by shareholders) or capital borrowed from 3rd parties.
Similarly, companies also have ‘liabilities’ or financial obligations to 3rd parties. The dynamics between the equity, assets, and liabilities is known as the ‘Accounting Equation.’Coming back to the balance sheet, it is based on the following formula- Assets= Liabilities + Equity This basically means that the assets of a company should be balanced by the shareholders' equity and liabilities. How well a company can balance this equation is what helps determine the company's financial health to a significant extent.

Assets are of two different types- Current and Non-current.

• Current Assets Any asset that the company believes will be realised, sold, or consumed in an operating cycle of 12 months is considered a current asset. For example, a company can have investments, cash and cash equivalents, inventories, trade receivables, etc., as their current assets.
• Non-Current Asset The assets which the company is not planning to realise, sell, or consume within 12 months are known as non-current assets. These can be financial, tangible, or intangible assets. Some common examples are property, equipment, work-in-progress capital, and tax assets.

Liabilities are also of two different types- Current and non-current.

• Current Liabilities All the financial obligations that a company is expecting to close within the current operation cycle of 12 months are known as current liabilities. These can be borrowings, trade payables, and tax liabilities.
• Non-Current Liabilities All the financial liabilities that will not be settled within the current operation cycle are non-current liabilities. These can be deferred tax liabilities and even financial liabilities, like borrowings or trade payables, which the company is expecting to settle after the current cycle.

The last component of the ‘Accounting Equation’ is shareholder equity. This is basically the total net worth of the company. It will provide information about the initial investment made by the company owner/s.When a company reinvests that net earnings in the business, it is reported under the shareholder equity column on a balance sheet.

If you want to know more about how to read a balance sheet , there are a few different ratios that you should know. The ratios are as follows-

1. Debt-to-Equity The debt-to-equity ratio is calculated with the help of this formula- Debt-to-Equity= Total Company Debt/Shareholders’ Equity By dividing the total company debt with shareholders’ equity, you can get great insights into how leveraged a company is and how much of the assets are debt capital.Companies with higher debt-to-equity ratios are known to be highly leveraged, which can both be good and bad for the company. Good because it helps reduce the cost of capital and bad because if the company cannot do well, high debt obligation can prove very challenging.
2. Return on Equity The return on equity measures the profitability of the company. It is calculated with the help of the following formula- Return on Equity=(PAT or Net Profit/Equity Share Capital) x 100 The primary goal of any company is to make money for the shareholders. With return-on-equity, you can determine the rate at which the shareholders are earning. Higher return-on-equity is considered a major positive.
3. Current Ratio The current ratio is the company’s total liquidity. It is calculated with the help of this formula- Current Ratio= Company’s Current Assets/ Current Liabilities The current ratio will help determine whether the company has adequate current assets to settle current liabilities.A higher current ratio doesn't necessarily mean that a company has solid financials. Similarly, a lower current ratio does not speak about the deteriorating financial health of the company. You should consider other liquidity aspects for a clearer picture.

As a balance sheet offers great insights into a company's financial health, it is one of the most effective ways to analyse any stock fundamentally.Check the recent balance sheets of a few different companies to better understand how the numbers vary and how they impact their fundamental analysis. You can try to learn more about the ratios discussed in this post to enhance your fundamental analysis skills and improve your ability to choose promising stocks for investment.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.