Analysis  of Balance Sheet / Financial Statements

In credit decisions, it is very important to know the financial health of the borrower. To determine the financial health, there is a set of financial statements i.e. Balance Sheet, P&L, Cash flow etc., required to be analysed to know whether borrower is financially sound ,moderate or weak. A brief description of these statements is as under:- 

A balance sheet is a financial statement that summarizes a firm's assets, liabilities and shareholders' equity at a specific point in time. It can be expressed as 

Capital + Liabilities = Assets

Profit & Loss Account is a summary of revenue earned and expenses incurred during a period of time normally a year, which ultimately results in profit or loss to the firm. In the case of a Non-Profit organization, instead of preparing P&L a/c, It prepares Income and expenditure a/c.

Borrowers for this purpose can broadly be divided into two parts i.e. corporate borrowers or Non- corporate borrowers. 

Corporate borrowers include Pvt. Limited companies, public limited companies, Limited liability Partnership, a Single Person liability company.

Non –Corporate borrowers include individuals, Proprietorship firms, Partnership firms, joint borrowers, HUF, Associations, Trusts, clubs etc. 

In case of corporate borrowers, preparation of financial statements is required to be prepared as per provisions of the company’s act 2013.

In case of non- corporate borrowers, there are no such regulations, however ,these borrowers follow the same type of pattern while preparing their financial statements.

Financial statements required to be prepared under company act 2013 include

• Balance Sheet*, 
• Profit and loss account/income and expenditure account *, 
• Cash Flow statement, 
• Statement of Changes in equity and 
• any explanatory note annexed to the above.

 * Formats are provided as per schedule III of Company act -2013

Further, Accounting principle and standards required to be followed by corporates are as under:-

In India, we have two different framework for preparing financials statements:

• Indian GAAP (IGAAP)
• Indian Accounting Standards (Ind AS)
• Ind As is applicable to all listed companies and companies having net worth more than Rs. 250 Cr. In the case of Banks ,it has been deferred.

Financial Statement  Analysis - Stakeholders' Perspective

 Lender’s Objective    -Interpretation of Balance Sheet

• To ascertain the Long -Term solvency
• Short Term Liquidity position
• Long Term Debt Servicing Capacity
• Earning Assets in total balance sheet
• Whether long term assets are financed by long term sources & Short term assets are financed by short term sources and partly by long term sources
• Earning Capacity of the firm

Analysis of Financial Statements

For the purpose of  financial analysis by credit analysts , Balance Sheet received from borrower is regrouped as under :- 

After regrouping the balance sheet items try to ascertain the following :-

• What is the capital structure of the business? Is it appropriate? Have the owners of the business put sufficient capital into the business?
• What are the short term and long term liabilities of the business? Are they properly structured? Is it possible to relate each source of finance to a particular item?
• What is the credit period provided by trade suppliers? Did the suppliers alter trade terms?
• What are the taxation and other statutory  liabilities outstanding ?
• What is the quantum of fixed assets and are they put to optimum use?
• What is the level of stocking required and what are the stock management policies, in broader terms?
• What is the level of trade debtors? 
• Adjusting Inventory Valuations, if required.
• Reassessing the Values of Balance Sheet Variables
• Converting off balance sheet items into One-Sheet items
• Dividends Payable
• Intangible Assets
• Unsubordinated shareholders Loan
• Dues from/to related parties
• Any auditor’s remark have implication on P/L or NW 

Profit & Loss A/c analysis 

• Some Situations require recasting of P/L also
• To give effect to the crystallization of a contingent liability.
• To reverse capitalization of a certain expenditure
• To provide for certain expenses or to make extra provisioning write down or write up certain asset / liability values, disclosed in the balance sheet.
• To assess the impact of auditor’s remark on P/L

RBI Ground Rules for classification of B/s 

Let us understand the above from a case Study 

Balance Sheet of ABC Pvt. Ltd.  As on 31.03.2015

 Additional Informations

1. Term loan is repayable in 4 Quarterly installments of Rs.500 each.
2. The company and directors have given an undertaking that no interest on long term loan from directors will be paid and the loan will not be paid till the dues to the bank are totally repaid. 
3. Bills receivable consists of Inland receivables of Rs. 10000/- and Export receivables of Rs. Rs.6000/-.
4. Prepaid expenses of Rs.1200 /- consists of Insurance premium of Rs.1000/- for the year 2015 – 16 and Rs. 200/- for the year 2016-17.
5. Deposit of Rs.5000/- pertains to deposit kept with the Electricity Board.
6. Cash in hand and at Bank consists of fixed Deposits of Rs.15000/- given as security for the term loan and cash credit availed from the bank.   

As a credit analyst , one is required to recast the above balance sheet along with additional information as mentioned above.

First step is to regroup the balance sheet items as per above format.

 If you examine the difference between the two balance sheets, it may be observed that

1. Unsecured loans of Rs.5000/- are taken as part of net worth because the borrower has undertaken that it shall not repay the same during the currency of the bank’s loan and no interest shall be paid on such loans . (Pease note such item can be considered as quasi capital only if undertaking from borrower is obtained)
2. Accumulated losses appearing in the balance sheet as part of Asset are to be deducted from the Net worth/capital, 
3. Term loan instalments due in next year are required to be shown as current liabilities. You may observe from the additional information that the quarterly payment of the term loan of Rs. 500/- per quarter. Therefore, Rs. 2000/- to consider in Current Assets and remaining Rs. 8000/ - to be shown as Term Loan.
4. From Gross Block amount of depreciation reserve and revaluation reserve to be deducted to arrive at the net block.
5. Net worth is shown as Rs. 63000/- in redesigned balance sheet and 
6. Tangible Net worth shall be Rs. 63000/-  minus Rs. 3200/-  = 59.800/-
7.  Please note that the above redesigning balance sheet is to be used for assessing working capital and term loan requirement of the borrower within bank norms.