Balance Sheet & Financial Statement Analysis

Balance Sheet & Financial Statement Analysis

Concept Explanation

The Balance Sheet is like a financial photograph — it freezes a company’s financial position at one instant. Think of it as a scale perfectly balanced at all times. On one side are everything the company owns (Assets). On the other side are all the claims against those assets — what the company owes to lenders (Liabilities) and what belongs to the owners (Shareholders’ Equity). The fundamental equation is:

Assets = Liabilities + Shareholders’ Equity

This always balances because everything the company owns was either bought with borrowed money or owner-contributed capital. When a company borrows ₹100 crore from a bank, its cash (asset) increases by ₹100 crore AND its liabilities increase by ₹100 crore — the equation stays balanced.

Now, why do we analyse financial statements? Because raw numbers don’t tell stories by themselves. A company with ₹10,000 crore in revenue and ₹500 crore profit looks different from one with ₹500 crore revenue and ₹500 crore profit. Financial ratio analysis converts raw numbers into meaningful comparisons — across time (trend analysis), across companies (peer comparison), or against benchmarks.

Four categories of ratios you must know:

1. Liquidity Ratios — Can the company pay its short-term bills?

• Current Ratio = Current Assets / Current Liabilities. Above 1.5 is generally considered comfortable.
• Quick Ratio (Acid Test) = (Current Assets - Inventory) / Current Liabilities. Better measure if inventory can’t be quickly sold.

2. Leverage (Solvency) Ratios — How much debt is the company using?

• Debt-Equity Ratio = Total Debt / Shareholders’ Equity. A ratio of 2:1 means the company uses ₹2 of debt for every ₹1 of equity — high leverage, meaning higher financial risk.
• Interest Coverage Ratio = EBIT / Interest Expense. If this is 3x or more, the company can comfortably service its debt.

3. Profitability Ratios — Is the company making money efficiently?

• Return on Equity (ROE) = Net Profit / Shareholders’ Equity × 100. This is the ultimate measure of how well equity capital is being deployed.
• Return on Assets (ROA) = Net Profit / Total Assets × 100. Measures how efficiently assets generate profit.
• Net Profit Margin = Net Profit / Revenue × 100.

4. Efficiency Ratios — How well is the business using its assets?

• Asset Turnover = Revenue / Total Assets. Higher means better utilisation.
• Inventory Turnover = COGS / Average Inventory. Higher generally means faster, more efficient operations.

DuPont Analysis is the most powerful framework — it breaks ROE into three components: $$ROE = \underbrace{\frac{\text{Net Profit}}{\text{Revenue}}}{\text{Profit Margin}} \times \underbrace{\frac{\text{Revenue}}{\text{Total Assets}}}{\text{Asset Turnover}} \times \underbrace{\frac{\text{Total Assets}}{\text{Equity}}}_{\text{Financial Leverage}}$$

This tells you WHY ROE is high or low — is it because of operational efficiency (high margins), asset efficiency (high turnover), or financial engineering (high leverage)?

Key Terms & Definitions

Term	Definition
Balance Sheet	Statement of financial position showing Assets = Liabilities + Equity at a point in time
Income Statement	Shows revenues, expenses, and profit over a period (P&L Account)
Current Assets	Assets expected to be converted to cash within 1 year (cash, debtors, inventory)
Non-Current Assets	Assets with useful life > 1 year (plant, machinery, land, long-term investments)
Net Worth / Equity	Total Assets - Total Liabilities; also called shareholders’ funds
CRR (Cash Reserve Ratio)	Percentage of NDTL that banks must keep with RBI as cash reserves (non-interest bearing)
SLR (Statutory Liquidity Ratio)	Percentage of NDTL that banks must invest in liquid assets like G-Secs
Common-Size Statement	Financial statement where each line item is expressed as a percentage of a base item (e.g., revenue or total assets)
Trend Analysis	Analysing how ratios change over multiple years to identify improving or deteriorating performance
DuPont Analysis	Decomposition of ROE into three components: Profit Margin × Asset Turnover × Financial Leverage

Real-World Example (RBI Context)

SBI’s Balance Sheet — Simplified (₹ lakh crore):

Assets	Amount	Liabilities	Amount
Cash & Balances with RBI	22.5	Deposits	52.4
Investments (G-Secs, etc.)	19.8	Borrowings	3.8
Loans & Advances	35.6	Other Liabilities	4.7
Other Assets	5.2	Equity & Reserves	22.2
Total	83.1	Total	83.1

Under CRR of 4%: Required reserves = 4% × ₹52.4 lakh crore = ₹2.1 lakh crore ✓ (SBI holds ₹22.5 lakh crore in cash — well above requirement, partly because cash includes other balances too)

Under SLR of 18%: Required SLR holdings = 18% × ₹52.4 = ₹9.4 lakh crore ✓ (SBI holds ₹19.8 lakh crore in investments — well above SLR requirement)

Notice: Total loans of ₹35.6 lakh crore represent only about 43% of total assets — the rest is SLR compliance and cash reserves. When RBI reduces SLR or CRR, it frees up capacity for more lending.

Exam Pattern / How It Appears

• Ratio calculation: Given a simplified balance sheet, calculate Current Ratio, Debt-Equity, ROE, etc.
• DuPont decomposition: Given ROE and two components, calculate the third
• Common-size analysis: Convert a balance sheet to common-size and compare two companies
• Impact of CRR/SLR changes: How does a change in CRR affect bank lending capacity?
• Case-based: Analyse a bank’s asset quality using the provided financial statements

Step-by-Step Example

Q: A company has the following simplified financial data: Revenue = ₹500 crore, Net Profit = ₹40 crore, Total Assets = ₹250 crore, Shareholders’ Equity = ₹125 crore, Current Liabilities = ₹60 crore, Current Assets = ₹90 crore. Calculate: (a) Current Ratio, (b) ROE, (c) Debt-Equity Ratio, (d) Asset Turnover, (e) using DuPont, what is the profit margin?

Answer:

(a) Current Ratio:

$$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} = \frac{₹90}{₹60} = 1.5$$

This means the company has ₹1.50 in current assets for every ₹1.00 of current liabilities — acceptable liquidity.

(b) Return on Equity (ROE):

$$ROE = \frac{\text{Net Profit}}{\text{Shareholders’ Equity}} \times 100 = \frac{₹40}{₹125} \times 100 = 32%$$

Excellent ROE — 32 paise of profit for every rupee of equity capital.

(c) Debt-Equity Ratio:

First, find Total Debt = Total Assets - Shareholders’ Equity - Current Liabilities = ₹250 - ₹125 - ₹60 = ₹65 crore (assuming non-current liabilities = debt)

$$\text{Debt-Equity Ratio} = \frac{₹65}{₹125} = 0.52$$

Moderate leverage — 52 paise of debt for every rupee of equity. Reasonable but not overly conservative.

(d) Asset Turnover:

$$\text{Asset Turnover} = \frac{\text{Revenue}}{\text{Total Assets}} = \frac{₹500}{₹250} = 2.0\times$$

The company generates ₹2 of revenue for every ₹1 of assets — very efficient asset utilisation.

(e) DuPont — Profit Margin:

$$ROE = \text{Profit Margin} \times \text{Asset Turnover} \times \text{Financial Leverage}$$

$$32% = \text{PM} \times 2.0 \times 2.0$$

$$\text{PM} = \frac{32%}{4.0} = 8%$$

So the company earns 8 paise net profit on every rupee of revenue — modest margin, but the high asset turnover (2.0×) and financial leverage (2.0×) amplify it to an excellent 32% ROE.