Financial Analysis
For Lending
Decoding the Balance Sheet as a story of business health, identifying structural strengths, and ensuring debt repaying capacity.
The basics of Balance Sheet
Let us take the Balance Sheet of an imaginary company for consideration.
M/s. A.B.C. Co. Ltd
As on 31.12.2020 (Rs. in Lacs)
| Liabilities | Amount | Assets | Amount |
|---|---|---|---|
| Capital & Reserves Invested Capital Long Term Liab. Bank Loan Payable Current Liab. Accounts Payable Accrued Expenses | 1.94 1.72 12.14 7.70 | Fixed Assets Land & Buildings: 12.00 Machinery: 3.00 Other Fixed Assets: 0.98 Current Assets Cash / Inventory / Debtors Intangible/Misc Deposits: 4.42 Other Assets: 0.21 | 15.98 17.90 4.42 0.21 |
| Total | 23.50 | Total | 38.51 |
* The above grouping is for analytical demonstration of classification principles.
One of the first things that may be noticed in the balance sheet is that the assets are divided into four classes namely, Fixed assets, Miscellaneous assets, Current Assets and Intangibles and liabilities into three classes namely, Short Term Liabilities, Long Term Liabilities and Shareholder Equity.
What is the significance of this classification?
Required for resale and converted to cash from time to time (Stocks, WIP, Debtors).
Purchased not for resale but for production cycle (Land, Plant, Buildings).
Slow-moving assets like loans, advances and miscellaneous investments.
Not available for debt payment (Goodwill, P&L loss, Preliminary expenses).
Liabilities Classification
Paid-up capital and reserves. These represent the core equity stake and are not outside liabilities.
Term loans repayable over a period exceeding one year.
Payable on demand and generally due within one year (Accounts payable, OD).
This completes the basic classification after which any balance sheet can be cast mathematically.
Eq. 1 Analysis: Utilization of Resources
How own funds (A), long-term debt (B), and short-term debt (C) are utilized to acquire fixed (D), current (E), and misc assets (F), while accounting for capital loss (G).
Eq. 2 Analysis: Shareholder Investment
Net shareholder funds (A-G) now remaining in business, invested in long-term net block (D-B) and liquidity surplus (E-C).
Form A and Form B cast from Balance sheet
Why this classification at all?
The answer is simple: we are measuring the debt repaying capacity of the enterprise, which is of primary importance for loan assessment.
Safety Principle: A + B > D
Long term resources should cover Fixed Assets. If not, current borrowings are being used for fixed assets (Bad Sign).
Liquidity Principle: E > C
Current Assets should exceed Current Liabilities to ensure day-to-day liquidity surplus.
A financial position is considered sound if own funds and long-term borrowings cover fixed assets, and current assets cover current liabilities.
In any enterprise, the most important determination is the total cost of the enterprise (Fixed + Current + Misc Assets) and its financing structure.
Example Scenario (Project Cost: Rs. 17 lacs)
Form A (Horizontal T-Format)
| Liabilities | Amt | Assets | Amt |
|---|---|---|---|
| Capital | 10.0 | Fixed Assets | 10.0 |
| Long Term | 3.0 | Current Assets | 6.0 |
| Current Liab | 4.0 | Misc Assets | 1.0 |
| Total | 17.0 | Total | 17.0 |
Form B (Analytical Vertical Format)
| Fixed Assets | 10.00 | |
| Less: Long Term Liab | 3.00 | 7.00 (Net Block) |
| Current Assets | 6.00 | |
| Less: Current Liab | 4.00 | 2.00 (NWC) |
| Misc Assets | 1.00 | 1.00 |
| Tangible Net Worth | 10.00 |
Form B Preference: This format is preferred for analysis as it directly derives Tangible Net Worth (Proprietor stake) and Net Working Capital (Liquidity Surplus), allowing for instant financial inferences.
Analytical Case Studies
Key Ratios/Groups to Study
Indicates the liquidity position of the business.
Indicates that own funds should cover fixed assets personally.
Indicates solvency — own funds should ideally exceed outside debt.
A. Raghunath & Co. (Liquidity Crunch)
Balance Sheet Audit as at 31.12.2021
| Liabilities | Amount (₹) | Assets | Amount (₹) |
|---|---|---|---|
| PARTNERS CAPITALInitial (42,000)Add: Profit (6,400) - Withdrawn (20,200) CURRENT LIABILITIESTrade Creditors, Loans & OD | 42,000 28,200 82,900 | FIXED / INTANGIBLE ASSETSGoodwill, Furniture, Sub. Shares CURRENT ASSETSStocks, Debtors, Cash | 47,000 64,100 |
| TOTAL | 1,11,100 | TOTAL | 1,11,100 |
Diagnostic Analysis
Liquidity Position
Liquid assets (64,100) vs Current Liab (82,900). Negative Net Working Capital. Insufficient liquidity.
Capital Erosion
Capital reduced to 28,200 due to heavy withdrawals (20.2k) vs profit (6.4k). Sign of weakening organization.
Diversion of Funds
Capital (28.2k) blocked in Intangibles (10k) and Subsidiary Shares (20k). Operations funded by Borrowings.
Debtor Velocity
Trade Creditors (55,700) are very high compared to Sales (2.40 Lacs), indicating delayed payments.
Capital erosion due to heavy withdrawals (Rs. 20.2k vs Rs. 6.4k profit) resulting in negative net working capital. High credit risk - proposal must be rejected.
A. Narayanan & Co. Ltd. (Sound Operations)
Vertical Analysis (Analytical Recasting)
| FIXED ASSETS (Block) Land, Buildings, Plant & Machinery | 1.37 | |
| CURRENT ASSETS Stock (1.14), Debtors (0.65), Cash (0.15) | 1.94 | |
| LESS: CURRENT LIABILITIES Creditors (0.35), Tax/Prov (0.24) | (0.60) | 1.34 (NWC) |
| TOTAL CAPITAL EMPLOYED Net Block + Net Working Capital | 2.71 | |
| FINANCED BY: TANGIBLE NET WORTH Capital (1.00) + Reserves (0.78) + P&L (0.12) | 1.90 |
Diagnostic Reports
Solvency
Total Assets (2.51) are 4x Outside Liabilities (0.60). Own Funds (1.91) cover debts comfortably. Safe for Creditors.
Liquidity
Liquid assets (1.14) > Outside Liabilities (0.60). Company can pay creditors without touching fixed assets.
Inventory Management
Stocks (0.22) represent only 15 days of sale. Efficient management.
Own Funds (1.91) cover Outside Liabilities (0.60) four times over. Highly efficient inventory management (15 days velocity). Proposal for OD renewal is safe and recommended.
A.F. & Company Ltd. (Undisclosed Purpose)
Leverage
Total Liab (8.67) to Net Worth (0.30) is 29:1. Dangerously high. Normal acceptable is 2.5:1.
Working Capital Gap
Needs 1.30 lacs more for working capital than it currently has.
Security
Loan is against shares of a company owned by Directors. Third-party shares are risky.
Dangerous leverage of 29:1 (Borrowings 8.67 vs Worth 0.30). Funds are locked in doubtful assets. Lending additional limits would be financial suicide.
F.C & Company Ltd. (Overtrading)
Debt-Equity Ratio
32:1 (Borrowings 77.91 vs Capital 2.00). Explosively high imbalance.
Diversion of Funds
Funds used for interlocking investments (7.59) and director loans (8.36). Surplus for actual business is nominal (0.47).
Overtrading
The company is "over blowing the balloon". Entire current assets are funded by debt.
Massive debt-equity imbalance (32:1). Funds are diverted into interlocking investments (7.59). Avoid unless significant capital is raised.