Beware of the Balance sheet bugs

The Balance sheet is one of the financial statements that has multitudes of users. It portrays the company’s financial position, its operations, and funding as on a particular date. The devil is in the details they say, none would have anticipated to say the details are the devil.

Shareholders are always interested to know about profitability, financial position, the solvency and the liquidity position. The management has the responsibility to safeguard profits and investments of the firm, and the balance sheet is used for making significant decisions by the management. Employees are interested to know about the bonus that they are entitled to at the end of the year. Investors would like to know the potential risk behind the organization. The creditors and the financial institutions would like to know about credit worthiness, cash flow. The government would like to know about the contribution the company has made to the nation’s income and about the tax part of the organization.

Do you think every user can be satisfied with the same balance sheet? This Blog, will let you know why one cannot solely depend on Balance sheets.

No, It doesn’t and cannot meet all the requirements of every users. There are a large number of parties interested in the affairs of the business where the balance sheet cannot help.

A testimony with with historic records?

The balance sheet is a static statement as on date. It is a record of all information about the organization that has happened till now. The users would like to know about the future of the company. They would like to diagnose and want to know more about the future of the company. So, One should know that the balance sheet is limited by the records of the past and there is no future in it. It is the responsibility of the user to dig information of what tool is given to them and make it fruitful.

Net assets≠Net worth?

A company’s actual worth is not shown in a balance sheet. Wondering how? Yes, The net assets of the organization are not equal to the market value (worth) of the firm. The value of the fixed assets in the balance sheet is the book value of the asset after the depreciation and adjustments are made, but it is not equal to the as on date’s value. As there is fluctuation in currency the price level changes, the change in prices is ignored. Suppose a land is purchased for INR 4 Lakhs in the year 2002 and another land is purchased for INR 6Lakhs of the same size. The property isn’t worthy of the latter purchase, even though the assets are revalued in the balance sheet- book value of the asset. Ambiguity prevails because the original value isn’t reflected and the market value can be more or less of the stated book value, which down turns the dependability. Often the book value is less than the market value, and the Book to Market ratio is chiefly less than 1. Ergo, the balance sheet limits itself by lacking transparency. The book value is static for the whole year and the market value is dynamic, that’s how the P/B ratio stays at the top where the numerator is oscillating every day.

Can be counterfeited by insiders?

The company does not actually want to showcase true position of the company. There sometimes happens to be off-sheet balancing. The management of the company sometimes tries to manipulate information so that shareholders, investors, and creditors would drop money. Often, the debt amount is understated. Some numbers are concealed and window dressed. The management can dress these figures up just a few days before the balance sheet as on date by selling or storing inventory. Major specification the balance sheet misses is the state of the inventory. In late 1990’s a manufacturing company had every raw material converted into half finished product anticipating future orders and the further completion demanded a huge amount of debts for full product conversion. Since they are under the assets region the investors believed they have adequate inventory to service orders, that’s how a contract manufacturer can go down the hill. FYI, semi finished goods are worth less when left for negotiation. The figures appear reasonable, but they are not true most of the times.

Problem of less accuracy

When some unknown expenditure is about to occur and we have to keep our money bags ready, we forecast the amount. Similarly, accountants make use of estimates of unforeseen expenditure, debts and current assets. It’s based on the individual’s opinion and prediction about the near future. Estimates are not accurate, but it is shown in the balance sheet and gets attested for unknown wrongful doing. Some fictitious assets which are not real assets and do not have realizable value, but are charged and shown in the balance sheet. Therefore the Balance sheet is less likely to be a snapshot of the company’s operations.

Makes us Indecisive

When the cash is less in the balance sheet of the organization. One cannot decide if the company has pooled its money for investment or has experienced loss. No firm conclusions can be drawn only with the figures from the balance sheet

Only monetary and materialistic things are recognized

The qualitative resources are often ignored.  Have you ever imagined what will happen when Steve Jobs dies? The share price of Apple might possibly go down. But how can a person’s worth be recognized in a balance sheet? Is he not an asset (or treasure) of the organization? The balance sheet is ignoring the qualitative aspect residing at the most quantitative end which is easy to manipulate. It acknowledges only that have money’s worth and can be recognized as numbers. Human resources like a good employee, better management, loyalty among hierarchies and many non-monetary assets are ignored, except some intangible assets such as goodwill, copyrights are monetized and are recognized in the balance sheet.

Makes comparison meaningless

The accounting practice in India is not the same as the accounting practice in America. The way how SJVN does depreciation is not the same as Sree leathers. SJVN might use a written down value method, Sree leathers might do depreciation on a straight-line basis. The inventory valuation under IFRS and GAAP is not the same. IFRS uses FIFO and weighted average method, whereas GAAP uses LIFO as well. The calculation of goodwill might be different among the firms. Company A might use the Annuity method, but Company B might use the Super profit method eventually the profit and loss of the same company differ largely, when different practices are followed. When comparison is made between the companies having different accounting practices, that puts a dilemma stop without the help of specifying the methods the researcher must do his own calculations to do in-industry comparison.

Note: To know more about the organization one can make use of annual reports of the organization and do analysis. The upcoming operations of the organization and much information is available over there, So you can exceed the limitation of the balance sheet by knowing where the profits are reinvested when the cash shown in the balance sheet is low. Even though the methods are mentioned in the annual report, balance sheet is only a tool to be used in financial analysis. It won’t diagnose the organization. If there is any problem, the management has to look forward. Investors and shareholders can do their own analysis or can depend on analysts because sometimes the market can be a lot unpredictable. I hope it reaches you well about the weakness of the balance sheet and now that you will not be misled. Happy investing.

1 Comment

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s