Reading a Balance Sheet

Reading a Balance Sheet

A balance sheet will tell us something about the financial strength of a business on the day that the balance sheet is drawn up.

This action list gives an overview of a balance sheet and looks at a brief selection of the more interesting figures that help with interpretation. It is important to remember that a lot of these figures do not tell you that much in isolation; it is in trend analysis or comparisons between businesses that they talk more lucidly.

What is a balance sheet?

A balance sheet is an accountant's view, the book value of the assets and liabilities of a business at a specific date and on that date alone. By balancing the assets and liabilities and showing how the balance lies, it gives us an idea of the financial health of the business.

What does a balance sheet not do?

A balance sheet is not designed to represent market value of the business. For example, property in the balance asset may be worth a lot more than its book value. Plant and machinery is shown at cost less depreciation, but that may well be different from market value. Stock may turn out to be worth less than its balance sheet value, and so on.

Also, there may be hidden assets, such as goodwill or valuable brands, that do not appear on the balance sheet at all. These would all enhance the value of the business in a sale situation, yet are invisible on a normal balance sheet.

Learn to interpret the balance sheet

Note that the balance sheets differ between one industy and another as regards the range and type of assets and liabilities that exist. For example, a retailer will have little in the way of trade debtors because it sells for cash, while a manufacturer is likely to have a far larger investment in plant than a service business like an advertising agency. So the interpretation must be seen in the light of the actual trade of the business.

Reading a balance sheet can be quite subjective - accountancy is an art, not a science and, although the method of producing a balance sheet is standardized, there may be some items in it that are subjective rather than factual. The way people interprete some of the figures will also vary, depending on what they wish to achieve and how they see certain things as being good or bad.

Look first at the net assets/shareholders' funds

Positive or negative? Positive is good.

If it had negative assets (same thing as net liabilities, this might mean that the business is heading for difficulty unless it is being supported by some party such as a parent company, bank, or other investor. When reading a balance sheet with negative assets, consider where the support will be coming from.

Then examine net current assets

Positive or negative? Positive net current assets (NCA) mean that, theoretically, it should not have any trouble settling short-term liabilities because it has more than enough current assets to do so. Negative net current assets suggest that there possibly could be a problem in settling short-term liabilities.

You can also look at NCA as a ratio of current assets/current liabilities. Here, a figure over one is equivalent to the NCA having a positive absolute figure. The ratio version is more useful in analysing trends of balance sheets over successive periods or comparing two businesses.

A cut-down version of NCA considers only (debtors + cash)/(creditors) thus excluding stock (Quick Ratio). The reasoning here is that this looks at the most liquid of the net current asset constituents. Again a figure over one is the most desirable. This is also a ratio that is more meaningful in trends or comparisons.

Understand the significance of trade debtor payments...

Within current assets, we have trade debtors. It can be useful to consider how many days' worth of sales are tied up in debtors - given by (debtors x 365)/annual sales. This provides an idea of how long the company is waiting to get paid. Too long and it might be something requiring investigation. However, this figure can be misleading where sales do not take place evenly throughout the year. A construction company might be an example of such a business: one big debtor incurred near the year end would skew the ratio.

...and trade creditor payments.

Similar to the above, this looks at (trade creditors x 365)/annual purchases, indicating how long the company is taking in general to pay its suppliers. This is not so easy to calculate, because the purchases for this purpose include not only goods for resale but all the overheads as well.


Recognise what debt means

Important to most businesses, this figure is the total of long and short-term loans. Too much debt might indicate that the company would have trouble, in a downturn, in paying the interest. It's difficult to give an optimum level of debt because there are so many different situations, depending on a huge range of circumstances.

Often, instead of an absolute figure, debt is expressed as a percentage of shareholder's funds and known as 'gearing' or 'leverage'. In a public company, gearing of 100% might be considered pretty high, whereas debt of under 30% may be seen as on the low side.

COMMON MISTAKES

Believing that balance sheet figures represent market value

Don't assume that a balance sheet is a valuation of the business. Its primary purpose is that it forms part of the range of accounting reports used for measuring business performance - along with the other common financial reports like profit and loss accounts and cash-flow statements. Management, shareholders, and others such as banks will use the entire range to assess the health of the business.

Forgetting that the balance sheet is valid only for the date at which it is produced

A short while after a balance sheet is produced, things could be quite different. In practice there frequently may not be any radical changes between the date of the balance sheet and the date when it is being read, but it is entirely possible that something could have happended to the business that would not show. For example, a major debtor could have defaulted unexpectedly. So remember that balance sheet figures are valid only as at the date shown, and are not a permanent picture of the business.

Confusion over whether in fact all assets and liabilities are shown in the balance sheet

Some businesses may have hidden assets, as suggested above. This could be the value of certain brands or trademarks, for example, for which money may not have ever been paid. Yet these could be worth a great deal. Conversely, there may be some substantial legal action pending which could cost the company a lot, yet is not shown fully in the balance sheet.


Also read:
Reading a Cash-flow Statement
Reading a Profit and Loss Account
Reading a Balance Sheet
Reading an Annual Report
Yield and price/earnings ratio (P/E)