How to read a balance sheet like a CFO: A risk-based approach

https://www.youtube.com/watch?v=DMv9JC_K37Y

Four Key Questions when using Financial Information and Interpreting Accounting Ratios

There are many traps in using financial information and interpreting accounting ratios.

You are advised to approach the job with caution and always keep in mind four key questions:

1. Am I comparing like with like?
2. Is there an explanation?
3. What am I comparing it with?
4. Do I believe the figures?

1.  Am I comparing like with like?

Financial analysts pay great attention to the notes in accounts and to the stated accounting policies.

One of the reasons for this is that changes in accounting policies can affect the figures and hence the comparisons.

For example:

• Consider a company that writes off research and development costs as overheads as soon as they are incurred.
• Then suppose that it changes policy and decides to capitalize the research and development, holding it in the Balance Sheet as having a long-term value.
• A case can be made for either treatment but the change makes it difficult to compare ratios for different years.

2.  Is there an explanation?

Do not forget that there may be a special reason for an odd-looking ratio.

For example:

• Greetings card manufacturers commonly deliver Christmas cards  in August with an arrangement that payment is due on 1 January.
• The 30 June Balance Sheet may show that customers are taking an average of 55 days' credit.
• The 31 December Balance Sheet may show that customers are taking an average of 120 days' credit.
• This does not mean that the position has deteriorated dreadfully and the company is in trouble
• The change in the period of credit is an accepted feature of the trade and happens every year.
• It is of course important, particularly as extra working capital has to be found at the end of each year.

3.  What am I comparing it with?

A ratio by itself has only limited value.

It needs to be compared with something.

Useful comparisons may be with the company budget, last year's ratio, or competitors' ratios.

4.  Do I believe the figures?

You may be working with audited and published figures.

On the other hand, you may only have unchecked data rushed from the accountant's desk.

This sort of information may be more valuable because it is up to date.

But beware of errors.

Even if you are not a financial expert, if it feels wrong, perhaps it is wrong.

Why profit is listed with the liabilities in the Balance Sheet?

Assets and Liabilities in the Balance Sheet

• Assets in the Balance Sheet are the debit balances in the bookkeeping system.
• Liabilities in the Balance Sheet are credit balances in the bookkeeping system.

Credit and Debit Balances in the Profit Statement

• In the Profit Statement, sales and income are the credit balances.
• In the Profit Statement, costs are the debit balances.
• The net total of all the balances is the profit or loss.
• This one figure (profit or loss) goes into the Balance Sheet as a single item.
• A profit is a credit which is listed with the liabilities.

Explanation on why profit (a credit balance in the Profit Statement) is listed with liabilities in the Balance Sheet

• The explanation is that the profit belongs to someone outside the business. 
• If the Balance Sheet is for a company, the profit belongs to the shareholders.
• It may one day be paid to them in the form of a dividend or by return of capital on the winding up of the company.

DIS Technology - Check List: What can we learn from this ugly saga?

As with Transmile, it is sad that the investors are again caught in such a fraud.  There must be heavy penalties for those involved, not least, to emphasize the seriousness of this matter and to deter future such happenings.

Could this fiasco, of false accounting, be predicted looking at the latest quarterly reported results?  Often the answer is NO, though it was obvious that the company's business was deteriorating and the balance sheet was not good quality. 

The revenues and earnings were manipulated in the accounting.  However, the cash flow statement would have indicated that not all is well with the company.  The CFO was strongly negative.

http://spreadsheets.google.com/pub?key=tZmdsnrXUbsFVCAmAaQRW4g&output=html

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Blogger Wisdom Wise has written a nice article on reading the annual report which I have copied and paste here:

Tuesday, March 09, 2010

Reading the Annual Report

When you look at a woman, which part of her anatomy do you look at first? Is it her face, her bosom or her bottom? It is all a matter of choice. It doesn't matter so long as you get to look at the whole picture. Now, when you look into an annual report, it is the same. Which statement do you prefer to see first. Is it the income statement, the cash flow statement or the balance sheet? Personally, I go straight for the balance sheet to find out what the company has and what it owes others. If I don't find things attractive there, I will just close the report, avoid the stock and move on.
The things that I pay attention in the balance sheet are: Paid-up capital, par value per share, retained earnings, current assets, and current liabilities. I pay special attention to its cash position and how much debt it has. If its debt is too high, when compared to its equity, I will normally lower the grading of the stock. Don't forget that all companies that folded are those with very high debt.
From the balance sheet, I go to the income statement , the cash flow statement, and then the CEO's statement, or Chairman's statement. If both are available, I'll read them both and also the notes in the annual report to ascertain that the company is not involved in any litigation. Lastly, I will go to the page that shows the names of the majority shareholders. A strong major shareholder is a advantage. Take the case of YTL Cement whose major shareholder is YTL Corp.
Things to consider when assessing a company are as follows: a) Calibre of management; b) Modal of business; c) Earnings per share; d) Dividend yield; e) Cash and debt position; f) Barrier of entry; and g) sustainability of profit.

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)