Interpreting Financial Statements – Balance Sheet

“Cash, is to a business as oxygen is to an individual: never thought about when it is present, the only thing in mind when it is absent”

-Warren Buffett-

Welcome to Part 2 of Interpreting Financial Statements – Balance Sheet. If you haven’t already, read how to interpret the income statement to see how it connects with the balance sheet.

The balance sheet is the statement of financial position that reports the company’s assets, liabilities and shareholders equity for a specific date. To get an overview of a company’s competitive advantage we have to analyse its assets (like cash, and property) and liabilities (debts and money owed to vendors or bondholders).

The balance sheet is broken into two parts, the first being its assets and the second its liabilities and shareholders equity.

Interpreting Balance Sheets – Current Assets

Current assets are assets a company owns that are readily available within the year. You may think of it as its working assets or a company’s cycle of cash. A company will use its cash to buy inventory. This inventory will then be sold to customers translating into accounts receivables. In turn converts back into cash. Hence the term working assets.

Cash and cash equivalents

These are the company’s cash and also short term deposits or highly liquid assets. Company’s that are generating tons of cash is considered to have a competitive advantage.

Excess cash could also be due to a recent sale of its assets or from issuance of bonds which may be a bad thing. To find out which of this true, you should take a deeper dive into their supplementary notes.

To get a better understanding of a company’s cash position, a cash flow analysis would provide a clearer picture.

Trade and Receivables

These are cash that is yet to be collected from the sale of its products or services. Customers tend to have a credit term in which they have a certain period to pay their invoices. In the event where payment is not yet received, it will be labelled as receivables.

There is a risk to receivables as customers could default on their payment and the company will not receive the money owed. Take a note of receivables and compare it to total revenue on the income statement.

A low receivables percentage to gross sales may indicate a company with durable advantage as they are able to convert their receivables into cash quicker than their competition.

Inventories

Inventories are the company’s products that have already been made and stored in a warehouse to be sold to their customers.

You should be on a look out for companies that have a high inventory to sales ratio. This may be a sign that the company has over-stocked or is expecting larger sales volume in the coming months.

Inventory that has been over-stocked can become obsolete or expire by the time they are bought.

You should keep in mind that excess inventory may be sold off at heavily discounted prices. In turn, this will hurt the company’s profitability.

Derivative Financial Instruments

Derivative financial instruments are contracts to hedge against price changes in commodity, currency, stocks etc. These can include forwards, futures, options or swaps. Companies use derivatives as way to mitigate short term risks especially if they are dealing in foreign currencies.

Other

Other current assets include non-cash assets that are due within the year and not yet in the company’s possession such as deferred income tax recoveries.

Interpreting Balance Sheets – Non Current Assets

Non current assets are assets that are not readily available and will take some time to liquidate. They usually include things such as plant, property and equipment.

Plant, property and Equipment (PPE)

PPE are tangible assets. These are the company’s manufacturing plant and equipment which are carried on the balance sheet at their original cost less depreciation.

Companies like mining/industrial that require lots of machinery to operate will have larger PPE. This is contrasted with software companies that have larger intangible assets compared to tangible assets.

Goodwill

When a company buys another company the difference between the price paid and the company’s book value is recorded as goodwill.

If you see goodwill increasing on the balance sheet over the years, you can safely assume that the company has been buying up other businesses.

If the company is buying businesses that has competitive advantages it could prove to be a good thing.

Intangibles

Intangibles are assets that is not physical. These include patents, copyrights, trademarks, franchises, brand names etc.

Interpreting Balance Sheets – Current Liabilities

Current Liabilities are debts and operating obligations the company needs to pay within the accounting period. These payments can be found under the headings accounts payable, accrued expenses, short-term debt, long-term debt and other current liabilities.

Trade and other payable

These are amounts payable to suppliers that have provided goods or services under a credit agreement. This is the opposite to trade receivables

Accrued expense

Accrued expenses are are liabilities a company has accrued and has yet to be invoiced.

Short-term debt

This is short term borrowing where money owed by the company that is due within the year.

Provisions

Provisions include bad debts, sales allowance or inventory obsolescence. You can think of it as the amount that is set aside to cover future expenses or a reduction of asset value.

Interpreting Balance Sheets – Non Current Liabilities

Non current liabilities are expense obligations a company incurs that is not due for more than one year.

Long-term debt

• Long-term debt: this is something great companies do not have a lot of. These are debts that have a maturity date of more than a year. The amount of long-term debt a company carries will indicate the economic nature of the business. Profitable companies are usually self-financing and will often not have much debt carried on their balance sheet.

Deferred Tax

This is tax that is due but has not yet been paid.

Other Liabilities

This is a broad category on the balance sheet and refers to a miscellaneous pool of debt. It includes expenses such as, non-current benefits, interest on tax liabilities, unpaid fines, and derivative instruments. It does not tell much about the competitive nature of the business.

Interpreting Balance Sheets – Shareholder Equity

Shareholders equity is the company’s net worth calculated by subtracting total assets by its total liabilities. Also often referred to as book value. It is the initial amount shareholders and owners have contributed in the business to keep it operational.

Issued Capital

This is the number of shares that have been issued by the company to its shareholders. It consists of shares that have been sold to shareholders against cash or some other form of consideration.

Reserves/Retained Earnings

A company’s net profit can either by paid out as dividends, used to buy-back shares or can be retained to keep the business growing.

When the cash is kept in the business, it is recorded as retained earnings and if used wisely can improve the long-term economic nature of the business dramatically.

Since retained earnings is an accumulated number the value changes each year and may be negative aswell.

If a company is not adding to its retained earnings, it is not growing its net worth. If it is not growing its net worth, shareholders will not be growing theirs either.

Interpreting Balance Sheets – Metrics

Current Ratio

The current ratio is a liquidity ratio of a company to be able to pay off its current liabilities. It is derived by current assets ÷ current liabilities.

As a general rule a company with a current ratio of above 1 is considered good, and anything below 1 is bad.

From the above balance sheet we can calculate as follows: $151,309 ÷ $87,206 = 1.74

Quick Ratio

The quick ratio is an “acid test”. It is used as an indicator on a company’s ability to pay off its short-term obligations with its most liquid assets.

A quick ratio of less than 1 indicates a company that is not able to fully pay off its current liabilities. This is calculated by (current asset – Inventory) ÷ current liabilities.

From the above balance sheet we can calculate as follows: ($151,309 – 78,534) ÷ $87,206 = 0.83

Return on Assets (ROA)

ROA is used to measure a company’s efficiency on generating an income on its assets.

You can calculate the return on assets by net income ÷ total assets.

Using the income statement from the previous post we can calculate ROA as ($29,924 ÷ $451,325) x 100 = 6.63%

Return on Equity (ROE)

ROE is a measure of financial performance calculated by net income ÷ shareholders equity.

ROE that is within the range of 15% – 20% is generally considered good.

Using the income statement from the previous post we can calculate ROE as ($29,924 ÷ 306,287) x 100 = 9.77%

Debt to Equity

This is the measure of a company’s financial leverage that determines the degree to which a company is financing its operations through debt.

A lower debt to equity ratio the better it is, usually a value under 1 is considered good. This is calculated by total liabilities ÷ shareholder equity.

From the above balance sheet be can calculate as follow: ($145,038 ÷ $306,287) = 0.47

Takeaway

• Interpreting balance sheets are the second part of the financial report that needs to be analysed in order to evaluate a company’s book value.
• It shows if a company is able to fulfill its financial obligations and also their financial health at a specific point in time.
• Stay tuned for part 3 of the series, and the last where we will dissect the cash flow statement.

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