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Understanding balance sheets

A balance sheet is a snapshot of what a company owns, and what it owes, at a certain point in time.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

A balance sheet is a snapshot of what a company owns (assets), and what it owes (liabilities), at a certain point in time.

It’s used in conjunction with the income and cash flow statements to assess a business’s financial health.

How does it work?

Balance sheets hold a clue in their name – a company’s assets, liabilities and shareholders’ equity must balance. This idea is highlighted in what’s known as the ‘accounting equation’, which is stated below.

Assets = Liabilities + Shareholders’ Equity

Shareholders’ equity represents the portion of the business over which shareholders have a claim, perhaps best thought of as the assets that are left over after paying borrowers. It includes money raised from share sales (share capital) and retained earnings, which is profits left over from previous years, and can be used to pay dividends or reinvested back into the company.

The easiest way to think about how the accounting equation works would be if a company wanted to build a new factory. It could do this by borrowing £10m, which would mean its assets, specifically cash, would go up by this amount. At the same time, its borrowing, or liabilities, would also increase by £10m.

Alternatively, if the company decided to raise the money by selling new shares, then assets would rise, but so would shareholder’s equity.

Example balance sheet

Scroll across to see the full table.

2019
(£m)
2018
(£m)
Assets
Non-current assets
Property, plant and equipment 50 45
Intangible assets 20 18
Deferred Tax 6 4
Total non-current assets 76 67
Current assets
Cash and cash equivalents 12 10
Inventories 18 15
Trade and other receivables 10 11
Total current assets 40 36
Total assets 116 103
Liabilities
Non-current liabilities
Loans 5 4
Deferred tax 3 5
8 9
Current liabilities
Loans and overdrafts 4 4
Trade and other payables 7 3
Tax payable 6 8
17 15
Total liabilities 25 24
Net assets 91 79
Shareholder's Equity
Share capital 50 45
Retained earnings 41 34
Total equity 91 79

What exactly is an asset or liability?

Assets and liabilities are split into two categories: current and non-current. Current assets can be turned into cash within the next year, while current liabilities are debts that must be paid in the same period. Non-current items have a longer shelf life.

The main types of non-current assets involves property, plant and equipment (PP&E). PP&E includes buildings and any physical fixed assets owned by the company. That could be anything from a forklift truck to the office chairs.

Then there are intangible assets, which are nonphysical things like patents or trademarks. Intangible assets also cover what’s known as goodwill. This is the premium paid when a company buys another business for more than value of its assets.

The major current asset is cash, including cash equivalents. So not only money in the bank, but also any investments that can be quickly converted into cash, like government bonds.

Next up are inventories, which is stock the company has available for sale, as well as any resources needed to generate those sales. Another key current asset is referred to as receivables. This is the money owed to a business for goods or services delivered, but haven’t been paid for yet. Think of it a bit like your salary before the end of the month – you’ve done the work but your employer is yet to pay you.

2019
(£m)
2018
(£m)
Assets
Non-current assets
Property, plant and equipment 50 45
Intangible assets 20 18
Deferred Tax 6 4
Total non-current assets 76 67
Current assets
Cash and cash equivalents 12 10
Inventories 18 15
Trade and other receivables 10 11
Total current assets 40 36
Total assets 116 103

Liabilities are made up of current or non-current borrowings, as well as things like pension payments owed to employees.

You’ll also see “payables” under liabilities. This shows how much a company owes to third parties, like suppliers.

2019
(£m)
2018
(£m)
Liabilities
Non-current liabilities
Loans 5 4
Deferred tax 3 5
8 9
Current liabilities
Loans and overdrafts 4 4
Trade and other payables 7 3
Tax payable 6 8
17 15
Total liabilities 25 24
Net assets 91 79
Shareholder's Equity
Share capital 50 45
Retained earnings 41 34
Total equity 91 79

Most companies will also show a deferred tax number. This can show up as an asset, where a company has overpaid tax, which will see an amount returned to the company. Deferred tax can also be a liability, when tax is due in the future. Both of these discrepancies usually occur because financial years don’t always match tax years. Generally this isn’t a number to be too concerned with – companies can’t do much to control the tax they pay after all.

What does this information tell me?

The balance sheet’s use is to show how stable a company’s financial position is. One way it can do that is by giving us the tools to work out a company’s net debt position.

Net debt is calculated by subtracting cash and its equivalents away from total liabilities.

If a company has more debt than cash, then it will have a net debt position. If there’s more cash than debt, then the net debt position will be negative and the business is net cash.

Debt isn’t necessarily a bad thing, lots of companies borrow to grow and support their business. Companies with large fixed assets, like oil and gas companies, are more likely to have bigger debt on the balance sheet. That’s why it’s important to compare debt levels with similar companies to understand if debt levels look high – this will vary greatly from sector to sector.

You can measure debt levels by working out the net debt to EBITDA (earnings before interest, tax, depreciation and amortisation) ratio. This shows how much debt a company holds in relation to its earnings, and is calculated by dividing EBITDA by the debt shown on the balance sheet.

Again, it’s important to compare this number with ratios from other similar companies. For some businesses you’d expect a company to have substantially more debt than earnings, but for others it can be a red flag.

Can a balance sheet help me understand if a company is profitable?

Yes, through a ratio called Return on Equity (ROE). As the name suggests, this tells analysts how efficient a company is at generating profits.

ROE is calculated by dividing the operating profit, found on the income statement, by shareholder’s equity. So, in the example balance sheet below, if the company had operating profit of £150m, its ROE would be 1.6 (£150m ÷ £91m).

Generally, rising ROE indicates a good performance, but there are exceptions. It’s important to understand why a ROE figure has changed, don’t just assume bigger is better.

For example, ROE can be boosted by increasing debt. If a company borrows heavily and uses the proceeds to buy back shares the equity figure will fall, because equity is equal to assets minus debt. This will improve ROE and make it appear as though the business performance has improved, when in reality it’s just the makeup of the balance sheet that’s changed.

Things to remember

The balance sheet is a very important tool used for assessing a businesses’ financial strength, but remember it’s a historic snapshot, not a summary of a longer period. That can make balance sheets prone to manipulation. For example, a company could call in debts for the balance sheet date, temporarily improving the net cash position.

Even if there’s no intentional manipulation at work – all companies will see their balance sheets vary over time. There’s no reason that the balance sheet date should be presentative of the longer-term norm.

This article, like our insight emails, isn’t personal advice. If you’re not sure an investment is right for you, you should ask for financial advice. A balance sheet should always be read with care and in conjunction with other financial statements, including the summary of cash flows which we’ll be looking at next week. Remember to look beyond the current year to see how a company and its position has changed.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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