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Understanding financial statements – balance sheets

In the second instalment of our three-part series on how to understand financial statements, we look at how balance sheets work, and why they matter to investors.

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.

The market was flooded with company results in April. If you’re a DIY investor or want to learn how to navigate a set of results – now’s the perfect time. This week, we’re breaking down how balance sheets work. It’s not as scary as you might think.

This article isn't personal advice and it should be remembered statements and ratios shouldn't be looked at on their own. Investments and any income they produce can fall as well as rise in value, so you could get back less than you invest. If you're not sure if an investment is right for you then seek advice.

What’s a balance sheet?

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 together with the income and cash flow statements to assess the financial health of a business.

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 shown below.

Assets = Liabilities + Shareholders’ Equity

Assets are the things a company owns. Typical assets are cash, property, equipment or vehicles. They can also be non-physical, like intellectual property, or brands.

Liabilities simply represent an amount owed. This could include unpaid bills, mortgages or bonds.

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

The easiest way to think about how the accounting equation works is through an example. Imagine 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 debts, 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

2020 (£m) 2019 (£m)
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
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

Numbers in brackets are negative.

The other odd wording on a balance sheet is when you see “current” and “non-current” attached to assets or liabilities. All this tells you is the timescale in which an asset could be converted to cash, or when a debt is due. Anything current can usually be turned into cash in under a year, and non-current is anything longer than that.

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. Investors shouldn’t worry too much about this number – companies can’t do much to control the tax they pay after all.

What does this information tell me?

The balance sheet shows 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 debt.

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”.

Isn’t debt bad?

Not necessarily. Lots of companies borrow to grow and support their business. Companies with large fixed assets (non-current), like oil and gas companies, are more likely to have more debt on the balance sheet. That’s why it’s important to compare levels of debt with similar companies to understand if it looks high – this will vary greatly from sector to sector.

You can measure levels of debt 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. It’s 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 a lot 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 above, 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 lots and uses the proceeds to buy back shares, the equity figure will fall. That’s because equity is equal to assets minus debt. This will improve ROE and make it look like the business has performed better. But 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 business’s financial strength. But remember it’s a historical 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 representative of the longer-term norm.

Investors should always look at a balance sheet with other financial statements, including the summary of cash flows which we’ll be looking at next week. Remember to look back beyond the current year to see how a company and its position has changed.

Understanding financial statements – income statements

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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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