If you’re a DIY investor or want to learn how to navigate a set of results, now’s the perfect time before the next wave of company earnings flood in.
Last week we kicked off our three-part series on how to read financial statements by looking at how to use an income statement. Missed it? Read it now.
This week we’re breaking down balance sheets – from how they work to how to use them to help you pick stocks.
This article isn’t personal advice. If you’re not sure an investment is right for you, seek advice. Investments and any income from them will rise and fall in value, so you could get back less than you invest. Ratios also shouldn’t be looked at on their own.
What is 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 do balance sheets 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 or is owed. Typical assets are cash, property, equipment or vehicles. They can also be non-physical, like software, brands or patents.
Liabilities are what the company owes to others, like unpaid bills, loans, or other debts. They show the financial obligations that must be settled in the future.
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 show cumulative profits left over from previous years that haven’t been distributed to shareholders.
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 £10mn, 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 £10mn.
Alternatively, if the company decided to raise the money by selling new shares, then assets would rise, but so would shareholders’ equity.
An example balance sheet
Assets | 2024 (£m) | 2023 (£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 |
|---|
Liabilities | ||
|---|---|---|
Non-current liabilities | ||
Loans | 5 | 4 |
Deferred tax | 3 | 5 |
Total non-current liabilities | 8 | 9 |
Current liabilities | ||
Loans and overdrafts | 4 | 4 |
Trade and other payables | 7 | 3 |
Tax payable | 6 | 8 |
Total current liabilities | 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 |
|---|
The other wording to consider on a balance sheet is when you see ‘current’ and ‘non-current’ attached to assets or liabilities.
This tells you the timescale in which an asset could be converted to cash, or when a debt is due. Broadly speaking, ‘current’ has a timeframe of under a year and ‘non-current’ is anything longer.
Most companies will also show a deferred tax number, which can be an asset or liability.
Without delving too much into the world of accounting, deferred taxes are paid or recovered in the future. They come from differences between how profits are reported in financial statements and how they’re taxed by the government.
These differences generate assets or liabilities if they’re expected to reverse in the future.
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 business is holding ‘net cash’.
Isn’t debt bad?
Not necessarily.
Lots of companies borrow to grow and support their business. It’s often a cheaper way to finance expansion than issuing new equity (shares).
Companies with large, fixed assets (non-current), like large factories or expensive equipment, are 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 see how debt compares to profit by working out the net debt to EBITDA (earnings before interest, tax, depreciation and amortization) ratio.
This shows how much net debt a company holds in relation to its cash profit.
Net Debt to EBITDA = Net Debt / EBITDA
A lower number suggests a more manageable debt level.
Again, it’s important to compare this number with ratios from other similar companies. For some sectors 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 is one way of looking at how efficient a company is at generating profits from the equity it’s issued.
ROE is calculated by dividing net profit, found on the income statement, by shareholder’s equity.
So, in the example balance sheet above, if the company had net profit of £150mn, its ROE would be 1.6 (£150mn ÷ £91mn).
Generally, rising ROE indicates 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.
A similar metric that looks beyond capital structure is Return on Capital Employed (ROCE).
This is calculated by dividing operating profit, found on the income statement, by equity + long-term liabilities. This is essentially looking at profit relative to the total amount invested in the company, from both equity and debt investors.
Things to remember
The balance sheet is a very important tool used for assessing a business’ 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 income and cashflow statements. Remember to look back beyond the current year too to see how a company and its position has changed.
Statements and ratios shouldn’t be looked at in isolation though. Instead, use them to form a bigger picture of company health and prospects, which can then help to inform your investment decisions.
Next week, and in our final part of this series, we’ll be covering how to use a cashflow statement.
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