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.
Read part one on income statements and part two on cash flow statements first.
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, 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 software or patents.
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 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 £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
Scroll across to see the full table.
| 2022 (£m) |
2021 (£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 earings | 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. All this tells you is 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 show up as an asset or liability. Without delving too much into the world of accounting, deferred taxes arise when there’s a difference between taxable profit (on the income statement) and accounting profit (what actual tax paid is based on). 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 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. It’s often a cheaper way to finance expansion than issuing new equity.
Companies with large, fixed assets (non-current), like oil and gas companies, 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
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 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 £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 an 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.
One 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.
Different types of profit – an investor's guide
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 income and cash flow statements which we recently took a closer look at. Remember to look back beyond the current year to see how a company and its position has changed.
Understanding financial statements – income statements
Understanding financial statements – cash flow statements
Let us do the numbers for you
If you don’t fancy doing the number crunching yourself, our team of equity analysts provide research on some of the UK’s biggest listed companies. If you’d like to receive our analysis, it can be sent straight to your inbox.