Breaking down the balance sheet

Morningstar | 03 Dec 2012

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The following article is part of an ongoing educational series. The previous article can be found here.


We concluded the most recent article in our ongoing educational series by putting the profit and loss statement through a series of "road tests."

In the next two parts of our series, we'll do the same with the two remaining statements found in every listed company's annual report: the balance sheet and cash-flow statement.

When it comes to working through the three key financial statements found in every annual report, it doesn't much matter in which order you do this but, somewhere along the line, it's worth scanning the balance sheet.

Fortunately, it appears in much the same format in each annual report and is fairly easy to understand. You may find this section easier to work through if you have a real balance sheet to refer to - any one will do - but it's not essential.

The balance sheet tells you what the company owns (its current and non-current assets), what it owes (its current and non-current liabilities), and the total value of shareholders' interests in the company (shareholders' equity or shareholders' funds).

In theory, shareholders' equity represents the amount that shareholders would have received if the company had been wound up on the balance date.

Why is it called a "balance" sheet? Because the company's total assets must always "balance" with the sum of total liabilities and shareholders' equity. This makes perfect sense if you think about it.

If a company owns $10 million worth of assets and owes its debtors $2 million, the stake owned by shareholders is the difference between the two: $8 million. Shareholders would have had $8 million to divide among themselves had everyone taken their bat and ball and retired that day.

This last concept is critical. A balance sheet represents merely a one-off glance at a company's financial health on its balance date, which for many companies is 30 June.

While it is an audited financial statement and should reflect the genuine state of financial affairs within the company, things can change literally within hours of a balance sheet being struck.

Those suppliers require payment on 1 July? That new short-term loan has finally been approved? New balance sheet!

Canny accountants have been known to take advantage of this by squeezing in transactions which "window dress" balance sheets towards the end of the financial year, when they receive all the attention. Equally, balance sheet entries are sometimes delayed until a new financial year.

This is referred to in polite circles as "creative accounting" and, while it may not be strictly illegal, it can make your job of working out the true state of affairs more difficult.

There's little you can do about this, other than simply being aware that it's the case so you don't place unrealistic emphasis on the balance sheet. Nevertheless, it's probably the best snapshot you will get of any company's financial position and does warrant some of your time.


Three faces of the balance sheet

Every balance sheet is divided into three sections: 1) current assets and liabilities; 2) non-current assets and liabilities; and 3) shareholders' equity or shareholders' funds.

1) Current assets and liabilities

Current assets are those that can usually be liquidated within 12 months, like cash, accounts receivable, inventories and so on.

Current liabilities, not surprisingly, have to be paid within 12 months and include things like: short-term loans; accounts payable to the company's suppliers; bank overdrafts; and any other debt that won't wait.

If a company has greater current liabilities than it has current assets to pay them, it may well be headed for cash-flow problems. This can be true even in companies that are generously endowed with long-term assets - just as you would face cash-flow problems if you owed money but had all of your assets tied up in your house.

Most investors prefer a company to have significantly more in the way of current assets than current liabilities, and you can determine the mix by calculating what's called the current ratio:

Current ratio = current assets/current liabilities

As with many balance sheet ratios, there's little point comparing current ratios between companies operating in different industries. Transport businesses, for example, traditionally have low current ratios but this is usually manageable because the industry has a relatively short activity cycle - you drive a load to Brisbane, you usually get paid for it within two or three months.

If a company makes jet aeroplanes, however, short-term cash can be a long time coming, and as a potential investor, you would be wise to require a significantly higher coverage of current liabilities to be on the safe side.

One of the best ways to use a current ratio is to compare it over successive reporting periods for each company. This should alert you to any major shifts in liquidity.

The individual components of those current assets and liabilities can also make a difference. For example, a company can have the same current ratio two years running but, if it has a higher proportion of cash in the second year, it's more liquid - despite what the current ratio is telling you.

For most companies, a useful rule of thumb is that a current ratio of 2:1 or greater should help you to sleep soundly. But some industries have managed on lower ratios for years without giving their shareholders any major palpitations.

As we discussed earlier, it depends largely on the activity and payments cycle of the business. When the ratio starts slipping down, however, it's time to ask some serious questions - even in industries with shorter cycles.

The current ratio is one of a tribe of "working capital" ratios, lumped together because they involve the capital that a company is employing at that time. These numbers generally reveal more about the short-term outlook for the company than what may happen three years down the track.

You will also come across tribes of working capital "efficiency" ratios, which help you to work out how efficiently a company uses its short-term capital - more than simply whether or not it's about to go bust.

Some of the most popular ratios include:

• Inventory turnover - how many times a company manages to "turn over" or sell its inventory each year,

• Debtors' turnover - how many times a company "turns over" its debtors each year. An easier way to think of this ratio is in terms of "debtor days," which refers to how many days on average it takes customers to pay their accounts. If a company has a debtors' turnover of 4, for example, it means the average customer account is paid within approximately 90 days (365 days in the year divided by a turnover of 4 times is one payment cycle every 90 days),

• Creditors' turnover - how many times a company "turns over" its creditors each year. Again, most people find it easier to think in terms of creditor days - how many days on average it takes the company to pay its suppliers each year.

These numbers are generally available in stockbrokers' reports, particularly for those companies in which stock and payments turnover is a particularly important issue. As with most ratios, the best way to treat these numbers is to compare them with data for competitors, as well as monitoring the trend within the company over time.

You can use the working capital efficiency ratios to identify issues that may warrant a closer look. If a company is stretching out the period it takes to pay its bills, for example, it could be a sign of impending liquidity problems. But it may also signal that the company is shrewdly delaying payment and re-investing capital it would otherwise have wasted on paying bills too early.

If a company is taking longer and longer to bring in customer payments, it could be that its credit policies are faltering. Or perhaps it has simply decided to offer extended payment periods to generate business as Harvey Norman (HVN) has famously done for years.

Start your analysis with the numbers but don't trust them implicitly - you will often need to dig deeper for the answers.

2) Non-current assets and liabilities

If current assets and liabilities are those that can be sold (or have to be paid) in less than 12 months, non-current assets and liabilities are those that can wait a little longer.

Non-current assets include everything from plant and equipment to long-term receivables, investments, and intangible assets (you can't touch them), including things like publishing mastheads (The Sydney Morning Herald) and the value of brand names (Coca-Cola).

Non-current liabilities include things like long-term debts and leases, provisions for major expenses that have been incurred but not yet paid, such as tax, and any other longer-term creditors.

3) Shareholders' equity or shareholders' funds

Shareholders' equity (also called shareholders' funds) is the difference between total assets and total liabilities - how much the shareholders would have received between them if the company had been wound up on balance date.

You can think of it simply as what the shareholders collectively own, consisting of share capital, reserves, retained earnings and minority interests. Shareholders' equity is exactly the same as net assets.


Balance sheet ratios: getting into gearing

If the current ratio provides a quick guide to a company's short-term liquidity, the company's gearing ratio (net debt divided by shareholders' equity) says more about its longer-term financial footing.

As we discussed previously, highly geared companies are often higher-risk companies, but those with very low or zero debt for extended periods of time may not be making the best use of their balance sheets to create value for their shareholders. It's a balancing act.

Company reports usually reveal the company's gearing level, which you can calculate from the balance sheet using the formula:

Gearing = net debt/shareholders' equity x 100 (to convert to a percentage)

In this case, net debt includes all the company's interest-bearing debt listed in the balance sheet, less cash and short-term (liquid) securities.

You will come across variations of the gearing formula, including gross debt/total equity, which produces a completely different set of numbers. It doesn't matter a great deal which ratio you prefer to use, but make sure you know which you're looking at so that you always compare apples with apples.

In your analysis of any company, high gearing levels should generate numerous leading questions: Why so high? Are those levels sustainable? And are they getting higher or lower, and if so, why?


Stress testing corporate debt levels

A relatively high level of gearing or leverage is more palatable when a business is generating strong and stable cash flow. Sure as the sun will rise, the debts will be there tomorrow, but will the cash keep coming in to pay them?

One way some analysts try to answer this question is by "stress testing" a company's gearing levels. This means dreaming up plausible worst-case scenarios, and working out whether the debts could be paid under those conditions. Then working out the probability of that worst-case scenario eventuating!

Companies with high gearing levels tend to be particularly vulnerable to rising interest rates, for example, because repayments on variable rate loans rise. So what would happen to them if interest rates were to rise by 2 per cent, 3 per cent, or 5 per cent?

Could the company meet its interest liability? Gold mining companies depend heavily on the fate of the gold price, over which they have little or no influence. So what if the spot price for gold was to fall by 20 per cent? Would the company even be around to care?

Many people go through a similar process when applying for a home loan. A more positive slant, of course, is that you can also "stress test" on the upside. How high could the share price rise if interest rates were to fall by 3 per cent, or if the gold price was to rise by 20 per cent?

As well as the absolute gearing level, it's worth briefly looking at how the company's debt is structured. This is the concept behind the current ratio that we met earlier.

It's usually preferable, for example, for companies with a long activity cycle like major manufacturers to fund their operations with long-term debt. This gives them room to move, given the considerable time lag between the day the company starts making products, and the day the customers' cheques start arriving.

Similarly, most companies manage their cash flow and debt obligations more efficiently if they fund day-to-day capital requirements out of short-term debt, such as bank overdrafts.


A note on notes

As an aside, the three key financial statements take up just a few pages of an annual report, so you may wonder why any report needs to be longer than a dozen or so pages, even allowing for the marketing guff.

Well, in addition to the "comfort" factor of giving shareholders a document that appears to be of substance, the financial statements themselves may not be detailed enough to answer every question you have.

And, depending on how closely you want to look, you will sometimes have to dig into the notes to the accounts to find details, for example, of things like the composition of reported abnormal or extraordinary items.

The notes will also reveal accounting policies that affect the way the numbers are crunched, as well as some tasty morsels such as how much company directors are paid. Sometimes you can learn almost as much from the notes as from the financial statements themselves.

But don't become so concerned about the small print that you take your eye off the bigger picture - publications such as Huntleys' Your Money Weekly should help you to identify any really major issues.


Balance sheet ratios: how well is the company using your money?

Along with gearing, one of the most fundamental indicators of a company's well-being is the percentage return it generates on the funds that shareholders give to it, or those held through retained earnings: its return on equity (ROE).

Also called the return on shareholders' funds, this is the clearest indicator of how efficiently the company uses the resources at its disposal to turn a profit.

Here's how it works. Say your cousin buys a house for $300,000. He puts $100,000 cash down (his equity) and borrows $200,000. If he receives $20,000 in rental income each year (after making interest payments on the loan), his annual return is 20 per cent ($20,000 divided by $100,000, expressed as a percentage).

The chances are he has also made a healthy capital gain on the value of the house, the second important component of return on equity. If the value of the house increases by 20 per cent each year (in addition to his $20,000 rental income), his return on equity is 40 per cent per annum (20 per cent return plus 20 per cent increase in capital value).

And if you can find a company with an ROE of 40 per cent, you've found either a truly rare company or a mathematical glitch! But you can see the fundamental concept.

The formula for calculating a company's ROE is:

ROE = net profit after tax (NPAT)/shareholders' equity

Great companies usually generate a relatively high return on equity - anything consistently above 15 per cent or so is exceptional. The occasional "super stock" may deliver a return on equity of 20 per cent or more, but few Australian companies reach anywhere near these heights.

As with all data, however, there can be more to ROE than meets the eye. For a company reporting a high ROE, the first question is the longevity of maintaining those high returns. One-off jumps in ROE are common among companies and do not necessarily mean a high ROE is there to stay.

Then come some other measurement problems: are the returns for real? Unreliable reporting of net profits, although rare, can distort the ratio beyond recognition. And how reliable are the shareholders' equity data?

Valuations of underlying assets can vary significantly, affecting the equity side of the balance sheet. For instance, media companies often devalue their mastheads, thereby lowering the return on shareholders' equity for the current year at the click of a mouse.

However, be aware that this will also raise ROE in future years as the return will be measured against a smaller base.


Balance sheet ratios: return on assets

For companies that use tangible assets like plant and equipment to generate wealth, such as the old-style manufacturers, it's also worth looking at their rate of return on assets using the formula:

Return on assets = earnings before interest and tax (EBIT)/total assets x 100

Just as it's expensive for a car manufacturer to have excess inventory in storage, it's also expensive to have piles of unutilised equipment sitting idle, so companies have to use their assets efficiently to generate a return.

Return on assets was one of the most commonly employed ratios in the 1970s and 1980s, but its use has dwindled as the market has changed.

Service companies, for example, have grown into a major slab of Australia's economy, but these businesses are less reliant than heavy manufacturing companies on diverting capital into plant and equipment.

This means that return on assets is less revealing about, say, a travel agency than it is about a heavy industrial company. A car maker's future depends on how well it employs production line machinery. A travel agency, however, may have little in the way of hard assets - in fact it may lease virtually everything - so the "return" on assets is less useful.

The next challenge is working out a realistic value for total assets. Assets are subject to all sorts of revaluations that may hopelessly under/overstate their true worth. This can make the return on assets figure either optimistically high, or absurdly low.

None of this means the ratio is without merit, but make sure you can live with the asset valuations behind it and be careful about which companies you apply it to.

While some research analysts calculate dozens of other ratios from the profit and loss account and balance sheet, those we've covered should already start to provide a good picture of the company.

Coming up next in our ongoing educational series, we'll take a look at the cash-flow statement.

This report appeared on 2022 Morningstar Australasia Pty Limited

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