A company’s balance sheet is one of the most critical tools at an investor’s disposal when it comes to stock picking. A balance sheet provides a snapshot of everything a company owns and how much it owes, at a specific point in time. It is made up of two sides that must ‘balance’, or be equal to each other.
The first side records the business’ assets, which are the things of value under its control. The second side records all outstanding liabilities, including all outstanding debts and other amounts owed and its shareholders’ equity. The shareholders’ equity figure will also include all accumulated profits and losses. Remember, assets are always equal to liabilities plus shareholders’ equity.
How a company’s balance sheet works
When it comes to reading a company’s balance sheet, the assets are divided into two categories. Current assets (assets that are cash, or are expected to be converted into cash, within one year) and non-current assets (assets that cannot or are not expected to be converted into cash within one year).
The contents that make up both current and non-current assets will vary depending on the stock that is reporting. However, current assets will often include the following:
- Cash and cash equivalents – these are the most liquid assets and feature instruments such as treasury bills, short-term certificates of deposits, and hard currency.
- Trade and other receivables – Also known as accounts receivable, this is money owed to the company by customers.
- Inventories – These are goods available for sale, valued at the lower of the cost or the market price.
Other common current assets include marketable securities, which are equity and debt securities that are part of a liquid market, and prepaid expenses, which is value that has already been paid.
Meanwhile, non-current assets will often include the following:
- Property, plant, and equipment (PP&E) – Also known as ‘fixed assets’, these are long-term assets vital to business operations that a firm cannot quickly convert into cash. This area can include things like land, facilities, machinery, office equipment, vehicles, furniture, and fixtures.
- Intangible assets – These are assets that do not physically exist but have value due to cash generated by them or identifiable unimpaired capital sums invested into them. They can include things like goodwill (the difference between the value of the physical assets purchased and the price paid for them), brand recognition and intellectual property.
- Non-current assets – These can include long-term investments. These are investments that a business will not touch, such as bonds invested as part of a portfolio.
When it comes to intangible assets it is worth noting that the market often applies a significant discount to intangible assets in a company’s share price, and can even assign no value to them at all. Although it is worth acknowledging a company’s intangible assets, it often pays not to include these when attempting to estimate what a firm’s quoted market capitalisation might be when measured against its balance sheet value.
As with assets, firms separate liabilities into those that are due within one year (current liabilities) and those that are due at any point afterwards (non-current liabilities). Once again, these will vary greatly depending on what type of stock is reporting.
It is also important to remember that some debts will be ‘off-balance sheet’ and will not appear. These can include things like operating leases and details will be found in a company’s full annual report. Common current liabilities include:
- Trade and other payables – Also known as ‘accounts payable’, it refers to goods and services that a company has received from suppliers but for which they have not paid.
- Loans and borrowing – Also classified as ‘short-term loans payable’ in some cases. The category refers to loans that require payment in less than one year.
- Corporation tax payable– This is quite simply the money the business owes to the tax office, which, in the UK, would be HM Revenue & Customs (HMRC).
Other common current liabilities are interest payable, rent, tax, and utilities, wages payable, customer prepayments, and dividends payable.
Meanwhile, common non-current liabilities include:
- Deferred tax liabilities – Generally speaking, these are taxes that have been accrued but will not be due for another year. These are often used to reconcile differences between the financial reporting year and the tax year.
- Loans and borrowing – These are loans that companies do not need to repay within the next 12 months.
- Accruals and provisions – Accrued liabilities are expenses that a business has incurred but has not yet paid. These expenses can include pension obligations, interest expenses, and wages.
Other liabilities include deferred compensation, deferred revenues (where a customer has paid for goods or services not yet received), and derivatives. Finally, in some cases, debt that is due within 12 months may, in some cases, be reported as a non-current liability if there is an intent to refinance this debt.
Another helpful indicator in helping to value a stock can be Shareholders’ equity. When you subtract liabilities from the assets, anything left over belongs to an enterprise’s owners and shareholders – this is also known as net assets.
In addition to net assets (or net liabilities if there are more liabilities than assets) are the profits accumulated over the years along with money put into the company through issue capital.
Much of this value is to be found in the company ’s share premium accounts (representing sums raised at above the nominal value of a company’s shares as the company has progressed). This can be divided into several areas such as retained earnings or share capital.
The share capital is the total amount of funds raised by a firm in exchange for a share of either common or preferred shares of stock. It only accounts for the amount initially paid by shareholders. It does not reflect any gain or loss made when reselling on the secondary market.
There are many ways a balance sheet can be used to analyse a business, some are very technical, let’s look at three simple, common calculations that any investor can use to assess a stock’s financial health:
Debt to equity ratio
As we have described, assets are funded either by creditors in the form of loans and other liabilities or from shareholders through share capital and retained profits. The ratio between the two sources is critical because debts can always be called in by a creditor while shareholder equity is ongoing.
The debt to equity ratio is calculated by dividing total liabilities by total shareholder funds. For example, £58,646/£94,938 = 0.62, often expressed at 62pc. There is no correct level because different types of business will require different amounts of debt relative to their equity.
However, a company with a high number is considered more ‘geared’ or ‘highly leveraged’ than one with a low number. In elementary terms, they can be considered riskier.
Having a high debt to equity ratio is not necessarily a bad thing. If the value of an asset increases, then a highly geared business will enjoy a higher return on their equity as the value of their loan will not increase in line with this growth. That said, it can work both ways. If the value of the asset decreases to below the size of the loan taken out to pay for it, then a business risks losing equity.
With this in mind, Tom Stevenson, investment director at Fidelity Worldwide Investment, advises investors using the D/E ratio to ask if a firm is vulnerable to an economic downturn before injecting their cash. He adds that it is worth looking at whether an enterprise’s revenues are predictable or protected by substantial barriers to entry. They should also look into how quickly a company will need to repay debt, how much cash it is generating and whether it enjoys fixed interest rates.
This is a straightforward measure of a business’s ability to cope in a worst-case scenario where it is forced to pay all of its short-term obligations in one go. It divides the firm’s current assets by its current liabilities, with a figure greater than one suggesting it would not have to go to the bank for more financing.
Return on Equity (ROE)
This is a measure of how hard a company is working its assets. It should earn an acceptable return on its assets, or, at the very least, make more from its investment capital than its cost through interest and dividends. It is worked out by dividing net income (found on a firm’s income statement) by total shareholders’ equity.
It is difficult to compare return on equity figures for businesses operating in different sectors. To give the percentage meaning, it is worth putting it up against historical ROE, to see if things are improving over time.
It should also be compared to names with a similar business model to get a better sense of how a firm is performing within its peer group. Finally, it should be put up against risk-free returns. There is little point investing in a business that is returning little more, or even less, than that offered by a deposit account.