Financial statements are very often overlooked by private investors. However, they do this at their own peril. You would not buy a house before viewing it, checking for damp, and making sure it is structurally sound.
Stock market investing is no different.
It is important to know what is going on before actually buying a stock- we do not want to become aware of company debt when it is called in by a bank shortly before bankruptcy.
Understanding a company’s finances allows us to make the right decisions when investing and help us to know better what we own.
The balance sheet
The balance sheet, or consolidated statement of financial position, gives a snapshot of a company’s financial health at a fixed point of time.
It can be used to assess how much cash a company has, how much debt it is carrying, and if it will be able to continue trading for the foreseeable future. This is the financial document that draws up a list of everything a business owns and everything that the company owes (we can use the balance sheet to calculate a company’s enterprise value).
The balance sheet is split into three parts:
Assets are the things that belong to a company, and can be both intangible (such as the Coca-Cola brand) and tangible (such as a property, plant, and equipment). They belong to both the liability holders and the equity holders.
The liabilities, meanwhile, are what the company owes. This can be payment for a service that the company received but has not yet paid for (trade payables) or it can be a loan from the bank (bank debt). The bank would provide a loan against the assets of a company – either the company pays the bank back or its assets are seized. This is no different to the bank taking back your house if you stop paying the mortgage.
Equity is what is left for company shareholders. When a company goes bankrupt, the creditors take priority and so it is the liabilities that are taken care of first from the assets. Only then are equity holders paid out with whatever is left from the company, if anything.
Those who own claims to the company’s assets through providing debt are always guaranteed to be paid out first, but have limited upside. Equity holders, conversely, take the risk of receiving nothing, but they get to partake in the profits of the company, which are potentially limitless! As shareholders, it is the equity that we are always interested in.
The balance sheet represents the accounting equation, and as we know in equations both sides of the equals sign must balance. This is a fundamental principle called the accounting equation.
As the assets of a company are split up between those who are owed (liabilities) and those who own (equity) we can further simplify the accounting equation.
Therefore, assets = claims.
Both the liability holders and equity holders have claims over the assets of the company.
Balance sheets must balance
The assets of a company are claimed by either the liability holders or the equity holders. As such, whenever the value of an asset goes up or down it must be reflected in the liability or equity section on the balance sheet.
Let’s say we create a company. We input £10,000 of our own cash, and borrow £10,000 from the bank. This would be our balance sheet below. On the left is our assets, and as assets equals claims we have the liability holders and the equity holders on the right to balance.
Now, let’s say we bought a workshop for £5,000 in cash. Is the workshop a liability? No, it’s an asset. So, we need to decrease cash by £5,000 and add the value of the workshop to our balance sheet like we do below:
We can see that the balance sheet still balances. All that is happened is our cash has decreased due to the payment of our workshop in cash. The bank’s claim over the assets is still the same. As there has been no profit or loss recorded. Shareholder equity stays the same too.
If we were to sell the workshop a year later without having done anything else for £10,000, then our cash would increase to £25,000, and the profit would be added to shareholder equity.
Assets and liabilities are split into two parts: current and non-current. Current assets are the assets that are available to convert into cash in the current financial year- cash, cash equivalents, inventory, and receivables, for example. Non-current assets are those that cannot be readily converted into cash like property, plant, and equipment, and intangible assets such as goodwill.
The same division applies for company liabilities. Current liabilities are debts that need paying within the financial year, such as trade payables and short-term debt. Non-current liabilities can include long term debt or convertible loan notes. A convertible loan note is a form of financing which is a debt loan that can convert itself into equity into the company under certain conditions. As we know, the equity is what is left over once the liability holders have taken their cut.
Let’s look at a typical balance sheet, the first part of which consists of assets. In the image below, we can see three columns for three different sets of results. On the right, we can see the audited results up to the six-month period up to 31 March (this was pulled from the half-year report). Audited means that the results have been verified by the company’s external accountants (the auditors) and so we can be reasonably sure that management have not just made the figures up out of thin air (only fraudulent management teams make the numbers up out of thin air and then they have to fool the auditors – if they can fool them then they will probably fool you or me).
The other two are the half-year results from the same period in 2017 and 2018 unaudited. Here, we can see for comparison the financial state of the company from the same period in two different years.
We can see that of the non-current assets there are two intangible assets listed on the balance sheet. Goodwill is the result of paying more than the fair value of the company’s identifiable assets, or as cynics would say: how much we overpaid! The book value is what the business would be worth if it were to stop trading tomorrow and be liquidated for its value.
It is rare that anyone is ever able to buy a business with potential for the sum of the parts price. It costs less than £1 for all the ingredients for a Big Mac, yet we do not expect to pay the book value for that!
Moving to the current assets, inventory represents the materials needed for the company to produce its final product (this includes both work in progress, or WIP, and finished goods). Some companies (such as software companies) may not own any inventory and so each balance sheet will be different. In this case, the cosmetics company needs to buy the chemicals and materials required to create the product and store it. Everything tangible that is required to create the final product is listed under inventory.
Trade and other receivables, meanwhile, is the cash the company is owed. It may have completed their service or made the sale and charged the revenue to the income statement, but the company has not yet collected the cash. When we go to the cinema, we pay up front before we receive the service. The cinema collects our cash beforehand. However, in many restaurants in Europe, we eat first and then pay for the service after. Until we have paid the restaurant, the restaurant would have the revenue charged to us on their income statement and our unpaid cash would be on their balance sheet as trade and other receivables. Once we have paid, the value of our meal would be removed from trade and other receivables and added to cash on the balance sheet.
Finally, cash and cash equivalents are the cash and liquid assets that are available quickly. These are needed for the business to carry out its ordinary operating activities.
Here is the second part of the same balance sheet that covers liabilities:
We can see that the company has received a service and not yet paid for it, which comes under trade and other payables. Imagine that we are in the restaurant again and have not yet paid – this payable amount would be on our balance sheet! The company clearly has some short-term borrowings that it will need to pay back at some point within the financial year as they are in current liabilities, but other than that the liabilities section is relatively clean in this example. Companies that carry burdensome debt well in excess of their market cap should be questioned, because if the company goes bust the equity holders will lose everything.
There is a non-current deferred tax liability, which is tax that will need to be paid, but this is only small and does not need to be paid in the current financial year.
Net assets at the bottom tells us the amount of assets left over when we take away the total liabilities from the total assets, which should equal the same as shareholder equity.
Finally, we come to the part of the balance sheet that tells us what we get:
The total equity attributable to the equity shareholders is what is left after the liabilities have had their claim over the assets, and as we can see this equals the net assets calculation.
We should always check for debt because the best way to avoid a company going bankrupt is to buy a company with no debt. A company that owes nothing to anyone cannot go bust overnight as there is nobody to call in the debt and pay back. That doesn’t mean that a company with no debt will never go bust, because some companies do suffer from accounting fraud, but it does eliminate the chances of a company not going bust because it cannot pay its debt.
Debt is not necessarily a bad thing, as it can be used for the tax shield. The tax shield is when a company financially leverages itself and can reduce its income tax because interest on debt is a tax-deductible expense. Sometimes debt for more capital is much better than diluting existing shareholders for cash, as long as the interest repayments are low and the company is able to pay off the debt sustainably from its own internally generated cash flow.
Key takeaways- Balance sheet check-up
Does the company have enough cash to conduct its normal operations?
Check how much of the company’s assets are current and also tangible
Look for debt and how much this is – as a general rule of thumb I believe any company that has twice as much debt as their revenue should be considered with caution
Are trade receivables growing a lot faster than trade payables? This can mean cash is leaving the business a lot quicker than it is coming in and could be a potential problem
Author Michael Taylor’s website www.shiftingshares.com contains a number of tutorials on how to trade and invest as well as his free book – ‘How to Make Six Figures in Stocks’.