Understanding the Balance Sheet
A balance sheet, also known as a “statement of financial position,” reveals a company’s assets, liabilities and owners’ equity (its net worth). It, together with the income statement and cash flow statement, makes up the cornerstone of any company’s financial statements. If you are a shareholder of a company, it’s important that you understand how the balance sheet is structured and how to read it.
A balance sheet is also referred to as a snapshot in time. It is like the “before” and “after” photo you put on your fridge. It will tell you what the company looked like at the beginning of a financial period (normally a year), and then again at the end of the financial year. Other than noting the differences between the 2 “snapshots’, we will not be able to ascertain precisely what happened in the period between those 2 photos.
We also say that the balance sheet deals with capital items. These are items we deal with in order to be able to do business. An example would be a truck we use for deliveries. If we are not in the business of buying and selling trucks, the truck is a capital item, as is the money used to finance the acquisition of the truck. The practical implication of this is that buying and selling this truck will not be reflected on the Income Statement, but only on the balance sheet. There are a few exceptions to this rule and we will deal with them later.
So basically the balance sheet tels you what you have invested in and how you have financed these investments.
The balance sheet is divided into two parts that, based on the following equation, must equal each other: assets = liabilities + owners’ equity. This means that assets, or the means of production – which we will use to generate a value for the shareholders, are balanced by a company’s financial obligations and the amount of money available to finance its operations. Plainly speaking, the assets will need to be financed from somewhere, and the 2 main sources are the money from shareholders (referred to as equity), and debt – or other people’s money.
Assets are what a company uses for its production process, while liabilities are the means we have used to finance these assets – they are obligations to outside parties such as shareholders, banks, and suppliers. Typical liabilities are bank debt and creditors, but more of this later. Owners’ equity, referred to as shareholders’ equity in a listed company, is the money initially invested into the company plus any retained earnings, and represents the source of the business’ funding from shareholders. Retained earnings is a figure derived from the income statement and refers to that part of the total income of the company that was not spent on costs and expenses or dividends. Together, liabilities and owners’ equity actually represent the options the company used to finance the assets the company has acquired.
As stated above, a balance sheet represents a specific period of time (usually one day – it is a snapshot in time) and is most commonly calculated on the last day of a company’s fiscal year, i.e. Dec 31.
Types of Assets
Three types of assets are included in the balance sheet: current assets, fixed assets, and intangible assets. Modern day terminology have started to refer to current assets and non-current assets. Current assets have a life span of one year or less, meaning they can easily be converted into cash. Such assets are cash and cash equivalents, accounts receivable and inventory or stock. All are short-term, highly liquid assets that can easily be converted into cash and used as currency. The expectation is that the conversion will take place at least within the next financial year. In the case of debtors (also known as accounts receivable) and inventory (or stock), the conversion should ideally be much shorter, as it represents cash being tied up. In the case of inventory, you have spent the money to buy the inventory, and now wait to sell it.
Cash. the most fundamental of current assets, also includes bank accounts and cheques. Cash equivalents are money market instruments that can be quickly changed into money. This is the lifeblood of the company. As it has been said, no one knows of a company that went bankrupt because it had too much cash!
Accounts receivable or debtors are the short-term obligations owed to the company from clients. You have already borne the costs and expenses. Accounts receivable for a company selling a good could expect to receive monthly instalments from its clients, while accounts receivable for a company offering a service could be in the form of monthly subscription fees.
Finally, inventory or stock represents the amount of materials currently available for production. You have already paid for the inventory and it is now waiting to be sold. As such, it locks in cash. You do not want to have too high levels of inventory, as it ties up cash. On the other hand, you need enough stock to ensure that you do not have a stock-out, which could lead to a loss of clients. For a manufacturing company, the inventory is divided into three different stages: raw materials, work-in-progress (WIP) and finished goods. Inventory for businesses that sell in the retail industry will consist of products purchased from the manufacturer and are yet to be sold to the public.
In determining the right level of stock, you need to understand the industry you find yourself in. If you sell Mercedes cars, you don’t need to have 3 cars of each colour on the floor. People know they place their order and then wait the appropriate time. On the other hand, if you want a pink shirt and the salesperson tells you to come back a week later, you just walk to the next shop in the mall!
When analyzing the current assets, we need to bear in mind that granting credit to potential buyers is used to stimulate sales. In some industries it is not used (food retail), while in others you will struggle to survive without granting credit (clothing retail). The debtors figure should therefore always be closely watched to ensure that the efficiency with which we manage our debtors are maintained at high levels. If your credit policy is 30 days, you need to ensure that your debtors pay within 30 days. Unfortunately, when we want to stimulate sales, we tend to let this efficiency fall by the wayside. In periods of high growth, we can frequently see that the amount of debtors relative to sales are climbing. But we will deal with this in more detail when we look at the ratio analysis.
Long-Term Assets (non-current assets)
Long-term assets, also known as fixed assets, have a life span of more than one year. They can refer to tangible assets such as machinery, computers, buildings, and land. Depreciation is calculated and deducted from these types of assets. Long-term assets are stated after deduction of accumulated depreciation. This figure is referred to as book value and is equal to cost price minus accumulated depreciation. Land is not depreciated, although it could be re-valued, which does happen from time to time. When this happens, the amount representing land is increased to what is deemed to be a more realistic figure. to balance the balance sheet, a non-distributable reserve under owner’s equity is created, and is referred to by the innovative name of “revaluation of fixed asset reserve.” It has the impact that the total assets are increased (somewhat artificially), and the owner’s equity is increased by the same amount. therefore the percentage of debt financing is reduced, creating a less risky profile of the company. It is therefore important to deal with this revaluation in a circumspect manner as it lends itself to manipulation.
Depreciation will be dealt with in more detail in the page on the income statement, but loosely refers to wear and tear an asset goes through in the process of generating value for the company. Whereas the cost of purchasing the truck for example, is a capital item, depreciation is an income item and is reflected in the income statement.
Long-term assets can also be intangible assets, such as a website domain, or a patent or copyright. The patent of Coke, for example, is an intangible asset that is worth billions of rands. The recipe for Kentucky Fried Chicken would be equally valuable. Even people could represent a brand, for example the brand name Tiger Woods is equally valuable. While these assets are not physical in nature, they are often the resources that can make or break a company – the value of a brand name, for instance, should not be underestimated, e.g. Coke, Nike, McDonalds, etc.
Long-term assets can also refer to investments. In this regard we can distinguish between three types of investments:
- Subsidiaries: The group owns more than 50% of the company and the statements of the subsidiary are consolidated on the statements of the group. Where it is not a wholly-owned subsidiary (group owns 100% of the company), one would find the items minority interest in both the balance sheet and the income statement. It reflects that part of the assets that do not belong to the group but to outside parties.
- Associates: The group owns between 20% and 49% of the company. The statements of the associate are not consolidated on the statements of the group.
- Other investments: Any other investments in shares or other instruments.
Types of Liabilities
On the other side of the balance sheet are the liabilities. These are the financial obligations a company owes to outside clients. Liabilities and equity together represent the manner in which the company has decided to finance its assets. Like assets, they can be both current and long-term. Long-term (or non-current) liabilities are debt that has more than a year’s maturity. Companies can either issue their own debt, which is not common in South Africa, or they borrow long-term debt from a bank or a consortium of banks.
Current liabilities are typically paid within one year or less, and are therefore ideally paid with current assets. Because current assets pay for current liabilities, the ratio between the two is important: a company should have enough of the former to cover the latter. Current liabilities include such items as dividends payable. accounts payable (what the company owes to suppliers for buying raw materials or retail products on credit), interest payments payable on long-term debt and taxes payable . Accounts payable are also referred to as creditors.
Owners’ equity is the initial amount of money invested into a business. It represents the share capital of the company paid in by the shareholders. If, at the end of the fiscal year, a company decides to reinvest its net earnings (after taxes) into the company, the retained earnings will be restated from the income statement onto the balance sheet here. The sum of the two figures represents a company’s total net worth.
There are 4 elements in the ordinary equity account of the balance sheet:
- Share Capital – issued shares at par value. Par is a nominal value decided upon by the accountants.
- Share Premium – the difference between the issue price and the par value.
- Non-distributable Reserves. Reserves such as share premium, as well as asset revaluation reserve.
- Distributable Reserves – this refers predominantly to retained earnings. This figure is increased every year with that amount in the income statement that is not spent on costs and expenses and dividends.
However, although you will frequently see the exact layout as described above, as frequently you will not see it. There is an example of a balance sheet below where the composition is slightly different. This is a reality you need to deal with. All that you need to do is to see what terms they use and what each consists of.
When a company is created, it requests as part of is creation the authorization of let’s say 200 million shares. They then issue these shares as and when they require funds for growth and other purposes, in combination with debt. What happens when the 200 million shares have all been used? Easy. They get a special decision (75% of shareholders + 1 share have to agree) to increase the number of authorized shares, where after they then can issue more shares for funding.
In order for the balance sheet to balance, total assets on one side have to equal total liabilities plus owners’ equity on the other. Here’s an example, demonstrating this balance between assets and liabilities plus net worth:
A figure that is not part of equity, is “minority interest.” Whenever we see this item on the liability side of the balance sheet, it is an indication to us of the following:
- We have purchased another company and own more than 50% but less than 100%.
- It is therefore a subsidiary of ours.
- As such we can consolidate the financial statements of this subsidiary on our statements as if we own all of it, which we, in this case, do not.
- We therefore put all of its assets on the asset side.
- We are then compelled to show that part of the assets that we have put on our balance sheet that do not belong to us, on the liability side.
- It is referred to as minority interest.
The assets will also equal the liability side of the balance sheet, meaning that assets = equity + liabilities.
We refer to the matching principle in finance. In an ideal world this means that we use long-term debt to finance long-term assets (or fixed assets or non-current assets). If we use short-term debt to finance a non-current asset, we could find ourselves in a liquidity problem. What do I mean with this?
- Say we buy an expensive piece of equipment with a lifetime of say 20 years.
- We use short-term debt to finance it. (Contrary to the matching principle).
- We will need to pay back the debt – let’s say over 5 years.
- Because the equipment could be very expensive, we will have high annual payments for the first 5 years, which will use up our cash flow.
- If we used long-term debt that reflects the life of the asset, our cash flow would have been under much less pressure as our annual capital payments would have been much lower.
- This is typically what we do when we purchase a house in our personal lives. When we buy a car, we use a loan of 5 years. When we buy a house, we use a loan of 20 years, called a bond.
Debt or Equity
A lot of my students initially fall in the trap of making an obvious mistake as to what is more expensive, debt or equity. The reality is that debt is less expensive than equity. The reason for this is that the shareholder has more risk than the bank as the holder of debt. When the company goes belly-up, the bank stands right in the front of the que when the assets of the company are divided amongst those who have a claim against the company. As they have more risk, the shareholder has a need for a higher return. This is an important principle in the world of finance. The return the shareholder wants is therefore always higher than the interest rate the bank will charge you.
Now, the next obvious question is but how will the shareholder force you to give him the returns he wants once he has bought the shares? Easily. If the share price is R20, and you give him returns in the form of dividends and share price appreciation of R2, his return is R2 on R20, which is 10%. If he wanted 20%, the easiest way is to have the share price drop to R10, in which case his return is 20%.
Is this a problem for the company? Yes it is, but probably more for the management and the current shareholders. If the share price of the company does not reflect its potential, you will be undervalued. You company will be worth more than the price of your shares. In such a case someone with a lot of cash can buy up your shares in the market and implement new strategies to realize the true potential of the company. In such a case, management will always lose their jobs, and rightly so!
When I deal with ratios, I will deal with the concept of net asset value (nav). It is closely linked to the above phenomenon. The nav refers to the book value of the share, where as the share price is the market value of the share. When the nav is higher than the market price, it means you are worth dead more than alive – the typical husband scenario! People can buy all your shares in the market for say R3 – let’s assume the nav is R5, and then sell off all the assets. It will pay off all the liabilities and make a risk-free profit of R2 a share. This is also referred to as asset stripping.
Another question I have to deal with is when do I use debt and when do I use equity? Ideally you develop a combination of debt and equity which will give us the lowest weighted average cost of capital. Remember, we said that our assets are financed with a combination of debt and equity. Each comes with a cost, frequently expressed as a %. We now also know that equity is more expensive than debt. We want that combination that together will give us the lowest cost of capital.
Also, there is a saying that goes that if your project is so good, why bring more owners on board? Rather go to the bank, borrow the money, do the project, pay back the debt and keep all the profits for your existing shareholders.
As debt is cheaper than equity, one could be forgiven if one were to think that a capital structure (that combination of debt and equity) that is 100% debt would be the cheapest. The reality is, however, that the more debt that you take on, the more riskier you become for both prospective shareholders and bankers. You still need to pay back the capital you borrowed, as well as the interest on that capital. They would become uneasy if you take on too much debt. As you would present a higher risk, the banker would charge more for his money and even at some point deny you any funds. Also, the shareholder would keep on asking a higher return until such a point hat he would want your shares for practically free.
The typical combination of debt and equity is more or less determined by the industry you are in. The banking industry uses about 10-12% capital (equity) and the rest is other people’s money. The same goes for the food retail industry in SA. Pick ‘n Pay has about 15% equity in its capital structure, whereas the rest is other people’s money. Interesting, they do not abide with the matching principle as about 75% of their total assets are financed by creditors, which are extremely short-term. The reason why they can get away with this, is the nature of the industry and the configuration of the operating cycle. I will speak more about this when I deal with ratios and analysis.
Analyzing the Balance Sheet
In addition to the issues regarding debt and equity, you would like to know how healthy the balance sheet is. We will do more of this when we do ratio analysis. However, here we can ask ourselves some of the following questions:
- What growth have we had in our fixed assets relative to last year?
- Has this lead to an increase in turnover? Have they been productive assets?
- Are we maintaining our assets? We need to remember that our turnover is dependent on the quality of our asset base.
- We need to understand the depreciation policy of the company. Is it being consistently and diligently applied, or are we manipulating this policy to suite ourselves? I will explain more of this when I explain the income statement.
- Do we have too much debt in our capital structure or are we under-geared? The latter is a term we use to say that we can take more debt on board than we currently have. Gearing is a term we use as an alternative to debt.
- What do our debtors’ figure look like relative to last year? Are they increasing relative to sales? Do we have bad debt locked up there that we do not want to write off as it will negatively impact our balance sheet and our income statement?
- What does our inventory figure look like? Are we keeping old and unsaleable stock on our shelves to pad our balance sheet? Do we need to write off some of our stock?
- What does our cash position look like? Remember that cash is king and the lifeblood of the company!
- Are there signs of channel-stuffing? This refers to a company sending stock to its clients to sell into the market, regardless of whetehr there is a demand. The result of this is that the stock figure in the wholesaler’s books are much less at year-end. When the retailer sends back the unsold stock after year-end, it does not affect the published year-end stock figure. The company then looks much better than it should. Remember, the photo is taken at year end and not 1 month later!
There are a host of issues we need to understand and ask about. We will deal with this as we go to the income statement and the ratio analysis. We also need to go to the first article and ask ourselves about the environment, the industry, the business model, the business and functional strategies, and the ability of the company to execute strategy! Then only will we start getting a more informed view of the company’s financial statements.
The next article will deal with the income statement of the company.