In an earlier post we sketched a scenario in which you’re sitting with a client and he or she has just given you the latest set of financial statements for the business and you have to say something quickly. In that post we talked about the first five figures to look at in an income statement.
In this post we’re going to think about the first five figures to look at in a balance sheet.
Before we get started, we should just mention that some of you might not call it a balance sheet these days. Depending on the accounting standards in use in your country you might call it a statement of financial position. But whatever the title, the information is the same so we’re going to stick to the name that’s maybe more commonly used and continue to call it a balance sheet for now.
When you look at the balance sheet there are some general points to keep in mind;
- There will be comparative figures alongside the most recent period. So for each figure you’re going to compare it with the previous year to see whether, and by how much, the figure has increased or decreased.
- That’ll then lead you to ask questions about the changes – in particular, you’ll want to know what caused the changes and how the figures will likely look in the future.
- Whenever you talk about a change in one of the figures, consider whether the cause was an internal issue – for example, the result of a management decision – or an external issue – perhaps a customer that hasn’t paid for goods supplied
- External issues will be more of a concern because they’re largely outside the control of management and so pose a greater threat to future sustainability. For that reason you want to fully understand the future impact of these issues on the business.
A good starting point when analyzing a balance sheet is to remember the accounting equation because it’s the three components of a balance sheet; the equation is assets equals equity plus liabilities or, more simply, A equals E plus L.
But before you start looking at the figures in detail there’s one thing you must check first. Does the total of the assets exceed the total of the liabilities?
If so, the business is solvent so you can carry on with your discussion with the client. If it isn’t solvent you wouldn’t be able to lend to the business so that may bring the conversation to an abrupt end.
So, let’s get started.
The first figure to look at is the total assets figure and we look at this total first because, from an analyst’s perspective, it’s the central point of the balance sheet and everything else revolves around it.
Depending on whether the total has increased or decreased we’ll then explore the other changes in the rest of the balance sheet and we do that by asking what changed on the other side of the equation. More or less equity? Or more or less liabilities?
Remember that the accounting equation tells us that if the total of the assets changed, something on the other side of the equation must also have changed to keep the accounting equation in balance and we want to know what that change is.
What we also want to know about the change in assets is; if non-current assets reduced was it due to depreciation or were assets sold off?
And if assets were sold off, were they productive assets and will their sale affect the businesses ability to generate revenue in the future?
The second figure to look at in the balance sheet is the total of current assets and we’d want to know whether the figure has changed as a result of a change in revenue and, if so, is it in the same proportion?
Another question to ask about the current assets is whether the inventory and accounts receivable are equally affected by the change. The reason we want to know that is to get an indication of whether the inventory figure is too high because it can’t easily be sold and whether accounts receivable are also high because they can’t be collected for some reason.
The third figure in the balance sheet to look at is the total of equity.
Remember that equity represents the total funds contributed by the owners or shareholders of the business so the first thing to look at is whether profits have been retained or have dividends been paid to shareholders.
If profits have been retained that’s a good sign but if dividends have been paid to shareholders that’s not so good because the ability of the business to fund some of its own growth is negatively affected when dividends are paid away.
Another question to ask if equity has increased is whether additional equity has been invested by the shareholders and, if so, has it been invested by the same shareholders as before or are there new shareholders that you don’t know about.
A final point to think about relating to the equity is whether reserves have been created that weren’t there in the previous year.
This might relate to reserves that are created as a result of new intangible assets that may not in reality have any value ………or it might possibly be due to the revaluation of property. The question in that case being; how reliable and accurate is that new valuation?
The fourth figure to look at in the balance sheet is the total of non-current liabilities.
Remember that non-current liabilities are those liabilities that are not due to be repaid within 12 months from the date of the balance sheet.
Of course, we’re going to look whether the non-current liabilities increased or decreased and if there’s there a corresponding change in the non-current assets.
What we mean here is that if there is an increase in non-current liabilities, there should be an increase in the longer term assets of the business since that is what these liabilities should finance.
If there is a decrease in the non-current liabilities, is that simply because of a debt repayment schedule reducing the amount of liabilities or have assets been sold and the proceeds used to reduce the liabilities?
If there’s new or increased interest-bearing debt included in non-current liabilities we’d want to know what collateral has been given as that’s going to affect the unencumbered value of the assets.
The fifth and final figure to look at in the balance sheet is the total of current liabilities. These are the liabilities that have to be settled within 12 months from the date of the balance sheet but, in reality, usually very much sooner than that.
The first question would be; have current liabilities increased or decreased and is there a corresponding change in the current assets?
Here we’re thinking particularly about the accounts payable. An increase or decrease in that figures should be reflected in a change in the inventory figure in the current assets.
The next thing to think about is; how soon must the current liabilities be settled?
Although technically they are due to be settled within 12 months from the balance sheet some of them will be payable within, for example, 30 days while some will be payable over a much longer period than that ……so it’s useful to know exactly how urgent the current liabilities are.
And the final question is; is there new or increased interest-bearing debt included in current liabilities and if so what collateral has been given?
This is a very similar question that we asked about the non-current liabilities except that this relates to short term interest-bearing debt…. but there may still be some assets which have been given as collateral for the debt to the lender.