- 13 Jun
Notes On Analysing A Company Balance Sheet.
Analysis of a company's balance sheet allows you to understand what assets and liabilities fall within the business, and whether the business is liquid (has enough liquid assets to pay its short term creditors as they fall due) and solvent i.e. assets exceed liabilities. Therefore it can be helpful in trying to establish the financial position of a company e.g. to decide on granting a credit account.
Analysing The Balance Sheet
Firstly I should say that the balance sheet will always be out of date, as the assets and liabilities can change rapidly after the balance sheet has been struck. The balance sheet is like a snapshot at a given time. The balance sheet is a statement of the assets and liabilities of a company at a given time.
Estimating Profit & Loss Performance
Within the balance sheet of the company there is normally an entry titled "retained earnings" or similar. This reflects the retained profit or loss figure for the business It's over time. If you are looking at two years worth of accounts, the difference between the retained earnings shown in the first years balance sheet, and the second years balance sheet gives you some indication of the trading success of the business.
For example, if the retained profit and loss account has increased, it suggests that the company has made a profit over the period. If the retained profit and loss account has reduced, it suggests that the company may have made a loss during the period. However, These figures are not as straightforward as they may appear.
If a company were to make say a substantial profit, but then the directors chose to draw out more than that years profit in say dividends, that could result in a reduction in the retained profit and loss account. Therefore, caution needs to be taken when using these type of properties to assess the profitability of a business. Looking at the profit and loss account, is a better way of assessing the trading performance of the company.
Net Worth - Assets & Liabilities
Considering the balance sheet, the first, is to see if the business has an overall net worth. This would be a surplus of assets over and above its liabilities. Whilst this may be an indicator of financial strength, it should be borne in mind that balance sheets are always historic, and the value of assets in a business failure situation can be substantially lower than the value they are recorded in the books of a company. Nevertheless, this can be an indicator of the substance behind a business.
Also bear in mind that the asset values can move from moment to moment as the company spends cash. So seeing a large cash balance in their year end accounts is no guarantee that they still have that same amount of cash. Indeed some companies actively retain as much cash as possible, over their year end, in order to maximise the amount shown in their balance sheet.
Returning to the net worth, I would then look further, beyond just the bottom line net worth figure, in order to understand how this has made up.
The type of assets Included within the balance sheet can give rise to either reassurance about the companies position or raise concerns. For example, one category of assets are "intangible assets". This is a class of assets that can include things such as goodwill within the business, or intellectual property. The value of these assets can be somewhat subjective. I have seen examples of balance sheets where substantial intangible assets have been added into the balance sheet, in order to increase the net worth. Whilst this may be absolutely allowed within standard accounting practice, some might question the value of some intangible assets should the business fail.
On the other hand, and assets such as cash, could be considered a very liquid assets that would demonstrate a position of strength. There are other numerous other methodologies that companies can use to increase the reported position on their balance sheet. I've recently seen a set of accounts from a company that showed a negative net worth, when the share capital and retained profit and loss account were added together. However, the business had been taken their long-term liabilities, shown them underneath the net worth on the balance sheet, and reported a far more substantial, positive figure at the foot of the balance sheet. At a glance, this would appear to show a much more substantial business. However, whilst liabilities may not be due for more than a year, This is very different from worth within the company.
Another key consideration when looking at the balance sheet of a company, is to understand how liquid is the businesses. The liquidity is normally calculated by taking the short-term liabilities (those payable in less than a year) and deducting them from the value of current assets. Current assets include those which are able to be liquidated quickly e.g. outstanding debtors, cash and stock. By deducting the liabilities from the current assets, it gives a measure of liquidity i.e. how easily a business would be able to meet its short-term creditors.
In a business where the current liabilities substantially exceed the current assets, and liquid trading position could lead to cash flow problems. You may want to remove stock from the equation, as it requires to be sold in order to create cash. This gives a further reduced asset position which when reflected as a proportion of the liabilities is called the "acid ratio" - the most cautious measure of liquidity.
Inter-Company Trading & Support
The other factor which I often consider when looking at an individual that has a number of businesses, are the interdependencies between the businesses. For example, you can find that there are intercompany loans, or debts between group companies. I always try to use the filed accounts to unpick these types of inter-relations, in order to better understand the financial position of a group of companies overall. For example, if two businesses are owned by one person, and one business owes a substantial amount to another, that could show as a substantial asset to the second business, giving it what appears to be a much stronger financial position. However, if the group were to fail, it is obviously likely that intercompany debt may not be repaid.
Help With Credit
If you need help understanding whether or not to grant credit, or you are looking for protection against bad debts, please contact us and we will refer you to parties that can help.
also please read my notes on analysing financial accounts.
The above is not intended to be a comprehensive guide to analysing financial accounts, and I am not an accountant, but it includes some pointers based on the approach that I tend to take. If you need help understanding financial accounts, you should seek support from a qualified accountant.
- 13 Aug
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