What is a Balance Sheet?
It is simply a statement of a company’s assets and liabilities at any given point in time. It’s the most useful document in understanding a company’s financial strength and its financial value.
The Balance Sheet is sometimes the most difficult statement for business people to understand because it is prepared under various accounting standards and conventions, some which are very prescriptive in how assets and liabilities are valued and categorised but also gives businesses some leeway in how it interprets certain items. So it will take a little bit longer to explain!
Once you understand the main items included in a Balance Sheet, it is easier to understand.
Essentially a Balance Sheet is based on the principle of ‘Owners Equity (shareholdings value) = Net assets (assets minus liabilities) of the business’. This means that the owners interest has to be always represented by the net assets of the company.
In the US, this equation is shown as ‘Net assets = Liabilities + Owners Equity’ but it’s the same principle.
To understand how to interpret a Balance Sheet, as an example, I have extracted a recent annual Balance Sheet Statement for Apple (courtesy of Yahoo Finance) and shown some analysis of how to interpret the figures.
The first item to note is that Apple’s net assets are $118.21b (total assets of $176.064b minus liabilities of $57.854b) which equals the stockholders’ equity. So Apple is a very strong company and when you read further you realise how much of these assets can be converted into cash quickly!
I’ll start at the top of the Balance Sheet with a short explanation of each line item.
1. Current assets
Current assets are termed as such since they are either cash or can be quickly converted into cash. For Apple, these consist of cash $10.7bn (all bank accounts), short-term investments $18.3bn (usually short-term bank deposits or other securities maturing in under 12 months), net receivables $21.2bn (debts due from customers) and inventory $791m (stocks of goods held which would be eventually sold to customers). Other current assets of $6.4bn would be items not falling into any of the above categories such as prepaid expenses such as rent etc.
2. Fixed assets
The next category is long-term assets, sometimes called the Fixed Assets. These usually benefit the business by earning it income whether through plant, machinery or buildings and property, which in Apple’s case amounts to $15.4bn. These are usually amortised or written off over a number of years.
Long term investments would be deposits, treasury bills, corporate securities, bonds etc that the company holds for a long time usually for over 12 months. These should ideally generate an income for the company and/or be expected to appreciate in value. In Apple’s case, it has invested $92bn into such securities both in the US and overseas. These are all marketable securities, i.e. can be easily sold for cash.
So when you see the usual reports of Apple having $121 billion in cash, these long-term securities of $92bn and the short-term investments of $18.3bn are being added to Apple’s actual cash balances of $10.7bn to derive this figure! Of course, it does mean that Apple has access to $121bn of cash because it can convert its investments and long-term securities into cash over time.
3. Intangible assets
Intangible assets have no physical existence. For e.g. goodwill is an intangible asset. This is the excess amount paid above the book value of assets to acquire a company and has to be shown separately to other intangible assets and in Apple’s case, goodwill amounts to $1.1bn.
Other intangible assets of $4.2b in Apple’s Balance Sheet would be patents, trademarks, copyrights, licenses, intellectual property etc which has a value to the company. All intangible assets usually have to be amortised/written off over time. Apple usually writes off intangible assets including goodwill over 3-7 years, i.e. charges to its Profit and Loss Account, as it explains in the notes to its financial statements.
However, there maybe some companies which argue that certain intangible assets gives the company an ongoing benefit and therefore these are not amortised.
It’s the intangibles and the periods these are written off over, which causes all sorts of distortions in balance sheets. There are accepted rules but companies also have some leeway on the period over which it is expensed to the Profit & Loss account.
Even the various accounting standards in the US and elsewhere differ on the treatment and reporting on intangible assets, although there is increasing convergence now since we are seeing more such assets being added to balance sheets.
This article is not meant to delve into such technical issues on intangible assets but for those who want more technical detail, visit the Institute of Chartered Accountants website http://bit.ly/XmbPg8.
4. Other assets
These are items that do not fall under any other category such as prepaid rents and expenses paid in advance.
Accounts payable is what is due to suppliers for purchases of $32.5bn and other current liabilities would be taxes, social security etc of $5.9bn, which are all due in under 12 months. Unsurprisingly, Apple does not have any short-term debt such as bank loans or an overdraft!
Other longer term liabilities of $16.6bn in Apple’s case are mainly longer term deferred taxes payable beyond 12 months. Deferred long-term liability charges of $2.6bn would be liabilities arising from financial derivatives and swaps – connected to some of the long-term securities Apple holds.
What is always interesting are the liabilities not shown on a balance sheet, known as ‘off balance sheet items’, such as purchase obligations and rental commitments on long-term leases, which are tucked away in the notes to the financial statements. Apple has $21bn of purchase obligations to suppliers for manufacture of components in the next year and also lease rental obligations of $4.4bn mainly for retail space over the next few years. Also, tucked away in the notes to the financial statements, would be any contingent liabilities emanating from outstanding Court cases and these have to be declared by the company and an estimate of potential damages declared. In Apple’s notes, its case against Samsung and the resulting judgement in favour of Apple of $1.05bn was mentioned.
So it is always worth reading the notes in the financial statements relating to contingencies and other commitments not included in the balance sheet.
6. Shareholders’ equity
These would be the shares at the original share costs plus the retained profits of the company. In Apple’s case there is a relatively small sum of $499m which relate to overseas securities and unrealised exchange differences.
So the explanation of individual items in a Balance Sheet is the easier part and the harder part is put these altogether to understand the financial strength of a business.
Here are some key tips to look for in a Balance Sheet:
- Current assets exceed current liabilities = company can pay its debts. It can be measured by the current ratio or ‘liquidity ratio’, i.e. current assets divided by current liabilities and the higher the ratio the better!
- Borrowing. There could be short and long-term borrowing to fund growth and if the debt can be serviced by this income growth, there is not too much to worry about. Borrowing can also indicate that the business has financial strength and a good management team in place.
- Positive net assets. The higher proportion of retained profits/earnings in shareholder equity shows a very profitable business e.g. Apple!
- High proportion of fixed assets in total assets. In a highly profitable company, this indicates company is investing for its future profits and hopefully in sound investments.
- Small proportion of goodwill in assets. Indicates that the company is not overpaying for acquisitions.
- High amount of intangible assets. Indicates high level of intellectual property etc which could mean better future earnings.
- Low short-term and long-term debts. Indicates the company generates sufficient cash for it’s working capital and replenishment of fixed assets.
Bad (or not so good)
- Opposite of everything above!
- Negative net assets. Never a good sign but may indicate a startup period and as long as the company is financially supported by its shareholders it will be fine.
- Potential contingencies arising from Court cases. These are tucked away in the notes to the formal financial statements but are difficult to estimate financially in advance of such cases being heard.
As always, a balance sheet statement should be read in conjunction with the Income and Cash flow statements and also with previous period comparatives and importantly the notes to the financial statements.
For your own business balance sheet, always ensure the key items and ratios are shown in chart form with trends so that you can pick up warning signs early.