This is a guest post re-published with permission from ValueTheMarkets.com
One of the most critical tools at an investor’s disposal when it comes to stock picking is a firm’s balance sheet. Here, we take a look at what a balance sheet is, what it consists of, and how it can be used to improve investment decisions.
What is a balance sheet?
A balance sheet is a snapshot of everything a company owns and how much it owes, at a specific point in time. It is made up of two sides that must ‘balance’, or be equal to each other. The first side records the business’ assets, which are the things of value under its control. The second side records all outstanding liabilities, including all outstanding debts and other amounts owed and its shareholders’ equity. The shareholders’ equity figure will also include all accumulated profits and losses. Remember, assets are always equal to liabilities plus shareholders’ equity.
To demonstrate an example of a balance sheet in action, we have used Hollywood Bowl’s (LSE:BOWL) results for the year ended 30 September 2018, released on 10 December 2018 (found here).
Assets are divided into two categories. Current assets (assets that are cash, or are expected to be converted into cash, within one year) and non-current assets (assets that cannot or are not expected to be converted into cash within one year). The contents that make up both current and non-current assets will vary depending on the stock that is reporting. However, current assets will often include the following:
–Cash and cash equivalents – these are the most liquid assets and feature instruments such as treasury bills, short-term certificates of deposits, and hard currency. As you can see below, Hollywood Bowl had around £26m in cash and cash equivalents when it calculated its balance sheet.
–Trade and other receivables – Also known as accounts receivable, this is money owed to the company by customers. Hollywood Bowl had around £6.6m of these when posting its balance sheet.
–Inventories – These are goods available for sale, valued at the lower of the cost or the market price. Hollywood Bowl has around £1.2m of these on its balance sheet.
-Other common current assets, not held by Hollywood Bowl, include marketable securities, which are equity and debt securities that are part of a liquid market, and prepaid expenses, which is value that has already been paid.
Meanwhile, non-current assets will often include the following:
–Property, plant, and equipment (PP&E): Also known as ‘fixed assets’, these are long-term assets vital to business operations that a firm cannot quickly convert into cash. This area can include things like land, facilities, machinery, office equipment, vehicles, furniture, and fixtures. As their value can increase or decrease over time, PP&E assets must be routinely updated.
The value of PP&E relative to total assets is likely to vary significantly between businesses in different sectors. For example, the long-term assets owned by an airline will likely be higher than those held by a consulting company, where staff will mostly operate on computers in a leased office. As you can see, PP&E assets are relatively significant for Hollywood Bowl, coming in at around £41.1m.
–Intangible assets – These are assets that do not physically exist but have value due to cash generated by them or identifiable unimpaired capital sums invested into them. They can include things like goodwill (the difference between the value of the physical assets purchased and the price paid for them), brand recognition and intellectual property (patents, trademarks, and copyright). As an enterprise that relies heavily on branding, Hollywood Bowl’s intangible assets are very significant, coming in at nearly £79m.
It is worth noting that the market often applies a significant discount to intangible assets in a company’s share price, and can even assign no value to them at all. Although it is worth acknowledging a company’s intangible assets, it often pays not to include these when attempting to estimate what a firm’s quoted market capitalisation might be when measured against its balance sheet value.
-Although not present on Hollywood Bowl’s balance sheet, non-current assets also can include long-term investments. These are investments that a business will not touch, such as bonds invested as part of a portfolio.
As with assets, firms separate liabilities into those that are due within one year (current liabilities) and those that are due at any point afterwards (non-current liabilities). Once again, these will vary greatly depending on what type of stock is reporting. It is also important to remember that some debts will be ‘off-balance sheet’ and will not appear. These can include things like operating leases and details will be found in a company’s full annual report. Common current liabilities include:
-Trade and other payables– Also known as ‘accounts payable’. Perhaps obviously, this is the opposite of trade and other receivables in the asset segment of the balance sheet. It refers to goods and services that a company has received from suppliers but for which they have not paid. These make up the bulk of Hollywood Bowl’s current liabilities, at around £16.6m.
-Loans and borrowing – Again, a pretty obvious one also classified as ‘short-term loans payable’ in some cases. The category refers to loans that require payment in less than one year. Hollywood Bowls has around £1.4m of these on its balance sheet.
-Corporation tax payable– This quite simply the money the business owes to the tax office, which, in the UK, would be HM Revenue & Customers. Hollywood Bowls has incurred c.£2.8m of corporate tax.
-Other common current liabilities that have not been incurred by Hollywood Bowl are interest payable, rent, tax, and utilities, wages payable, customer prepayments, and dividends payable.
Meanwhile, common non-current liabilities include:
-Deferred tax liabilities– Generally speaking, these are taxes that have been accrued but will not are not due for another year. These are often used to reconcile differences between the financial reporting year and the tax year. Hollywood Bowl currently has just £487,000 worth of deferred tax liabilities on its balance sheet.
-Loans and borrowing– These are loans that companies do not need to repay within the next 12 months. They make up Hollywood Bowl’s largest non-current liability at c.£26.8m.
–Accruals and provisions – Accrued liabilities are expenses that a business has incurred but has not yet paid. They can either be short-term or, as in the case of Hollywood Bowl, long-term. These expenses can include pension obligations, interest expenses, and wages.
-Other liabilities that are not present on Hollywood Bowls’s balance sheet include deferred compensation, deferred revenues (where a customer has paid for goods or services not yet received), and derivatives. Finally, in some cases, debt that is due within 12 months may, in some cases, be reported as a non-current liability if there is an intent to refinance this debt.
Shareholders’ equity can be an extremely helpful indicator in helping to value a stock. When you subtract liabilities from the assets, anything left over belongs to a enterprise’s owners and shareholders. This is also known as net assets. In addition to net assets (or net liabilities if there are more liabilities than assets) are the profits accumulated over the years along with money put into the company through issue capital. (e.g. through placings) Much of this value is to be found in the company ’s share premium accounts (representing sums raised at above the nominal value of a company’s shares as the company has progressed). As can be seen in the image below, firms divide this segment into several areas.
–Retained earnings, by far the biggest component in Hollywood Bowl’s balance sheet, are the net earnings a company either reinvests or uses to pay off its debts.
–Share capital – This is the total amount of funds raised by a firm in exchange for share of either common or preferred shares of stock. It only accounts for the amount initially paid by shareholders. It does not reflect any gain or loss made when reselling on the secondary market.
How do you interpret a balance sheet?
There are many ways a balance sheet can be used to analyse a business, some far too technical for this piece. Here we will look at three simple, common calculations that any investor can use to assess a stock’s financial health:
Debt to equity ratio
As we have described, assets are funded either by creditors in the form of loans and other liabilities or from shareholders through share capital and retained profits. The ratio between the two sources is critical because debts can always be called in by a creditor while shareholder equity is ongoing.
The debt to equity ratio is calculated by dividing total liabilities by total shareholder funds. So, Hollywood Bowl’s ratio would be £58,646/£94,938 = 0.62, often expressed at 62pc. There is no correct level because different types of business will require different amounts of debt relative to their equity. However, a company with a high number is considered more ‘geared’ or ‘highly leveraged’ than one with a low number. In elementary terms, they can be considered riskier.
Having a high debt to equity ratio is not necessarily a bad thing. If the value of an asset increases, then a highly geared business will enjoy a higher return on their equity as the value of their loan will not increase in line with this growth. That said, it can work both ways. If the value of the asset decreases to below the size of the loan taken out to pay for it, then a business risks losing equity.
With this in mind, Tom Stevenson, investment director at Fidelity Worldwide Investment, advises investors using the D/E ratio to ask if a firm is vulnerable to an economic downturn before injecting their cash. He adds that it is worth looking at whether an enterprise’s revenues are predictable or protected by substantial barriers to entry. They should also look into how quickly a company will need to repay debt, how much cash it is generating, and whether it enjoys fixed interest rates.
This a straightforward measure of a business’s ability to cope in a worst-case scenario where it is forced to pay all of its short-term obligations in one go. It divides the firm’s current assets by its current liabilities, with a figure greater than one suggesting it would not have to go to the bank for more financing. In the case of Hollywood Bowl, the ratio comes in at 1.62 (£33,859/£20,846), suggesting the company is well prepared to pay off all its current liabilities in one go.
Return on Equity (ROE)
Finally, this is a measure of how hard a company is working its assets. It should earn an acceptable return on its assets, or, at the very least, make more from its investment capital than its cost through interest and dividends. It is worked out by dividing net income (found on a firm’s income statement) by total shareholders’ equity. In the case of Hollywood Bowl, this would be £18,784/£94,938 = 19.7pc.
Once again, it is difficult to compare return on equity figures for businesses operating in different sectors. To give this percentage meaning, then, it is worth putting it up against historical ROE, to see if things are improving over time. It should also be compared to names with a similar business model to get a better sense of how a firm is performing within its peer group. Finally, it should be put up against risk-free returns. There is little point investing in a business that is returning little more, or even less, than that offered by a deposit account.
A final tip for AIM stocks
For investors on the London Stock Exchange’s Alternative Investment Market (AIM), the usefulness of the information above can diminish somewhat, since most of the companies listed here tend to be much smaller and higher risk. As such, they do not tend to make profits nor have they accumulated much in terms of realisable assets. From a pure balance sheet perspective, these companies are, in the main, not “investment grade”.
However, one particular aspect of balance sheet analysis can be extremely helpful in determining a stocks prospects. Since many of the companies on AIM are reliant on issuing shares for cash (via placings) or borrowing monthly to survive, their balance sheets can often reveal how near or far they are to needing to raise money.
To work this out, the investor simply needs to calculate the firm’s net current asset position. This is straightforward to do, by deducting the company’s total current liabilities from its total current assets. If the result is a negative number or a low positive number, then the chances are the firm could be expected to run out of cash within twelve months and will, therefore, need to raise money.