Understanding Balance Sheets

Foreword from ShareInvestor

This article “Understanding Balance Sheets” by Cai Haoxiang was first published in The Business Times on 17 Jun 2013 and is reproduced in this blog in its entirety.

The balance sheet statement is key to understanding a business and whether it makes for a good investment, writes CAI HAOXIANG

LEARNING how to read, understand and analyse financial statements is critical for novice investors. Through the statements, you can understand a business and also decide if a company is a good investment.

Financial statements comprise three main items: the income statement, the balance sheet and the cash flow statement.

We have previously introduced the income statement. This statement gets the most attention from analysts and investors. It tells you about revenue, which is money brought in from ordinary activities of a business, as well as profit, which is what is left over after accounting for costs.

This week, we focus on the balance sheet. This is an equally important statement that investors should take heed of.

If the income statement tells you how much money the company is making, the balance sheet tells you interesting things about a company’s financial state of affairs.

For example, it shows you how much cash the company has in the bank. It also tells you how much money the company owes other people. These nuggets of information can be used to figure out whether the company is financially sound.

Why is it called the “balance” sheet?

This is because there are two sides to the balance sheet, and both sides must balance each other.

For now, remember this accounting equation: Assets = Liabilities + Equity.

A Personal Analogy

An analogy can help in explaining the concept of the balance sheet.

At the end of every month, you might receive a paycheck telling you how much you earned during the month. The paycheck is akin to the revenue component on your personal income statement.

If you roughly know how much you spent during the month, you can deduct your expenditure from your revenue, to get profit.

The balance sheet is somewhat different from the income statement.

It is also known as the statement of financial position. It is a snapshot of what you own, what you owe, and what you have left over.

What you own is otherwise known as assets. Perhaps the most expensive item you own could be a property, a car, or a laptop. You could also own cash through bank account balances, cash stashed under your mattress, and stocks.

All these items will be classified under assets.

In accounting, what other people have promised to pay you are also classified under assets, even though you might not have received the money yet.

These are known as receivables. For example, you might have sold your comic book collection to your friend for $100. Your friend has no money now but promises to pay you the sum next month. Even though next month has not arrived, accountants include the $100 as part of your assets.

Meanwhile, what you owe is known as liabilities. This refers to what you have borrowed to support your lifestyle. A housing loan, for example, is a liability. If you promised to pay your friend $20 for the Hello Kitty toy she recently got you, but haven’t done so yet, the $20 goes under liabilities too. It is known as a payable.

Let’s say you own $500 of assets and owe $300 of liabilities. What do you have left that’s due to you? To find out, you deduct what you owe from what you own, and get $200.

This is otherwise known as equity.

We tweak the accounting equation to become: Assets – Liabilities = Equity.

Fishing For Data

Let us look at a real life example: ornamental fish seller Qian Hu Corporation. The company is known for its transparency and clear annual reports, so it is a good place to start.

We use Qian Hu’s annual report for the year 2012, which can be found on Singapore Exchange’s “Company Disclosure – Annual/Financial Reports” page, or on Qian Hu’s own website. Go to the “Statements of Financial Position” in the report.

The top half of the page shows Qian Hu’s assets.

Non-current assets refer to assets that cannot be easily sold off and turned into cash. Usually, they are assets that the company does not expect to sell for at least a year.

Hence “property, plant and equipment” are considered non-current assets. When you buy a factory, you usually expect to use the factory for many years.

As Qian Hu explains in its notes to the financial statements, this category includes freehold, leasehold land and buildings, motor vehicles, computers, furniture, office equipment, as well as machinery.

Next, Qian Hu has biological assets classified under both non-current and current assets. Biological assets appear in businesses that engage in farming and cultivation. Here Qian Hu’s non-current biological assets refer to so-called brooder stocks, or the parent stock of dragon fish.

Intangible assets refer to non-physical assets like patents, intellectual property, trademarks, and goodwill. Goodwill is an accounting item that comes about when a company buys a subsidiary for more than it’s worth. Think of it as COV, the cash-over-valuation that is paid for resale flats here. In a takeover, the fair value of the subsidiary’s assets goes into the relevant categories like property, plant and equipment. The excess goes into goodwill under intangible assets.

Subsidiaries refer to companies that Qian Hu controls, that is, owns more than 50 per cent of. Their assets are put into the various relevant categories under the “Group” column. Investors should typically look at the “Group” column for an overall picture of the wealth of the company and all its subsidiaries.

Associates refer to companies that Qian Hu does not control but which it has a significant stake in.

Note that group non-current assets decreased to $20.8 million in 2012, down from $45.2 million in 2011. This was due to the sale of Kim Kang Aquaculture, a Malaysian dragon fish breeder. Qian Hu sold it because an oversupply of mass market dragon fish in Malaysia was causing the breeder to lose money, and Qian Hu wanted to focus on distributing fish instead of breeding them.

Current Assets

Moving down the balance sheet, we come to current assets, or assets that the company expects to trade or hold on a short-term basis that is less than a year. This includes some biological assets which Qian Hu classifies as breeder stocks, held for two to three months before they are put up for sale.

Inventories can refer to goods in various stages of production: raw materials, work-in-progress, or finished products ready to be sold to customers.

Inventories can form a significant part of companies’ balance sheets, so investors should track how they are valued and how they change. If some costs that should be expensed are hidden in inventory costs, the company could be overstating its profits.

Qian Hu’s trade and other receivables was the only item on the asset side that saw an increase in 2012. The company said this was due to higher credit sales in the last three months of 2012. When customers are given more time to pay, it can mean that the company is trying to stay competitive by giving customers more lenient payment terms. A sharp spike in receivables (which is not the case here) can also raise question marks about whether some of that could be bad debt.

Finally, on the asset side, we see that Qian Hu has $8.3 million of cash and cash equivalents. Maintaining some level of cash is important because the company needs to have liquidity to pay suppliers and workers. But too much cash is not a good sign, because it signals that the company does not know how to invest it for better returns, and should just return it to shareholders if it lacks ideas.

This was a criticism levelled at iPhone maker Apple, which had US$145 billion in cash at end-March and recently decided to return more to shareholders by increasing its dividend payouts and buying back its stock.

Liabilities And Equity

On the liabilities side, we see that Qian Hu has a lot more short-term than long-term liabilities.

This includes $13 million of current liabilities, mostly comprising $12 million of Singapore dollar short-term, unsecured loans and some bills payable to banks.

Qian Hu also has some short-term and long-term finance lease liabilities classified under current and non-current liabilities. This is a way which Qian Hu pays for the use of assets.

Deferred tax liabilities occur when the company is supposed to pay more based on accounting measures compared to what it is actually charged under tax laws. We see that Qian Hu could pay $410,000 more income tax in the future. Current tax payable, meanwhile, refers to taxes due within a year.

Assets are balanced out by liabilities and equity in the balance sheet. The two sides have to add up to the same number. Here, we see that after deducting $24 million of liabilities from $78 million of assets, we are left with $54 million of equity.

Qian Hu’s equity is made up of $31 million of share capital, or the amount of money that owners of Qian Hu have contributed, and $22 million of reserves, which consists mostly of accumulated profits. There is also $1.6 million of non-controlling interests, which is Qian Hu’s ownership stake in companies which it does not control.

It is tempting to treat a company’s equity as what it should be worth on the market. But remember that some assets can be measured at cost while others are measured at market value. Some things, like the power of a brand or talented management who can generate a lot of cash in the future, are also not included on the balance sheet.

At A Glance

Nevertheless, one look at the balance sheet, and the investor should be able to make a couple of rapid analytical calculations in the head.

First, check if current assets cover current liabilities. Here, what Qian Hu owns that can be converted to cash in the short-term is enough to cover what it owes others in the short-term by more than two times. This is known as current ratio calculation.

Second, see if total debt is relatively low as a percentage of the company’s equity, in a debt-to-equity ratio calculation. We see that Qian Hu’s short- and long-term financial liabilities add up to around $13 million, which is about a quarter of its total equity of $54 million. This means that the company can well afford to pay off creditors.