CLARITY How to Read a Balance Sheet TRUST • INTEGRITY • INDEPENDENCE CA Services for Your Business A Chartered Accountant’s signature is synonymous with objectivity, reliability, and credibility. CAs are proven financial experts. The CA’s signature on an audit report means the CA has examined an organization’s books and has expressed an informed opinion on the fairness of the financial information. It’s important to know that not all financial statements are audited. Many small businesses don’t need an audit. Whether a CA is required to perform an audit or simply a review, those who read financial statements and the accompanying communications should note the accountant’s professional status. Readers can expect the highest standards of competency and professionalism from a Chartered Accountant. CAs are proven financial and management experts, and business advisors. Balance Sheets The balance sheet is a key part of a company’s financial statements, but it alone doesn’t offer a complete picture. The complete picture comes from looking at all aspects of the financial statements, including the balance sheet; income statement; statement of cash flows; notes; and management’s discussion and analysis (MD&A). Usually financial statements are produced one to four months after the end of the financial period, so bear in mind that this information is historical. The financial statements indicate how a company is being managed, whether it is profitable, and if it can become or continue to be profitable. You need the information found in financial statements to calculate the key ratios that will allow you to make informed investment decisions. The balance sheet is a snapshot of the company’s assets, liabilities, and equity at a given point in time. In a nutshell, the balance sheet tells you what a company owes and what it owns. Reading a balance sheet may seem confusing at first, but understanding all of the terms will remove the mystery and allow you to begin evaluating a company’s health. When you look at a balance sheet, you’ll notice that assets are listed on one side and liabilities and shareholder equity are listed on the other. This basic format is used for all balance sheets. That’s why it’s called a balance sheet— because it balances. Assets - Liabilities = Equity Key Parts of a Balance Sheet ASSETS are anything a company owns or is owed. Current assets are the most liquid of assets and can be easily converted into cash in a short amount of time (usually less than one year). Current assets include cash, marketable securities, receivables, inventory, and prepaid expenses. They are valued at the lesser of their current value or their original cost. Property, plant, and equipment are items the company uses to produce its product or service. They’re listed separately from current assets because the company does not intend for them to be sold. They are generally valued at their original cost, rather than their current value. Property, plant, and equipment assets are long-term and are depreciated each year based on their original cost. Other assets account for items that don’t fit into either of the above categories. Often these include capitalized leases and interest, deferred charges, and intangible assets (items that generally can’t be sold and used to pay debts, but that still have value to the company). LIABILITIES are debts the company owes. Current liabilities are debts that will be paid off in one year or less, and are incurred in the day-to-day running of a company’s operations. These include accounts payable to suppliers, demand loans, and taxes payable. Long-term debt is what a company usually incurs to purchase long-term assets such as a premises or equipment. This usually comes in the form of bank loans, mortgages, debentures, or promissory notes. Long-term debt also differs from current debt because it is due sometime in the future, but not in the current year. Shareholder equity is the final item on the balance sheet and consists of the company’s assets minus its liabilities. Shareholder’s equity shows how much value shareholders have in the company. Shareholder’s equity is only noted for companies that issue shares. In organizations without share capital, shareholder equity is simply referred to as equity. Sample balance sheet XYZ Company ($ millions) ASSETS Current assets $ 2.1 Property, plant, and equipment $57.8 Other assets $ 5.2 Total assets $65.1 LIABILITIES Current liabilities $ 5.3 Long-term debt $24.1 Shareholder equity $35.7 Total liabilities and shareholder equity $65.1 COMMITMENTS AND CONTINGENCIES You might also find commitments and contingencies noted on the balance sheet without a dollar value. These represent liabilities that will or might be incurred by the company in the future. This is important information for investors who are trying to assess a company’s future viability. Analysing the Balance Sheet By analysing the balance sheet you can assess a company’s liquidity, how much its leveraged, its return on investment, and more. The balance sheet can answer questions like: • Is the company solid? Can it pay its bills today and in the future? • Is it making the kind of returns it should? • What kind of return can you expect from investing in this company? To get answers to these questions you need to calculate ratios. When you’re deciding to invest in a company or assessing a company’s health, determining these ratios can be very helpful. But don’t just calculate them for one year—get data from previous years and compare your findings. These comparisons will help you determine if the company is consistent, growing, or declining. And don’t forget to compare the company with others in the same industry. This will help you measure the company’s success more accurately. Liquidity The liquidity of a company is how much in readily realisable assets the company has on hand after paying its current liabilities. Performing this calculation is a good way to figure out whether or not the company will be able to cover its short-term obligations. The way to figure this out is to look at the company’s current ratio: Current ratio = Current assets Current liabilities To make sense of the current ratio you must compare it to the ratios of other companies in the same industry. If the ratio is lower than the average, the company may be having liquidity problems. But you don’t want the ratio to be much higher than the average either, because this could mean the company isn’t using its liquidity to grow. Generally a company with a ratio of 1.5 or better is in good shape from a liquidity standpoint. Leverage Another important factor to examine is how “leveraged” the company is—in other words, how much debt does it have? Leverage ratio = Long-term debt Shareholder’s equity The higher the leverage number the more risky the company’s situation. You can’t expect a company to have no debt, but too much debt puts a company at risk for bankruptcy. Return on Investment Return on investment (ROI) = Net income Shareholder’s equity Return on investment measures how much money the company is making for investors. High-growth companies will have high ROI values. If the ROI value is 10%, that means that for every dollar invested the company is making $0.10 in new assets. Bringing it all Together As you can see, the balance sheet contains a great deal of valuable information and can give you tools to better understand a company’s financial situation. But remember: don’t just read the balance sheet. Review the other parts of a company’s financial statements and perform additional analyses to make truly informed investment decisions. For more information on financial statements and help making financial decisions, contact your local Chartered Accountant. The Institute of Chartered Accountants of British Columbia is the self-regulating professional body for all Chartered Accountants in the province. One of the Institute’s prime mandates is to protect the public interest. As members of the Institute, Chartered Accountants adhere to a strictly enforced code of conduct and ongoing professional development. The CA designation is your assurance of credible and expert financial, business, and management advisory services. For more information on Chartered Accountants or for a free referral to a Chartered Accountant in your area, call 604-681-3264 in the Lower Mainland or toll free at 1-800-663-2677. www.ica.bc.ca