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Top Ten Most Frequently Asked Questions on how to interpret a
Balance Sheet
1. Under “99 business definitions – accounting
terminology” the alternative of OFF being more important than ON was
given in relation to a balance sheet, was this a joke?
No it was not. Whilst it is probably true
that off-balance sheet financing is not as big a problem as it used
to be and due mainly to the tightening of accounting standards, the
reader of balance sheets must always be on guard to detect new ways
to borrow money and hide it from the eyes of the financial
scrutiniser. Where it exists, off-balance sheet financing allows a
company to borrow and hide this action and therefore for the
borrowings to not affect calculations of indebtedness such as
“gearing” (see later). The motive may be to mislead investors and
remain within debt covenants. The balance sheet interpreter should
study the subject of Special Purpose Vehicles (SPV’s) because their
use can be open to abuse. SPV’s have often been used to manipulate
balance sheets and notably in recent times by Enron.
2. How can I tell from a balance sheet if a company is using
Operating Leases?
The trouble is, you usually cannot and it might be very relevant
to an assessment of the financial state of the company, especially
in circumstances where such leases have been used in preference to
Hire Purchase or a Business Loan as a means of finance. These two
will appear on the balance sheet under either short or long-term
liabilities whereas the operating lease will almost certainly not
appear at all. One way to look for this activity is to scrutinise a
heading such as “Rental of equipment” in the Profit & Loss Account.
If this is a significant figure, operating leases could be in play
and you should ask for details.
3. Will I get a true picture of borrowings and commitments when
Finance Leases are used?
Yes because under the rules of finance leases, the underlying
asset must appear on the balance sheet of the lessee (the party that
uses the asset). Specifically, the amounts due on the lease must be
shown under liabilities and also divided between amounts due within
one year and in later periods.
4. I often hear about gearing. Can you explain exactly what it is
and how it can be measured from the balance sheet?
Gearing (or leverage) measures the extent to which a company is
funded by debt. The measurement of debt is probably the most
important task in interpreting the financial health of a business
and it is why the questions 1 & 2 (above) are given top billing. The
most used definition of gearing (there are others) is “debt divided
by shareholders funds – also known as equity”. It is expressed as a
percentage and as a rule of thumb, a figure of 100% is considered to
be high. In the context of measuring the gearing of a company, debt
includes only borrowings and not other debt such as trade creditors.
On the other side of the equation, it is usual to subtract goodwill
from the value of shareholders’ funds on the basis of it
representing history and not present financial strength. It is
necessary to have regard to the nature of the business in deciding
whether the level of gearing is safe or a risk. For example,
non-cyclical stable businesses (say public utilities) can justify
higher levels than more fickle beasts such as in the leisure sector.
To assess the effect of gearing on a company, look at “interest
cover” that is how many times profit after tax is greater that total
interest charges. Two or three times greater is obviously safer than
just one times.
5. Gearing has been explained, is operational gearing the same
thing?
No. Operational gearing is a feature of fixed costs. If two
companies have the same turnover and the same net profit, the effect
of increased sales on net profit will be determined by the degree to
which costs are variable (move in relation to sales – distribution
costs perhaps) or are fixed (not affected by sales growth – maybe
rent for example). The company with the higher fixed costs will make
more profit with an increase in sales simply because they stay
fixed. Of course the converse is also true, that is lower sales
means less margin over the variables to cover these costs. When
studying the balance sheet, open up the profit & loss account and
study the variable and fixes costs as best you can to assess how a
change in turnover will impact net profit
6. What is meant by the current assets ratio?
One looks at the current assets ratio to determine a company’s
ability to pay those liabilities that have to be paid soon by
liquidating the assets that should yield cash the quickest. It is
found by dividing the current assets by the current liabilities
(refer to “how to read a balance sheet”). Normally, a current asset
ratio of two is considered adequate. If the ratio is less than this
and certainly if it is negative, red lights should be flashing.
7. Can you explain the term “Quick assets ratio”?
We need to go back to the current assets ratio because one
problem with it (depending on the type of business being looked at)
is the inclusion within the current assets of stock. Stock may not be
turn-able into cash in anything like the timescale needed in an
emergency or perhaps only at a big discount. The quick asset ratio
therefore deducts stock from the current assets so it is found by
current assets minus stock divided by the current liabilities. A
quick assets ratio of more than one is usually thought of as ok.
This ratio is also known as the acid test ratio and this is arguably
a better title since it represents the most demanding of all the
commonly used tests of short-term financial stability
8. Aside from the acid test, how else is cash a determinant of
financial strength?
The acid test is intended to gauge liquidity as at the balance
sheet date but there is a measure called “operating cashflow ratio”
that uses cashflow over an accounting period. It is found by
dividing operating cash by current liabilities. If the answer is
less than one it means that the business has generated less cash in
a full year than it needs to pay off its short-term liabilities at
the end of that year. This fact may well signal a need to raise
money and once again a red light should be flashing. Often the
operating cash ratio is used to compare companies across a sector or
to look at changes over time. The reconciliation between cashflow
and profit is always a useful piece of information to study because
it highlights the non-cash elements that made up the profit such as
depreciation and accruals and the cashflow resulting from movements
in working capital as distinct from actual trading in the period.
9. What is the working capital ratio?
It is an indicator of the efficiency of a company’s management
of stocks, debtors and creditors. It is expressed as stocks plus
trade debtors minus trade creditors divided by sales. For example,
if the working capital ratio is 0.3, it means that the business
needs 30p of working capital for every £1 of annual sales.
Therefore, if annual sales increase by £1m then the company will
have to invest £300,000 in working capital to be able to fund this
increase in business. Modern accounting packages express debtors and
creditors in terms of days of elapsed time to pay or be paid, this
is most useful in improving the working capital ratio.
10. Why is dividend cover important?
Here we have another example of prudence or profuseness.
Companies pay out dividends to satisfy their shareholders that in
turn assists the share price that builds the market value of the
company. But, are they paying too much? Is what they are doing safe
and can it be sustained? Dividend cover measures how many times the
profit could have funded the dividend. It is found by the formula
earnings per share divided by dividends per share. There needs to be
a word of warning about the definition of “earnings” in this context
of dividend cover. It will always be expressed after tax but does it
include any one-offs or items outside the normal core activity? Try
to find out before forming a judgement.
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