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Interpreting company reports and accounts

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6. What to look for in the balance sheet

A balance sheet is useful to you for two reasons:

• Used in tandem with the P&L, it helps you refine your analysis of the year's trading
• It provides a fundamental snapshot of the company's financial strength.

Click here for an example of a balance sheet.

1. Balance sheet in tandem with P&L

The recommendations below require you to calculate ratios from the balance sheet. If you don't already know the ratios, either take the tutorial 'Using Ratios to Analyse Companies' first, or look up the definitions in the Glossary.

• How has the return on assets been achieved?
  Check the return on capital employed (ROCE) and sales on capital employed to see whether the profits being made are satisfactory in relation to the capital invested in the business.
  Also check interest cover and gearing to see whether returns have been increased by using a large proportion of borrowed capital.
  Be aware that capital employed is one of the easiest figures for companies to manipulate through depreciation policies.
• How much money is tied up in stock?
  In particular, is stock staying in line with sales, or is stock creeping up? Check the stockturn. Be aware that manufacturing for stock is sometimes used as a device to prop up profits.
• Are trade debtors rising faster than sales?
  Slowness in collecting debts reduces the money available to the business and often conceals a bad debt.
  Check whether the debt collection period is increasing unduly.
• Does the company get reasonable credit from its suppliers?
  If key suppliers are insisting on very tight credit terms (or cash with order) it may be because they know something that you don't. Check the cash-to-cash cycle.

2. Fundamental health check

• Gearing (borrowings as a percentage of shareholders funds)
  If the company is highly geared, its profits are vulnerable to changes in borrowing rates.
  Check gearing, and borrowing as a percentage of shareholders funds. Borrowing of one third of shareholders funds is okay for a normal company.
  For a company in a volatile business (e.g. commodity trading) borrowing should be lower than that; for a company in a stable business (e.g. electricity supply) it can be higher.
• How is borrowing being used?
  Remember that borrowing is only worthwhile if the return on capital employed outstrips the cost of the borrowed money.
• Consider the quality of the assets
  Remember that the gearing ratio is based on asset valuation. If possible check what the assets are and how they have been valued. If most of shareholders funds are deployed in old manufacturing plant which needs overhauling, the true gearing ratio may be both understated and set to rise sharply.
• Liquidity
  Can the company pay its bills? Check the current ratio and the quick ratio.

1. The five main components of a set of report and accounts 2. What to look for in the directors' report 3. What to look for in the P&L 4. Earnings per share (EPS) 5. Price earnings ratio (P/E) 6. What to look for in the balance sheet 7. What to look for in the cash flow statement 8. What to look for in the auditors' report 9. Other information sources 10. Conclusion

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• Accounting for Growth