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These simple concepts will help you decode company accounts.
By Owen Richards, AIA
Every listed company is legally required to produce an annual report, a stylised document essentially in two parts. The first is descriptive, giving the required information on what the company does, who its directors are and how it has performed. The second part is a set of accounts. These are a profit-and-loss account (formal title, The Statement of Financial Performance), a balance sheet (The Statement of Financial Position), cash flow statement and, often, notes on the accounts. This should provide all interested parties with an honest and accurate picture of the financial health or otherwise of the company.
One of the oldest sayings in financial circles is, “figures don’t lie but liars can figure”. This does not suggest all reports should be treated with suspicion, but the reader needs to be aware that, at the very least, every company will present itself in the best possible light. Accounting policies can differ and companies have considerable latitude as to how they can interpret them, so a healthy scepticism is sometimes appropriate.
These documents are the most basic elements in providing financial reporting to banks, investors and vendors, and anyone else considering how much input to provide to the company.
The balance sheet
The balance sheet is a formal document that must meet the requirements of company law, the Australian Accounting Standards Board form (which largely mirrors international standards) and ASX listing requirements (for listed companies). The balance sheet is essentially a snapshot in time of a company’s state of affairs, taken at the close of trading on its balance date – June 30 for most Australian companies.
The balance sheet should be in synchrony with the information in the annual report as well as the other accompanying accounts. It is called a balance sheet (in common parlance, rather than its formal title) because it is required to, well, balance. It is in two parts, which must equal or balance each other out. The simple equation behind a balance sheet is:
Assets = Liabilities + Shareholders’ Equity
The balance sheet itself is also set up like the accounting equation. This means that assets, or what the company owns, are on the left-hand side of the sheet. This is balanced by the company’s financial commitments (what the company owes) together with the equity investment brought into the company and any retained earnings. These are shown on the right-hand side of the balance sheet.
Types of assets
Assets are generally listed down the page based on how quickly they can be converted into cash. The first shown are current assets that have a life span of one year or less, which means that they can be converted easily. These include cash, cheques and cash equivalents, accounts receivables and inventory.
Accounts receivables are the short-term obligations owed to the company by its customers. Companies often sell products or services on credit and these commitments are held in the current assets account until they are paid by the clients.
Inventory represents the raw materials, goods in manufacture and finished products. The composition of inventory will vary with the company’s role. A manufacturer, for example, will carry raw materials; a retailer’s inventory will typically consist of goods purchased from manufacturers or wholesalers.
Assets that are not readily turned into cash or have a life span of more than a year are known as non-current assets. They can refer to tangible items such as machinery, computers, buildings and land. Non-current assets can also be intangible but important resources, such as copyright, patents or goodwill. Depreciation is calculated and deducted from most of these assets, which represents the economic cost of the asset over its useful life.
Types of liabilities
On the other side of the balance sheet are the liabilities. These are the financial commitments a company has to outside organisations. Like assets, they can be both current and long-term. Current liabilities are those that will become due, or must be paid, within one year. This will include short-term borrowings, such as accounts payables, along with the current portion of long-term borrowing, such as the latest interest payment on a 10-year loan.
Long-term liabilities are debts and other non-debt financial obligations that are due after a period of at least one year from the date of the balance sheet. You may occasionally see the inclusion of Provisions in either current or long-term liabilities (sometimes both). Provisions are liabilities that allow for events or transactions that have taken place but are not due or payable until a future date.
Shareholders’ equity is initially the amount of money invested into a business. Should the company decide to reinvest its subsequent net earnings after tax back into the company, these retained earnings are transferred onto the balance sheet as shareholders’ equity. This represents a company’s total net worth.
Calculation of ratios
The real worth in reading a balance sheet is often in comparing figures within the balance sheet and calculating the ratios between the various components of a company’s assets and liabilities. These calculations usually involve only some simple arithmetic using a pocket calculator, although this is also known to some as, “torturing the numbers until they confess”. Perhaps the more common ratios from the balance sheet are in calculating gearing as well as liquidity and solvency, although there are considerably more that can be used.
This is also known as the debt-to-equity ratio and is found by dividing the net borrowings (all borrowed money or debt securities) by the (tangible) shareholders’ equity, and expressed as a percentage. The customary rule of thumb is that a company should be somewhere around 50 per cent; half funded by debt and half by equity, although a figure between about 40 and 60 per cent is generally acceptable.
The level varies between types of companies. Financial companies can have higher levels of debt, while mining companies should have relatively low gearing. The gearing relationship should not be significantly higher than a company’s major competitors. High gearing will exaggerate falling profits and highly geared companies may suffer if interest rates rise.
Liquidity and solvency
Liquidity is a company’s ability to meet its short-term obligations, such as its working capital needs and debt obligations. Solvency is a measure of the company’s ability to sustain its activities over a longer period of time.
The current ratio measures liquidity by comparing a company’s current assets to its current liabilities. Current assets are those that can be converted into cash or used up within the current period. Current liabilities are those that have to be paid over the coming year. An acceptable ratio for, say, a small business would be about 2:1 of current assets to liabilities. Clearly, the strength of the ratio as a measure of liquidity will also vary by industry. A large manufacturer’s inventory will be much less liquid than that of a grocery store.
Because inventory can be difficult to turn into cash, another ratio known as the quick (or acid) ratio can measure liquidity. Typically this ratio excludes inventory, leaving just cash and receivables to be divided by current liabilities. These are considered the assets most easily turned into cash. However, some companies, such as retailers, can probably convert their inventory into cash more quickly than others can collect their receivables.
About the author
Owen Richards has been a trader for some years and is a member of the Australian Investors Association, previous editor of its Equities Bulletin and a contributor to local and overseas trading magazines. The AIA is an independent, non-profit organisation aimed at helping its members become more successful long-term investors. It holds regular meetings and seminars, which can be viewed online.
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