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Why does the balance sheet matter?

The balance sheet is often overlooked by investors who are usually more interested in a company's profit and loss statement for a particular period.  But the balance sheet can provide investors with a good indication of a company's future performance, as what is on the balance sheet will directly influence what is in the profit and loss statement.  In this article John Russell, an investment analyst from Aspect Huntley, provides an insight into what to look for in a balance sheet.

New investors will hear many seasoned investors talking about balance sheet statistics with almost spiritual reverence. At this time of the year, with the June and December balance date companies reporting annual or half yearly profits, the profit and loss (P&L) (now known as the statement of financial performance) receives most of the limelight. And why not? The earnings of a company drive the returns to shareholders in the form of rising stock valuations and those all important dividends so why look at the balance sheet at all.

If you think of the P&L as a scorecard for a big game, the balance sheet is the list of players. The player list, including strengths and weaknesses, are what will drive winning or losing performances and the standard of quality and consistency for the team over extended periods of time. The balance sheet, or what is now known as the statement of financial position, reveals the assets, liabilities and equity of a company at a certain date. It is an important tool in assessing the financial health and consequently the risk inherent in a company.

One of the most focussed on items on the balance sheet is the level of debt. Companies with no debt are usually hailed by investors for displaying a sound financial approach. Why? Because the absence of debt means that the company is able to grow without requiring debt which suggests a good business which generates lots of surplus cash. It also provides the company with financial flexibility to "gear up" or take on debt to fund expansion, make an acquisition or if conditions soured, to borrow some money until business improved.

While this is a strength of a debt-free company, debt by itself is not necessarily a bad thing.

Debt is a cheap source of funding for most companies. The cost of using debt is interest. Interest costs reduce net profit but also reduce the amount of tax payable, adding to the appeal of debt funding. However, debt can grow to levels where it stifles the company's ability to operate freely and effectively. This occurs when a company is unable to finance the debt by paying the interest or meeting repayment timetables.  Defaulting on interest payments could lead to receivers being appointed and possibly to company bankruptcy. By looking at a company's gearing, investors can forewarn themselves of high-debt companies.

Gearing can be calculated a number of ways but the most common is to divide total debt by shareholder's equity. The result is expressed as a percentage. Shareholder's equity equals total equity less outside equity interests, should they exist. To give a more useful measure, subtract the cash holdings from the total debt to give a net debt amount and then divide this number by shareholder's equity to give net gearing. As cash is a liquid asset, it could theoretically be used to pay off the debt at any time, so removing it from the debt gives a more accurate picture of any debt problems the company might face.

As a general rule, gearing under 70% should not cause too much problems. Levels over 70% should also be alright although the company could run into trouble raising money if it wished to make an acquisition or pursue another business opportunity. High debt levels may also limit the ability to pay dividends as surplus cash may be needed to retire debt. Gearing over 70% and definitely over 100% is when debt should be a focus. However, high levels of debt are only a problem if they can not be financed. A company with strong and consistent cashflows, such as a utility, usually operates quite comfortably at net gearing levels often greater than 100%.

John Russell is an investment analyst with Aspect Huntley, more information about the products and services available from Aspect Huntley are available from their website.

© All rights reserved 2004. This article has been prepared by the Aspect Huntley Team and licensed to ASX. The views are those of the author and not necessarily of ASX. This material is educational and it is not intended to constitute financial advice.

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