How to pick apart a balance sheet in five minutes

Over the last couple of weeks I've run through my crash course in analysing companies - using the five-year summary and analysts summary, you can click on the links here and here for a reminder.

Today I'm going to finish this three part series by showing you an easy way to tackle balance sheets - even if you don't know anything about accounts.

Again, my aim here is simple. I'd like to point to one of the best shortcuts I know to valuing a company.

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I'll point to the two most important signals to watch out for on a balance sheet. And we'll use the balance sheet to help us gauge whether Sainsbury's (LON:SBRY)could be good for your portfolio.

Don't worry about complicated sounding ratios

A balance sheet can look a bit daunting. If you're not familiar with the balance sheet ratios (things like acid test', ROCE', quick ratio') then don't worry. All these ratios are really only useful if you know what to compare them with. And anyway, ratios and rules of thumb are generally specific to company sectors.

For instance, if you use many of the standard ratios on SBRY, you'd come unstuck - very quickly!

If you look at the popular current ratio' (current assets over current liabilities) you'd probably conclude that SBRY is going bust. Their current liabilities are nearly £2.8bn though they've only got current assets £1.8bn - you'd tell me that they haven't got enough cash to pay the bills!

And then if you use the common ratios on working capital, you get yourself into a right old pickle. That's because the big supermarkets don't operate like most businesses. Most companies need working capital to buy stock. But the supermarkets are different...

Because stock turnover is so high, supermarkets have already sold their goods before they've even paid their suppliers for them - suppliers may not get paid for two, or three months. This is known as negative working capital' - it's great for the supermarkets, but could leave you scratching your head if you're trying to analyse the books.

The two most important signals on a balance sheet

As with the five-year summary - it's really useful to see how the business is progressing over time. So I take a close look at the last 3 years balance sheets to see what's going on.

Look out for two things. First look for any major changes in the figures. Have current liabilities suddenly shot up? That's like running up an overdraft - so watch out. Have fixed assets (things like property and plant) gone down? That may indicate that our infrastructure isn't receiving enough investment.

Most of the balance sheet items will be explained in detail in the notes to the accounts.' If you see something suspect, then look up the note to see what's going on.

The second thing to look out for are any significant figures. There's no point wasting time investigating all the trifling stuff; it's usually the big items that count (more on this below).

So, first we're looking for major changes. And 2009 (the middle column) stands out like a sore thumb.

In 2009 nearly £600m of shareholder funds (the bottom line) got wiped out! That's nasty. You'll notice that liabilities shot up nearly £500m while assets actually fell - this is not a happy situation. It needs investigating.

And looking back at the 2009 accounts, you'll see that most of this was down to one item - and it's something you can't ignore these days... defined pension schemes.

March 2009 (when the accounts were produced) marked the bottom of the market as the financial tsunami hit. SBRY pension scheme moved from a £366m surplus in '08 to a £222m deficit. And in the latest accounts, the pension scheme is in an even worse state - it's £303m in deficit.

Clearly there's a problem here - but remember, these accounts are nearly a year old now. And in the past year, the markets have had a pretty good run. I want to see that deficit reduced by the time I see the next set of accounts. It's definitely something we should be keeping an eye on.

It's the big figures that matter

Of our £10.8bn assets, fixed assets make up £8.2bn and that's massive. It probably doesn't surprise you though, as SBRY has loads of money tied up in property. And because this is such a large figure, we need to know a bit more about it.

When it comes to accounting for property, there's a critical fact you need to know. A company can either value its property at the price it cost them to acquire it, or they can revalue property as prices move up and down with the market. As you can imagine, this makes a massive difference...

SBRY tells us that their property portfolio is worth some £9.8bn, but when you look at the accounts, fixed assets (and that includes the rest of SBRY's infrastructure) show up as a only £8.2bn. Clearly we've got some hidden off balance sheet' value which isn't identified because SBRY don' regularly revalue property. It just sits on the balance sheet at whatever it cost to acquire it.

This is another reason why you can't just plug balance sheet figures into a ratio and expect it to be meaningful - in this case our fixed assets are understated by nearly £2bn.

This £2bn kind of puts the pension deficit of £303m in context.

Keep on digging

Overall the latest balance sheet made up to March 2010 looks much improved on the previous year. Current creditors (short term) have fallen from £2,919m to £2,793m, while current assets have increased from £1,591m to £1,853.

Shareholder funds were up by nearly £600m despite the pension fund moving into a bigger deficit.

With all those juicy property assets, SBRY seems to be in a pretty healthy position. And more importantly, the balance sheet is on the mend after a terrible 2009.

I'm happy to say that there are no immediate threats to the business. If anything there's hidden value in the property portfolio that could provide a buffer for any nasties - like a further deterioration in the pension scheme deficit.

Now my three part crash course' on company analysis really only covers the bare essentials. The five-year summary, analysts summary and balance sheet are the absolute minimum of things you must look at before investing.

Using this method, you'll get a great understanding of the business, and it'll highlight areas you need to investigate further.