Tim Bennett explains what a balance sheet is for, including the type of information it contains, and how you can use it.
In today’s video, we’re going to take a look at balance sheets. Now, in a previous video, we’ve looked at “What is profit?”
A lot of investors look at profit and loss accounts, and as long as profit is rising, they think, “Great. This is a company I want to buy,” but, actually, that can be a mistake. You need to look at the balance sheet as well.
It’s not the most exciting document to read. It’s got a lot of numbers and a lot of jargon in it, but without a balance sheet, you can’t really get a sense for what a business is maybe worth and what its, therefore, long-term prospects are.
This video is all about what balance sheets are for and the very basic types of information you can expect to take away without getting buried in the jargon and the accounting buzzwords.
Where do they fit in?
Well, accounts, basically, can be divided into three important statements.
Buried right in the middle of the 100-page document is a set of accounts: you will find a profit and loss account, a balance sheet and a cash flow statement.
Let’s take a look at those first two.
Every 12 months, the directors will prepare a balance sheet. As such, it represents you freezing the business and taking almost a photograph of where it’s at right now. You will notice the balance sheets are prepared at specific dates. For example, you might have a balance sheet prepared on 31 December for a particular year, say, 2010.
Another popular one is the end of the tax year for companies; so quite often, you will find 31 March 2011, let’s say.
The point is that the directors pick a point in time: the end of a trading year if you’re a retailer, for example, around Christmas-time or the end of the tax year. They’re quite popular, but certainly not the only options. See balance sheets very much as taking a photograph at one point in time.
Now, as such, it’s a slightly artificial exercise. Balance sheets are out of date almost as soon as they’re prepared, because, of course, in reality, businesses don’t just stop. They keep going. Nonetheless, as a quick snapshot of what a business might be worth, balance sheets can be quite useful.
Usually, they’re prepared at 12-month gaps to keep the accountants happy, with a possible interim statement somewhere in between, say, every six months or even every three months.
Now, it’s just worth noting that although we’re going to focus on balance sheets, if this is a 12-month period, a profit and loss account is more of a story. It tells the tale of how the business got from here to there. Hopefully, the answer is by making profits. In other words, the business grew.
Although this video isn’t about profit and loss accounts, see the profit and loss account as more like a cinema-camera capturing everything that’s happened and summarising it between two balance sheet dates. Then, the balance sheet is a photograph.
The language of profit and loss accounts is sales revenues minus costs to give you a profit. It’s a story. Sales will have been made in January, February, March, April, May and so on, costs will have been incurred, and they’re just summarised for each 12-month period.
Really, for a sense of what the business might be worth to an accountant, let’s say, you want the balance sheet; the snapshot.
What is a balance sheet? What makes it difference to this thing: the profit and loss account?
Well, basically, balance sheets are simply quick snapshot statements of net worth.
It sounds very flash. It’s actually very simple.
As Tim Bennett, I could draw up a personal balance sheet. I could start to list, right now, what my assets are, what I own; so, a property, some cash in my pocket and so on.
Then, I’ve got some things like ‘Owe other people’, so my net worth isn’t my property, because I’m forgetting there is a mortgage on it. Actually, if I sold my property tomorrow, all the cash isn’t mine. I’m not going to sell it tomorrow, but if I did, I would have to pay back a mortgage first. Actually, the net bit I own is a bit smaller.
Then, perhaps I remember that I owe my mate £20 from last week down the pub, so I’ve got to think about repaying him at some point. That’s called a liability: an amount that I’ve got to pay back at some point, even if I don’t do it now.
I could start to think about my personal net worth in terms of the assets I own, and some of them will be long-term and short-term, and the amounts that I owe other people. Some of those are short-term and long-term.
My mate’s debt: I’ll pay him back next week. That will be gone in a week, but my mortgage is not going to be gone for 20 years.
Some of my liabilities are short and long-term, too, and my net worth is presumably the difference. That will increase or decrease depending on which day of the week you ask me to do it.
That’s roughly what companies do. A balance sheet is simply a statement, if you like, of what they own minus what they owe other people at, let’s say, at 31 March. The difference is known, not surprisingly, as the net position. Then, at the bottom, the reason they balance is that you answer the question, “How has that net position been funded?”
Balance sheets balance because those two numbers should be the same. In other words, you can’t conjure net worth out of thin air. It would be nice if you could, but no-one I’ve yet met can do it. In other words, somebody has funded that net position.
Maybe I started my whole personal balance sheet as Tim Bennett.
How did I ever go to a bank to afford a property? Perhaps my father gave me some money to get me going, and with that, I put the deposit down on a property. That allowed me to borrow and so on.
Now, companies don’t have friendly dads who give them money. Well, some do, but normally, they have shareholders.
“How has the whole thing been paid for?” is normally called shareholders’ funds.
The balance sheet balances because the company’s net worth is equivalent to what shareholders have put in plus any profits the company has made since it started.
Taking this a step further, companies use jargon at this point to explain what they own, but the jargon shouldn’t put you off.
For example, they’ll break their assets into ‘Fixed’, a slightly confusing term, and ‘Current’.
In other words, just like I did with my personal balance sheet back there, companies own some things long-term. ‘Fixed’ doesn’t mean nailed to the floor. It means stuff we’re going to keep for more than a year from the balance sheet date, so it includes land and buildings, plant and machinery, vehicles and that kind of stuff.
Current assets: short-term assets. The stuff that if you did this exercise in a year’s time is probably all going to be gone or at least have changed to cash.
Stock: stock in the sense of the stuff the companies makes. For example, raw materials and components lying around if it’s a car manufacturer.
Receivables: for example, if you lend someone £100 down the pub and you were to draw up a personal balance sheet, and that would be a little bit of a sad thing to do, they owe you the money in your books. This would be the sad bit: that would be a receivable. If you didn’t think you would receive it all, you would write some of it off.
Companies have things called receivables as well within current assets. These are the accounting headings that you start to see.
Also, companies like to break what they owe to external creditors, so banks, for example, and other lenders, into short-term amounts due in less than one year and long-term amounts, where, realistically, they will be paying it off in more than one year.
For me, an overdraft, for example, is a short-term creditor. It’s an expensive way to fund a business, long-term. It’s an expensive way to fund Tim Bennett, long-term. A personal loan for me, or a ten-year loan for a company, falls into creditors due in more than one year. That’s just a bit of jargon.
Debtors or receivables are current assets. That’s people who owe us money. Creditors are amounts that we owe other people.
Nonetheless, even if you break it down into four numbers, those are positive because they are assets and those are negative because they are liabilities, you still end up with, hopefully, a net asset position.
Now, done here, ‘Funding’, as it’s called, breaks down, broadly speaking, into share capital and profits.
In essence, what we’re saying is, in the past, in order to build the business, the company has probably sold shares to external shareholders. That funding is represented here as share capital. Also, over time, hopefully, the company has been trading profitably. Every 12 months, that profit statement is positive.
If you run a positive profit statement for, say, ten years since you started a business, you will have ten years of accumulated profits, assuming you haven’t paid out dividends, and all of that ultimately belongs to the shareholders of the business.
The shareholders’ contribution sits at the bottom of the balance sheet. This is a simplification, but it’s split, broadly speaking, into amounts the shareholders have put in to fund the business and the accumulated profits that, if the business was liquidated tomorrow, so the theory goes, they would receive.
Now, I’m just going to finish with the reason balance sheets balance. Just to give you a flavour for that, they always balance, and that’s because accountants have a habit of recording everything twice, which forces them to balance.
What that means is that when you look at a balance sheet, that number is the same as that number, or that number is the same as that number.
The reason is simply this: if, for example, I were to borrow £100, as an accountant, I would raise my current assets by £100, cash, and I’d also raise my current liabilities by £100, because I’ve got to pay it back at some point. Net effect: £0.
If I ask my shareholders for some more cash, share capital rises to reflect their contribution by, say, £100, and cash up here rises by £100. That’s up £100, that’s up £100, and the whole thing balances.
This isn’t a bookkeeping course, but because accountants record everything twice, balance sheets always balance. That doesn’t matter too much. What’s more important to realise is that the top half represents net ownership of assets and a snapshot point in time, and the bottom half represents how that’s all been paid for.
Now, as an investor, what are the takeaways from this? Number one: don’t just look at profit and loss accounts. That’s dangerous because a company may make one-off profits one year, but what about the longer-term picture? For that, you need the balance sheet.
The balance sheet is also the place where you will find hidden nasties that are simply not in the profit and loss account. For example, there is a part of the balance sheet called ‘Contingent Liabilities’. It’s written and it’s quite a long way after the balance sheet, and that reveals liabilities, ‘nasties’, in this little section here, that the company hasn’t yet recorded on the balance sheet that might become a problem in the future: lawsuits, for example, outstanding at the balance sheet date.
Also, if you’re looking for “What’s the business worth?”, whilst a balance sheet isn’t fantastic because it’s out of date and it’s prepared according to accounting rules, so assets are often recorded at their historic cost and not always at their current market value, it’s a good starting point.
A profit and loss account will not tell you what a company is worth. It just tells you what one year’s profitability looks like.
A balance sheet is at least a starting point for getting a handle on, essentially, the value of the entire business.