What are the salient features of a balance sheet? Firstly, there are only three places money can come from. Initially, when a business starts, the owners put in their own money and the business borrows money – either from the bank or from suppliers, or both. Later, as the business generates a profit, the owners will take a portion of the profit by way of dividend and leave a portion as retained income (a reserve) to fund the growth of the business.

Similarly, there are essentially only three places money can go to. Initially, obviously, it goes into the bank, but the owners funds and borrowed money is used to purchase those assets the company needs to produce its products or services (the assets we call Fixed Assets) such as plant and equipment, property, office furniture and equipment, motor vehicles and so on. The money is also used to purchase merchandise for resale or to purchase the raw materials required to manufacture its products. As the business operates, the cash is used to fund the manufacturing process or operations and the company also “lends” money to its customers by allowing them time to pay after a sale is made and the goods or services have been delivered. These assets we hope to convert into cash in the short-term and therefore they are called Current Assets.

This picture can be expanded further to include what we call an Income Statement, but should call a Profit and Loss account. The whole picture then looks like this:

I said above that the money coming into the business was used to buy Fixed or Current assets. Well it is also used to pay for expenses. At the same time, the money coming from sales the business makes also provides funding for the business – either to purchase new stock, or to pay for expenses, or to “lend” to debtors. The profit, which is the Income less

Expenses, belongs to the owners, the shareholders in a company, and is their reward for accepting the risk involved in investing in the business. It is also from the profit that the loans are repaid.

A last observation, before taking this further. Initially, if money only comes from loans and owners and is only used to purchase assets then we have a simple equation: A = L + O (Assets equal Loans plus Owners’ Equity). This is the Balance Sheet. Then, as the business operates, the equation expands to become: A + E = L + O + I or, Assets plus Expenses equal (or are funded by) Loans plus Owners Equity plus Income. We show the detail of Income less Expenses as the Income Statement in the Financial Statements. However, these amounts also affect the Balance Sheet and so the net of Income minus Expenses is shown as Retained Income in the Equity portion of the Balance Sheet, as it belongs to the owners.

The reasoning behind this basic bookkeeping lesson is that we need to keep in mind the structure of the balance sheet at all times when we are trying to evaluate balance sheets. Too often, we use ratios or similar evaluation tools without thinking about the underlying structure of the business. This can lead to some really bad decisions – we either accept bad business or we reject good business based on some, often arbitrary, yardstick.

Evaluating a business
When we start to evaluate a business ideally we should firstly get to understand the industry in which the company operates. We need to understand the economic cycle and the business cycle in relation to the economy. For example, businesses such as construction tend to lag the economic cycle as the investment decisions are often made during good economic times but the actual contractual and construction process is long-term and often runs through into times of economic slow down; later, investors are cautious before entering into new contracts, and so a boom is well underway before new construction projects are entered into. We also need to understand the business’s or the sector’s life cycle. The South African cellular telephone industry is a good example. In the early days as the industry developed it was cash hungry as it set out to build networks and to build a customer base, with all those related expenses. Now, with the major infrastructure in place and the market approaching saturation, these business are extremely cash generative. Their businesses are totally different, with substantially different funding needs.

Turning to the analysis of the financial statements, the most important aspect to consider is liquidity. Liquidity represents the businesses ability to pay its immediate obligations – both its loans and its expenses. If a company does not have this ability to pay, it does not matter whether its assets exceed its liabilities (it is solvent) or not. There are many stories of companies with substantial assets going into liquidation because they have not been able to convert those assets into cash in time to pay their obligations. Elsewhere the Current and Acid Ratios are discussed. These are the start of this process. However, do not fall into the trap of building rules around these ratios. A company such as Pick n Pay can have a Current Ratio of below 0.9 and an Acid Ratio in the region of 0.4 because it converts its stock of merchandise into cash so quickly it does not have a liquidity problem, even though its ratios would traditionally be considered dangerous. Similarly, if one was evaluating a jewellery retailer, we would expect a Current Ratio to be well over 2, depending on the level of stock and debtors, and the Acid Ratio should be at least 1. Understanding the nature of the business helps us understand the significance of the ratio. A better liquidity ratio to use is the Immediate Solvency Ratio. Here we take all liquid assets (in other words those assets which can easily be converted into cash) and compare them with our current liabilities – those liabilities payable within the next year. Now a ratio of 1:1 makes sense and below this level may be a good indicator of short-term problems. In establishing the liquidity of assets, we may find that some stock is easily convertible into cash while other stock would take months or years to sell (for example I am reliably informed that a 750ml (or quart) bottle of beer is sold, paid for and returned empty well within 72 hours – that makes the beer more liquid [pun intended] than money on 32-day call!). Similarly, the company may have investments in listed companies, which could be easily sold if necessary. This all requires an understanding of the business and its balance sheet.

The next issue to consider is the company’s solvency (the relationship between assets and liabilities) and its funding structure. Again, we need to consider the macro picture. Consider the assets of an IT company compared with a major steel or chemical producer. The IT company will have little by way of fixed assets, whereas the steel or chemical company will have a substantial investment in plant as well as in raw materials, work in progress and finished goods. In order to acquire the assets the manufacturing companies will usually have to make substantial loans, so it will be more highly geared that our IT company. So high gearing for a manufacturer is not a problem (within reason) but would be cause for concern in a service business. We also need to look at the age or maturity of the business. If the plant was acquired many years ago and no new plant has been purchased compared with a newly established or expanding business we would expect to see some interesting differences. The mature business would have low gearing (debt mostly paid back by now), low depreciation charges (assets close to being fully depreciated) but probably high maintenance charges. The company with new plant would be more highly geared and would have a different cost structure. It would also most likely be more efficient.

Here one would look at interest-bearing debt to equity and we would expect this ratio to vary between 60:40 and 40:60 debt: equity. But again, this is not a hard and fast rule and depends on a number of factors. Furthermore, we would be more tolerant of higher gearing in times of low interest rates.

We do need to understand that debt is important and beneficial to shareholders as debt, usually, costs the company less than equity (shareholders require a higher return than banks because they take on more risk). If a company can borrow funds at a cost of, say 12%, and invest in assets producing a return of, say 15%, then the 3% difference goes to creating wealth for the shareholders. Of course, the problem arises when, in a recession, the return on assets is 12% and the cost of debt is 15%! So debt levels need to be watched.

One ratio that I believe is useful here is to consider the Immediate Solvency ratio. In this case one takes the total amount owing by the company – all debt and other amounts payable such as lease commitments – and divide this total debt by the company’s after tax profit (or better still its after tax cash flow) to give an indication as to how many years earnings are committed to debt repayment. Of course, the company can re-finance its debt but this is a useful indicator of ability to pay.

Related to this is to delve into the notes to the financial statements to establish the debt repayment terms. Recently a South African industrial conglomerate was in the news when a journalist noted that most of the company’s debt matured at the same time. The company’s management downplayed this as a problem but now, with the economic downturn, refinancing has proved to be a problem and the company is in the process of selling off assets to reduce its debt.

From a credit perspective, the final element which should be considered is the company’s cash flow. It is easy to make a profit (well, sort of) and I could do this by, for example, offering long credit terms to anyone who walked in the door. My sales would rocket, my profits would soar, my shareholders, at first, would offer me enormous salary increases and then reality would set in. My creditors would demand payment, the revenue authorities would be knocking and I’d still be trying to get my debtors to pay. The third of the financial statements we should consider is the cash flow statement. In very simplistic terms, the cash flow statement explains the difference between the opening and closing bank balances from one year to the next.

The cash flow statement is split into three segments: funds from operations, funds from or utilised in investing activities and funds relating to financing activities. Funds from Operations comprise profits adjusted for non-cash items such as depreciation and capital profits or losses. This “cash” profit is then adjusted by the change in working capital. Working capital is essentially debtors plus stock minus creditors. Any increase in working capital absorbs cash from operations as can be seen if we consider that an increase in debtors means that less cash flows into the company from sales made. This leaves us with the figure “Funds from Operations”.

The next segment of the cash flow statement is Investing Activities. This segment comprises any funds fl owing into the company from the sale of assets or investments; then funds fl owing out of the business are split into two elements – funds used to maintain operations and funds used to expand operations. For credit purposes, the cash fl ow we are concerned about takes the funds from operations and subtracts the expenses used to maintain operations. Depending on the nature (and amount) of the proceeds from sales of assets, we can usually ignore this number in our calculation. This cash flow we have derived is the current free cash flow being generated by the operating assets of the company. It is a far better indicator of the true profitability of the company than the actual profits themselves. It also is a good indicator of the sustainability of the business. Use this when looking at gearing and profitability ratios for a different insight into the business.

For completeness, we should finish the description of the cash flow statement. So far we have: Funds from Operations less (usually) Funds used in Investing Activities. The third segment comprises the Financing Activities of the company. Here we will see any loans repaid, new borrowings and new capital raising. These three segments added or subtracted from each other provide us with a net figure which is the difference between the opening and closing bank balances.

A final comment. Or two. Firstly, the descriptions of the financial statements are, of necessity, simplistic. They are merely designed to give a flavour of what comprises the financial statements. Secondly, for any ratio analysis you need to ensure that you have comparatives and trends, and all the other perspectives noted above. Ratios in isolation are really pretty meaningless.