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How To Analyse Financial Statements: The Balance Sheet

money Lately, we’ve been answering a host of investing-related questions posed by our readers in our ‘Ask A Foolish Question’ series. A bunch of those we’ve received pertain to the question of how to go about analysing financial statements.

Those are great questions – and important ones as well. At the Motley Fool Singapore, we aim to be part-owners of businesses and to understand them, we need to understand their numbers. That’s where knowledge of financial statements comes into play.

Every company has three financial statements: the balance sheet, the income statement, and the cash flow statement.

In this series of articles, we’ll cover all three financial statements in three separate articles. Let’s get started here with the balance sheet.

The balance sheet

The balance sheet is the core of the financial statements: all other statements either feed into or are derived from the balance sheet.

It is a snapshot in time, much like a ‘photograph’ that captures the financial condition of a company at a particular instant.

The fundamental and all-important equation that governs a balance sheet is:

Assets = Liabilities + Equity

It should be noted that the relationship described above would always hold true. Looking at a company’s balance sheet tells us what it owns (assets) and the source of funding (liabilities or equity) that enabled it to own what it does.

What a company owns…

Generally, assets are broken down into two major categories: current assets and non-current assets. The former consists of assets that are either cash (as well as its close equivalents) or will very likely be converted into cash within a year, such as inventory and trade receivables.

Meanwhile, non-current assets can be understood to mainly consist of assets that are needed by the company to run its business over the long-term, such as properties, factories, and manufacturing equipment etc.

In the case of Singapore’s flagship carrier, Singapore Airlines (SGX: C6L), it’s pretty clear that airplanes are a crucial asset it needs in order to run its main business of flying passengers and cargo around the globe. And, these airplanes are used for years.

So, from SIA’s latest financials (for the first quarter of its financial year 2013/2014), we can see that it has an asset on its balance sheet that’s named “Aircraft, spares and spare engines” with a monetary value of S$10.47b that’s grouped under its non-current assets.

… And what it owes

Moving on, liabilities that are found on the balance sheet can be understood as obligations that a company has to meet. Similar to how assets are broken down into two categories, liabilities are also split into current liabilities and non-current liabilities, with the difference between the two being the time-frame at which the obligations must be fulfilled. The former will have to be met within a year starting from the reporting date while the latter comes due more than a year later.

Some current liabilities can include loans that are due within the next 12 months as well as bills that have to be paid to suppliers. As for non-current liabilities, common types would include loans that mature more than a year later from the date on which the balance sheet is compiled.

If we take a look at commodity trader Olam’s (SGX: O32) latest financials (for the 12 months ended 30 June 2013), under its current liabilities there are the liabilities named “Borrowings” and “Trade payables and accruals” among others. They have a monetary value of S$1.75b and S$2.97b respectively, meaning Olam has to cough up a total of S$4.72b in cash to meet these two liabilities within the 12 months ending on 30 June 2014.

And, under the company’s non-current liabilities, there’s also another liability named “Borrowings” worth S$5.882b. These are loans that Olam will have to repay starting from at least a year after 30 June 2013.

… And what belongs to us, shareholders

Finally, we come to the equity portion of the balance sheet. The simplest way to look at equity would be to think of it as what’s ‘left over’ for shareholders of a company after it has used up its assets to meet all its financial obligations (remember the all-important equation mentioned earlier?).

Generally, this equity portion is built up over the years from the profits that are not distributed as dividends, in addition to capital that a company has taken in from the sale of its shares (through IPOs, private placements, rights issues etc.), among other means.

Sometimes, part of the equity reported by companies includes those of minority interests that do not accrue to shareholders, so it’s something to take note of.

For example, marine engineering firm Sembcorp Marine’s (SGX: S51) financials for the second quarter of 2013 showed that it had “Total equity” of S$2.58b, of which S$110m belongs to “Non-controlling interests”. So, shareholders of the company are left with equity of S$2.47b.

Making sense of it all

Now, as investors, we want to scrutinise the balance sheet because it gives us crucial information about the financial health of a company; a company with negative equity would mean it has more financial obligations than it can manage to meet and would very likely go bankrupt. That’s not the kind of investment we want to be in.

Some back-of-the-envelope checks we can use to analyse the health of a company’s balance sheet includes: the current ratio; the quick ratio; and the debt-to-equity ratio.

The current ratio tests the ability of a company to meet its short-term liabilities. It’s given by dividing current assets by current liabilities and generally, a ratio above one indicates that a company is capable of paying off its short-term financial obligations.

Meanwhile, the quick ratio is an even more stringent test of a company’s ability to pay-off its short-term obligations. Mathematically, it’s given as:

Quick Ratio = (Current Assets – Inventory) / Current Liabilities

The last ratio we’ll be taking a look at is the debt-to-equity ratio, which is taken as total liabilities divided by total equity. Ideally, we’ll want to see a debt-to-equity ratio that’s below 1, which indicates management’s prudence in managing their company’ finances.

As an example, the table below showcases the relevant figures from commodities company Wilmar’s (SGX: F34) balance sheet for the second quarter of 2013:

Current Assets US$25.75b
Inventory US$6.83b
Current Liabilities US$24.41b
Total Liabilities US$29.18b
Total Equity US$15.40b
Current Ratio 1.05
Quick Ratio 0.775
Debt-to-Equity Ratio 1.89

It’s important to note that these ratios can’t be studied in isolation. We always have to keep a look out on how they have evolved over time and how a company’s various figures compares with its peers. Has it been improving or worsening? Does it have a stronger balance sheet than most other companies? These are the real questions we want to answer.

Foolish Bottom Line

What’ve we given here is useful in giving ourselves a head start in understanding financial statements. But truth be told, financial statement analysis itself entails a wide breadth of knowledge and is definitely not something that can be easily covered in its entirety in an article or two.

It would definitely serve an investor well to continue digging in further.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.