The clues that tell you whether a company is

worth investing in: How to read a balance sheet

By Tanya Jefferies for Thisismoney.co.uk

I'm new to investing and keen to learn more before making any rookie mistakes.
I have noticed in your stories you mention that investors buying individual shares or
retail bonds would be wise to learn the basics of reading a balance sheet to get an
idea of the financial strength of a business.
Can you explain how to 'read' the figures on a balance sheet - what am I looking out
for, and what criteria do you use to judge the health of a company?

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Business model: Tom Stevenson chose builders merchant Travis Perkins as his test case

Tanya Jefferies, of This is Money, replies: Making sense of a balance sheet is

important when you're deciding whether or not to buy an individual share or a retail
bond. You want to be sure a company you're investing in or lending money to is
financially sound.
We asked Tom Stevenson, investment director at Fidelity Worldwide Investment, to
explain the basics of reading a balance sheet.

HOW THIS IS MONEY CAN HELP

Travis Perkins shares: Latest price and charts

He has also flagged up three key ratios you can work out to help assess the health of
a company in which you're considering making an investment.
Stevenson chose builders merchant Travis Perkins as his test case. You can follow
his analysis by checking out the most recent Travis Perkins annual report, and use
it as a model when running the rule over other companies.

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Balance sheet exercise: Follow Tom Stevenson's analysis using the most recent Travis Perkins annual
report

Tom Stevenson, investment director at Fidelity Worldwide Investment, replies: A

balance sheet is a snapshot, usually on the last day of a companys financial year, of
everything a company owns and how it has paid for it.
As its name suggests, these must always be equal. A companys assets are always the
sum of what its shareholders own (their equity stake in the business) together with
any money the company has borrowed (its liabilities).
A balance sheet can, therefore, be represented like this: Assets = liabilities +
shareholders funds

The assets side of the balance sheet includes: cash, inventories (sometimes called
stocks) and property. It also includes some things that you cant touch like any
difference between the value of assets purchased and the price paid for them this is
called 'goodwill'.
The liabilities on the balance sheet include bank loans, any money owed to the
companys creditors - often other companies that have supplied goods and services
but not yet been paid - and other money set aside to pay for things in the future like
pensions or tax bills.
When you subtract the liabilities from the assets, anything thats left over belongs to
the owners of the company, its shareholders.
These shareholders funds can also be expressed as the amount that shareholders
initially put into the company plus any profits retained at the end of each year of
trading.
What are assets?
Balance sheets usually distinguish between short term assets, usually less than a year
old and called 'current' by accountants, and longer-term assets, called 'non-current'.
These are clearly separated in Travis Perkinss balance sheet.

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What are assets? Balance sheets usually distinguish between short term assets, usually less than a year
old and called 'current', and longer-term assets, called 'non-current' (See p134 of the Travis Perkins
annual report)

Current assets: These include cash and things that can easily and relatively quickly
be converted into cash. In the case of a company like Travis Perkins these are largely
materials held in the companys yards for sale (inventories) and the value of goods
that have already left the premises but not yet been paid for (trade and other
receivables).
Travis Perkins manages its exposure to, for example, changes in interest rates using
financial instruments called derivatives - dont worry about these because they are
very small in the context of the companys balance sheet.
Non-current assets: On Travis Perkinss balance sheet, these are dominated by
goodwill. This is a reflection of the fact that the company has grown over the years
by acquiring other builders merchants such as Wickes, Toolstation and BSS.
When these were bought, the value of the businesses to Travis Perkins was much
more than the stock and buildings from which they operated. The difference appears
in the balance sheet as goodwill.
What are liabilities?
The liabilities on Travis Perkinss balance sheet are also divided between short-term
or current obligations and longer-term ones.

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What are liabilities? The biggest item within the current liabilities of Travis Perkinss balance sheet is
trade and other payables - goods and services received but not yet paid for (See p134 of the annual
report)

Current liabilities: The biggest item within the current liabilities of Travis Perkinss
balance sheet is trade and other payables. These are similar to the trade and other
receivables on the asset side of the ledger.
They refer to goods and services that the company has received from suppliers but
not yet paid for. This section also includes short term loans outstanding and some
provisions for tax bills and other items.
Non-current liabilities: The longer-term obligations for Travis Perkins are mainly
loans that do not need to be repaid within the next 12 months, together with the
present value of money that the company expects to pay out in pensions and tax bills
that it anticipates having to pay more than a year out.

What are shareholders funds?

Everything left over after all the liabilities have been subtracted from Travis
Perkinss assets belongs to its shareholders. The lions share of this is accounted for
by accumulated profits over the years.
The other key contributor to shareholders equity is the money put into the company
by shareholders - issued capital and the share premium account. There are a number
of reserves which have resulted over the years from share issues for acquisitions and
the revaluation of properties.

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Shareholders' funds: Everything left over after all the liabilities have been subtracted from Travis
Perkinss assets belongs to its shareholders

How to read the balance sheet

Just as a doctor can learn a lot about a patient from an X-ray, an investor can get a
sense of a companys health from its balance sheet.
Sometimes its also necessary to combine elements from the balance sheet with
others taken from the other two key statements in an annual report the cash-flow
statement and the income statement (also known as the profit and loss account).
The best way to analyse the financial statements is using some simple ratios:

The debt-to-equity ratio

As we have seen, a companys assets can be sourced in two ways from creditors in
the form of loans and other liabilities and from shareholders in the form of share
capital and retained profits.
The ratio of these two is a key measure of a companys strength because debts can
always be called in by a creditor while shareholders equity is forever.
A company with high levels of debts compared with shareholders funds is said to be
highly 'geared' or highly 'leveraged'.
Many people have experienced this ratio in a personal capacity when they took out a
mortgage to buy a house. A borrower will be able to access funds more cheaply if
they have a big deposit relative to the amount of money they want to borrow.
In balance sheet terms they have a lower debt-equity ratio and lenders consider them
a lower risk as a result. The same is true of companies.
The debt to equity ratio is expressed like this: Debt-to-equity ratio = Total
liabilities/Total shareholders funds
For Travis Perkins the debt-to-equity ratio is 2,044.5m/2,677.7 = 0.76, sometimes
expressed as 76 per cent.
There is no 'correct' level of gearing and the appropriate level will vary from industry
to industry so it is best to compare the debt-equity ratio with comparable companies
in the same sector.
Also a company which has few fixed assets and relatively high levels of goodwill on
the balance sheet, like Travis Perkins, might look highly-geared without this actually
being a problem.
Why does the debt-equity ratio matter? How a company balances the sources of its
funding is a matter of choice. There are advantages to relatively high levels of
borrowings which are well illustrated by returning to the house purchase example
above.

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Check out rivals: There is no 'correct' level of gearing and the appropriate level will vary between
industries - it is best to compare the debt-equity ratio with comparable companies in the same sector

Imagine you put down a deposit of 20,000 and borrow 180,000 to buy a house for
200,000. Now consider what happens when the value of the house rises by 10 per
cent to 220,000.
The amount of debt outstanding is still 180,000 which means that the amount of
equity you own is now 40,000. The house price has risen by 10 per cent but the
slice which you own has doubled in value.
Unfortunately, the same process works in reverse. If the value of the house fell by 10
per cent the value of your equity would be wiped out completely. Gearing or
leverage magnifies returns in both directions.
When deciding the debt-to-equity ratio that is appropriate for any given company
you need to ask a few questions:
Is the company particularly vulnerable to a downturn in the economic cycle?
Are its revenues predictable?
Is it protected by a strong brand or other barriers to entry?
How quickly might the debt have to be repaid?

 Is the company generating lots of cash (to pay the interest on its debt)?
Is the interest rate on that debt fixed or variable (just like with a mortgage)?

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Doing the sums: A company needs to generate an acceptable return on its assets

Return on equity
Another key measure for investors is how hard a company is working the assets at its
disposal. Wherever it has sourced its assets, from borrowings or from shareholders
funds, it needs to generate an acceptable return on those assets.
At the very least it needs to earn more from the capital it has invested than its cost in
the form of interest payments on debts and dividends on equity.
Many investors consider return on equity to be the key determinant of whether or not
a company is worth investing in.
To calculate the return on equity you need to look at both the balance sheet (for the
equity) and the income statement (for the return).

Number crunching: To calculate the return on equity you need to look at both the balance sheet for the
equity and the income statement for the return (the income statement is on p132 of the Travis Perkins
annual report)

The return on equity is then calculated as follows: Return on equity = net

income/total shareholders equity
The relevant number from Travis Perkinss income statement is the profit attributable
to owners of the company - 258.5million in 2014. As we have already seen, the total
shareholders funds are 2,677.7million.
Current ratio: Measures a companys ability to meet its short-term obligations

The return on equity for Travis Perkins in 2014 was, therefore, 258.5/2,677.7 x 100 =
9.7 per cent.
Again there is no 'right' return on equity, so the best thing to do is to compare the
return against:
Risk-free returns - why would you take the risk of investing in a business if it was
returning no more than a deposit account, for example?

 The returns from other similar companies

The returns from the same company in recent years - you should worry if returns
are declining and ask why that might be the case.
In the case of Travis Perkins the return on equity in 2013 was 10.5 per cent, not so
very different from the 2014 ratio.
Current ratio
A quick and easy ratio to measure a companys ability to meet its short-term
obligations is called the current ratio.
It compares a companys current assets - cash and receivables within one year - to
current liabilities like this: Current ratio = current assets/current liabilities
Basically, you are looking for a ratio of more than one, because this shows that in the
unlikely event that a company was obliged to pay all its obligations in one go it could
do so without resort to new loans from the bank.
In the case of Travis Perkins, the current ratio is 1,785.3/1,432.0 = 1.25. Nice and
comfortable