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INVESTMENT CLINIC: I want to start a stocks and shares Isa – should I rush to beat the tax year end? Beat cash Isa deadline with top fixed deal at 1. The clues that tell you whether a company is worth investing in: How to read a balance sheet By Tanya Jefferies for Thisismoney. 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? 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. What should you know before buying a fund?
Please help me decode gibberish fund names! How many funds should you invest in? 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. A balance sheet is a snapshot, usually on the last day of a company’s financial year, of everything a company owns and how it has paid for it. As its name suggests, these must always be equal.
The liabilities on the balance sheet include bank loans, any money owed to the company’s 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 that’s 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. 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 Perkins’s balance sheet. These include cash and things that can easily and relatively quickly be converted into cash.
Travis Perkins manages its exposure to, for example, changes in interest rates using financial instruments called derivatives – don’t worry about these because they are very small in the context of the company’s balance sheet. On Travis Perkins’s 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. The liabilities on Travis Perkins’s balance sheet are also divided between short-term or current obligations and longer-term ones.
The biggest item within the current liabilities of Travis Perkins’s 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. 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. Everything left over after all the liabilities have been subtracted from Travis Perkins’s assets belongs to its shareholders. The lion’s 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. Just as a doctor can learn a lot about a patient from an X-ray, an investor can get a sense of a company’s health from its balance sheet. The ratio of these two is a key measure of a company’s 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. 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. The house price has risen by 10 per cent but the slice which you own has doubled in value.