The balance sheet is one of the key financial statements for investors to focus on when conducting financial analysis for potentially investable companies. In simple terms, a company’s balance sheet lists what it owns and owes. The balance sheet is also known as the statement of financial position because it shows the company’s net worth at a point in time.
There are three main parts to the balance sheet of a company: assets, liabilities and equity. The relationship between these three elements can be summarised by the following formula: Assets – Liabilities = Equity.
Generally, the balance sheet is examined by investors to assess the financial safety of a company. The type of debt, financial health ratios and balance sheet valuation are three main areas investors could look at when doing the assessment.
Debt, which is part of a company’s liabilities, can give a good indication of its financial health. Investors should look out for two main types of debt — fixed-rate debt and floating-rate debt — when assessing the liability portion of the balance sheet.
The type of debt determines the level of risk, based on the composition of fixed-rate debt and floating-rate debt. This is especially important when the company’s debt levels are high. Floating-rate or variable-rate debt or liabilities are much riskier than fixed-rate debt or liabilities because the interest rates could move in an unfavourable direction, which deteriorates the company’s financial health. The higher the proportion of variable or floating-rate debt, the more uncertain the impact on the balance sheet. Investors can check the notes to the financial statements to assess the breakdown of debt or interest-bearing liabilities, if available.
Investors should also scrutinise the financial health and safety ratios. There are two main ratios: liquidity and solvency ratios. Liquidity ratios reflect the company’s ability to meet short-term financial obligations or debt that is usually due in less than a year. Solvency ratios indicate the company’s ability to settle long-term financial obligations or debt that is usually due in longer than a year, and also the company’s ability to remain as a going concern.
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The current ratio is one of the most commonly used liquidity ratios, and it measures the company’s abilities to settle its current liabilities with its current assets. A ratio of 1 or higher usually indicates that the company has good liquidity. A more stringent liquidity ratio is the cash ratio, which is the company’s ability to settle its current liabilities with only its cash and cash equivalents. Similar to the current ratio, a higher ratio is better, and a ratio of 1 or higher generally indicates superior liquidity. Table 1 shows SGX-listed companies with the best liquidity.
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Solvency ratios of a company can be represented using gearing ratios and the interest coverage ratio. The debt-to-equity ratio or net debt-to-equity ratio are examples of gearing ratios, and reflect the company’s financial leverage. When it comes to financial safety, the lower the ratio, the better. If a company is net cash, which is when it has more cash than debt, it indicates sound solvency. The interest coverage ratio shows the company’s ability to settle interest payments on its debt, using its operating income. Generally, a ratio of 2 or more is a good benchmark for a company’s interest cover. Table 2 shows SGX-listed companies with the highest net-debt-to-equity ratio.
The balance sheet valuation can be used to determine the financial safety of investing in a company. The net asset value or book value represents the total assets of a company minus its total liabilities. A price-to-book or P/B ratio of less than 1 generally indicates that the company has strong financial safety. A ratio of less than 1 implies that if a company were to wind up, investors would receive more than what they paid for, since the share price is lower than the net assets per share of the company. A more conservative way to compute this ratio is to discount the value of assets, where the less liquid the asset, the higher the discount. If the P/B ratio is still less than 1 even after discounting, then the investment risk is low for the investor. Table 3 shows SGX-listed companies with the lowest P/B ratios.
Essentially, these three areas should aid investors in assessing the financial health aspect of a potentially investable company. Investors should note that just because a company has solid financial health, it doesn’t mean that it is a good or suitable investment. This is because other elements and factors such as profitability and future prospects, for example, are not emphasised in these areas of analysis. Assessing the financial safety of a company is key in minimising risk to investors, and ought to be practised by investors seeking to be financially savvy.
