How to read and interpret a balance sheet: a beginner's guide

6–9 minutes

This post is instalment 1/3 of the essential financial statements series.

Balance sheets can be overwhelming and complex, however once you know what you’re looking for they become extremely useful tools due to the insight they provide. A balance sheet is designed to be a magnifying glass for investigative purposes to be utilised by potential shareholders or parties that are intertwined with a business’s performance. It can be an effective revelatory medium through which a business’s prosperity or shortfalls can be exposed.

Balance sheet for George’s Law Updates Capital (GLUC) (a fictional private equity firm)

Assets

Cash	£120,000,000
Accounts Receivables	£15,000,000
Inventory	£0
Property and Equipment	£10,000,000
Investment in Portfolio Companies	£855,000,000
Total Assets	£1,000,000,000

Liabilities

Accounts Payables	£8,000,000
Short-term Loans	£20,000,000
Long-term Debt	£250,000,000
Total Liabilities	£278,000,000

Equity

Share Capital	£100,000,000
Retained Earnings	£622,000,000
Total Equity	£722,000,000

Total Liabilities + Equity

£1,000,000,000

What can we observe from looking at GLUC’s balance sheet?

That GLUC has Strong Liquidity

Substantial sum of cash at £120 million, which suggests that the firm has a lot of liquidity in order to cover its short term obligations. Good liquidity is also important to the firm’s operations in its facilitation of resilience to market erraticism and fluctuations. Similarly, having high liquidity allows GLUC to take advantage of investment opportunities and benefit from early movers advantage to maintain a competitive edge in the highly saturated PE market.

2. That GLUC is Asset Heavy

The firm is invested primarily in portfolio companies, as you would expect from a PE firm; and they have a modest £10 million in property and equipment demonstrating that the firm isn’t capital intensive outside of its investment activity. This has a positive impact on profitability, as the firm will likely have lower fixed costs and thus a larger potential for a positive disparity between their revenue and costs.

3. They have high retained earnings

It can be inferred that the firm’s operations have been successful and financially efficient from their £622 million retained earnings; which demonstrates that they have been able to reinvest significant profit. This would be a positive signpost to potential investors, or parties affected by the firm’s positive performance such as customers and other stakeholders.

What a lawyer would likely take away from reading this balance sheet:

Strong liquidity
Effective investment strategy
Controlled debt
High level of profitability
Good operational efficiency

A breakdown of each component:

ASSETS:

Cash = Money that a company has immediately available, this includes physical currency, bank deposits, unrestricted savings accounts and highly liquid assets. Cash is widely considered to be the most important liquid resource that a company has.

Accounts Receivable = Money owed to a company by its customers for goods or services delivered on credit. It is recorded as a current asset because it is expected that it will be converted to cash in a short period of time. An excessively high amount of receivables can negatively impact liquidity.

Inventory = Goods a company holds for sale, or the raw materials that will be used to produce those goods. Similar to accounts receivable they are listed in the current assets section because they will likely be used up within a year.

Property and Equipment = Long-term tangible assets that a company uses in its operations to generate revenue. They are in the non-current assets category because they will likely provide value over many years rather than being consumed within a year.

Total Assets = The sum of everything a company owns, including both current and non current assets, as long as they have measurable economic value. This is the figure at the bottom of the assets section and it must always equal the combined total of liabilities and equity.

LIABILITIES:

Accounts Payables = The money that a company owes to its suppliers, vendors or service providers for goods and services received but not yet paid for. It is listed under the current liabilities because these obligations are usually due within a year.

Short term Loans = Borrowings that must be repaid within a year, these are also listed under the current liabilities category because they create immediate obligations for the company.

Long term Debt = Borrowings and financial obligations that are due more than one year from the reporting date. These are listed under the non-current liabilities category because the repayment extends further into the future.

Total Liabilities = The sum of all of the company’s financial obligations to external parties; it combines both current liabilities (those due within a year) and non current liabilities (those due after one year).

EQUITY:

Share Capital = The amount of money shareholders have invested in the company by purchasing shares. This is listed under equity and reflects the legal ownership stake in the business.

Retained Profits = The cumulative profits a company has earned over time, minus any dividends that are paid out to its shareholders. Retained profits are listed under equity and shows how much of the company’s net income has been reinvested back into the business rather than distributed elsewhere.

Total Equity = The residual interest in the company’s assets after deducting its liabilities. It is essentially what the owners and shareholders own outright. It is the combination of share capital, retained earnings and any other reserves.

Total Liabilities + Equity = The combined value of everything the company owes (liabilities) and everything that owns outright (equity). This figure should always be equal to total assets.

Balance sheet warning signs

Balance sheets can be extremely revealing of potential imbalances, unusual debt structures, inflated asset values and other financial inconsistencies. These can all be clear signposts of fraud, insolvency issues or potentially even breaches of fiduciary duty.

If the Total Assets doesn’t equal the Liabilities + Equity

This suggests accounting errors or financial manipulation.

2. Excessive Debt

If there are large short-term loans compared to cash reserves or sudden spikes in long term debt without a clear rationale.

3. Inflated Asset Values

Common issues include overstatements of inventory such as obsolete stock not being labelled for its obsolesce. Property and equipment may be valued far above market rates to make the balance sheet appear more favourable and profitable. Intangible assets, such as intellectual property in particular may be drastically overvalued.

4. Low Liquidity

Low cash relative to a company’s current liabilities, or if accounts receivable are growing faster than revenue, which could suggest collection problems.

5. Inconsistent Trends

Retained earnings aren’t matching the company’s reported profits. Sudden changes in accounting policies or valuation methods, or frequent restatements of the figures of previous years.

Notable contexts where balance sheets are essential to lawyers

Along with being a clear intersection between the legal and financial realms, balance sheets are integral tools to many corporate legal processes.

In Mergers & Acquisitions

For due diligence: lawyers review balance sheets in order to check for hidden liabilities, debt levels and assets valuations (see the list of warning signs earlier in the article)

For negotiation: by looking at a company’s equity and retained profits on their balance sheet, alongside other values, lawyers put themselves in a much more informed position to determine purchase prices and deal structure.

For risk assessment: red flags that appear during lawyers’ reviews of balance sheets such as inflated assets or excessive short term debt can beneficially stop a transaction and save the firm money and time.

In Regulatory and Compliance law

Company law: Many jurisdictions require accurate balance sheets in annual filings.

Financial regulations: Lawyers check compliance with capital adequacy rules.

Anti money laundering: Unusual balance sheet entries which include things such as unexplained cash which may trigger legal scrutiny.

In Contracts and Financing

Loan agreements: Lenders require balance sheets in order to assess creditworthiness, the lawyers themselves draft covenants which are tied to debt ratios.

Investments contracts: Balance sheets help to define warranties and representations of financial health.

Security interests: Lawyers verify which assets are available to be used as collateral.

Key questions that lawyers ask when reading a company’s balance sheet

Do the numbers match across all statements?

Are all the assets valued realistically and do they reflect the current market?

Is the debt structured sustainably?

Do the auditors have concerns and if not are they trustworthy?

“Having a fortress balance sheet means being prepared for the unknown. You don’t know what’s coming, but you know it’s coming.”
Jamie Dimon, CEO of JPMorganChase

By George Hocking

georgeslawupdates@gmail.com