Phil Oakley 

Getting behind a balance sheet

Phil Oakley

Getting behind a balance sheet

Last week, I showed you what you could learn from a company’s income statement. This week, I will be looking at what you can learn from a balance sheet. Brewing and pub company Marston’s (MARS) will again be used as an example. I won’t cover everything that you will come across in a balance sheet, but hopefully you will see the value to be gained from studying them.

What is a balance sheet?

A balance sheet is a snapshot of a company’s financial position on one particular day of the year, usually the end of a financial reporting period such as a year. This is different to an income or cash flow statement, which shows what’s been going on throughout a period of time.

A company’s balance sheet shows what a company owns (assets) and what it owes (liabilities). The difference between the amount of assets and liabilities is the value of equity that belongs to the company’s shareholders. It is sometimes referred to as the statement of financial position.

Balance sheets are so called because they always balance. The value of a company’s assets will always equal the value of liabilities and equity.  Another way in which the balance sheet will balance is that its net assets (total assets less total liabilities) will equal total equity.

We can see from Marston’s balance sheet that it has total assets of £3046.8m, which is the same as the sum of total liabilities of £2089.2m and total equity of £957.6m. Also net assets of £957.6m equals £957.6m of total equity.

Now let’s look at Marston’s balance sheet in more detail. As with the income statement from last week, each part of the balance sheet has a note attached to it.

 

Non-current assets

Sometimes called fixed assets, they are assets that are intended for long-term use (more than a year) in the business to generate revenues and profits. The assets can be tangible (things that you can touch) such as land, buildings, machines, computers and cars, or intangible (things you can’t touch) such as brands, trademarks and patents. There is another intangible asset called goodwill.

Goodwill

Marston’s has a goodwill asset of £230.3m on its balance sheet. Goodwill represents the amount of money paid by the company above the value of the net asset values (NAVs) of any businesses that it has acquired in the past. So, for example, if Marston’s has spent £730.3m to buy businesses with NAVs of £500m, the excess of £230.3m is goodwill. You can find out the actual amount of money spent by looking at past annual reports.

Unlike other non-current assets, the cost of goodwill is not spread – or amortised – over its useful life. Instead it is tested annually for any reduction in value or impairment. The company tests for impairment by calculating the value in use of the goodwill asset. It does this by estimating the future cash flows of it and discounting it back to a value in today’s money.

If the value in use is less than £230.3m then the value has to be written down to its lower value. This will be reflected as an expense in the income statement as well. We can see that only £1.1m of goodwill has been previously impaired.

Note 10 tells us that Marston’s assumes that cash flows grow by 2 per cent a year and are discounted at a rate of 5 per cent. On that basis, the goodwill asset was not impaired in 2018. Having said that, 5 per cent is a very low discount rate and will give a much higher value in use than something like 7-8 per cent which lots of companies still use. It could be argued that Marston’s is being a bit aggressive here and that it could be elsewhere.

 

Other intangible assets

The £70m is explained by looking at note 11 to the accounts.

We can see here the original cost – the money spent – on intangible assets, the amortisation (the spreading of the cost) and the net book amount (the original cost less amortisation). £3.3m has been spent in 2018, £1.5m has been transferred and £1.1m of amortisation has been expensed.

By far the biggest intangible asset is the brewing brands that Marston’s has bought over the years. Note that its own brands are not shown as an asset on its balance sheet. The acquired brands are not amortised but tested annually for impairment, like goodwill.

Computer software is a common intangible asset, as are development costs. The latter need to be watched carefully in some companies as sticking these costs on the balance sheet rather than expensing them through the income statement is a way of boosting profits.

 

Property, plant & equipment

This is by far the biggest and most important asset number on Marston’s balance sheet and one that you should spend some time trying to understand if you are doing a thorough analysis of its financial statements.

 

 

These assets are largely concerned with land and buildings, machinery and fixtures and the fittings of the company’s pubs and breweries. The numbers in note 12 can be used to find out some extra useful bits of information about its property, plant and equipment such as:

  • How worn out they might be
  • How old they are
  • How quickly they are being replaced
  • How fast they are being depreciated.

You can do this by setting up a spreadsheet.

 

Marston’s property, plant & equipment analysis

Cost (£m)

Land & buildings

Plant & machinery

Fixtures & fittings

Total

At 1/10/2017

2153.7

72.2

331.4

2557.3

Additions

94.1

17.7

50.6

162.4

Net transfers

-42.7

-5.1

-37.3

-85.1

Revaluation

-39

  

-39

At 29/09/2018

2166.1

84.8

344.7

2595.6

     

Depreciation

    

At 1/10/2017

7.6

30.8

158.2

196.6

Charge for the period

3.6

6.4

29

39

Net transfers

 

-4.4

-35.3

-39.7

Revaluation/impairment

-8.8

 

0.4

-8.4

At 29/09/2018

2.4

32.8

152.3

187.5

     

Net book value 29/09/2018

2163.7

52

192.4

2408.1

     

Average Cost

2159.9

78.5

338.05

2576.45

Depreciation rate

0.17%

8.15%

8.58%

1.51%

Capex to Depreciation

2614%

277%

174%

416%

NBV as % of Gross BV

99.9%

61.3%

55.8%

92.8%

% written down from cost

0.1%

38.7%

44.2%

7.2%

Estimated life

600.0

12.3

11.7

66.1

Estimated age

0.7

5.1

5.3

4.8

Source: Annual report/Investors Chronicle

 

As with most number crunching, you will get the most value from it by comparing your calculations over a number of years and with similar companies. Lack of space prevents me from doing this here, but hopefully you will get the feel of what you can do.

Depreciation is a very important number. Its purpose is to match the cost of an asset with the revenues it generates over its useful life. There are different ways of calculating depreciation, but the most common method is known as 'straight line' where the depreciation as a percentage of its costs is the same each year. 

Annual depreciation charge = (cost - residual value)/estimated useful life

This gives a company some leeway to change its depreciation on an asset by changing its estimate of its residual value (how much it will be worth at the end of its useful life) and its useful life. You can pick up signs that this might be going on by calculating its depreciation rate.

The depreciation rate compares the depreciation charge for the period with the average cost of assets. The higher the rate, the faster the assets are being depreciated or written off. You should look out for a falling depreciation rate as this may be a sign that a company is extending the useful life of its asset. With Marston’s, you should focus your attention on its fixtures and fittings as that is the biggest source of depreciation.

You can see how quickly an asset base is being maintained by comparing additions (capex) to assets with depreciation. Anything more than 100 per cent shows that a company is expanding its asset base. This was comfortably the case with Marston's in 2018.

An estimate of how worn out the assets might be can be found by comparing the net book value with its original cost. For example, Marston’s fixtures and fittings was 56 per cent of its original cost, or 44 per cent written off. This looks acceptable and not a sign that the company is under-invested in its business.

You can estimate the life by taking the reciprocal (one divided by) the depreciation rate but this does assume a residual value of zero. The estimated age can be calculated by taking the cumulative depreciation and dividing it by the annual charge. So, for fixtures and fittings, it would be £152.3m divided by £29m, or 5.3 years. 

 

Current assets

Current assets are assets that are assumed to be turned quickly into cash – they are liquid assets. The most liquid of all is cash and cash equivalents. The other two that you should concern yourself with are stocks (often called inventories) and receivables (sometimes called debtors).

 

Inventories or stock

Stock is very important for retailing and manufacturing businesses. There are usually three types of stock:

  • Raw materials
  • Work in progress
  • Finished goods

You should look at the change from year to year and be wary of any big increases. The cost of stock on a balance sheet includes the costs – such as labour – and overheads to create it. It can be used as a way of shifting costs away from the income statement and onto the balance sheet and boosting profits. Increased stock also ties up valuable cash resources in a business.

Of all the types of stock, it is finished goods that are arguably the most important. Rising stocks of finished goods can be a sign that demand for a company’s products is weakening and selling prices may have to be cut to shift them, which could result in a fall in profits.

Rising stock levels aren’t always a sign of trouble brewing; they can be a sign that a business is growing. Looking at stock as a percentage of revenues (using the number from the income statement) is more revealing. Marston’s is not a stock-intensive business as stock represented 3.9 per cent of turnover in 2018, down slightly from 4 per cent in 2017.

 

Receivables

Trade receivables represent money that has not been paid by customers for sales that have been made. They are sales made on credit. Most businesses offer their customers credit and there is nothing wrong with it. Problems occur when credit sales become a much bigger slice of revenues and this increases the risk that some customers cannot pay their bills.

We can see that Marston’s trade receivables at the balance sheet date are lower in 2018 than 2017. As a percentage of revenues they fell to 5.9 per cent from 6.9 per cent. There is also a helpful note which tells the reader whether customers are late in paying their bills. There has been a slight increase in the amount that is 30 days overdue or less, but this does not seem to indicate a big problem.

Prepayments represent money that has been paid in advance, such as rent or insurance. Accrued income may refer to interest or rents that are due to be received.

 

Liabilities

Liabilities refer to amounts of money that a company owes or obligations to make payments. They are current (due within one year) or long term (more than one year). We will look at Marston’s liabilities in total.

The most significant liabilities are borrowings, trade and other payables, derivatives and deferred tax. Borrowings are by far the most important when it comes to Marston’s and most other companies, so I will just concentrate on this for now.

 

Borrowings

Companies borrow to finance their businesses. This is not a problem. Problems only occur when borrowings get too big relative to a company’s profits, cash flows and assets. Borrowings or debts can be a big problem for shareholders. This is because shareholders get paid last. The more of a company’s profits and assets that are eaten up by debts, the more risky the shareholders’ investment tends to be.

You should look at the amount and types of borrowings. Bank borrowings can often be repayable on demand and can cause problems in times of economic distress when banks are desperate for cash. 

Marston’s has a lot of securitised debts. These are like mortgages in which the lender has a claim on an asset or assets to give added security to their loan. Marston’s securitised loans are mainly against its tenanted pubs.

You should also look at when borrowings have to be repaid. Large repayments within a year can be a problem if interest rates are rising. Long-term borrowings secured at attractive interest rates can put a company on a sound financial footing. Just over 10 per cent of Marston’s debt was due to be repaid within one year.

To judge whether a company’s debts are too big and potentially a problem, we can calculate some ratios from the company’s balance sheet. Investors often look at the ratio of debt to equity. If debt is much bigger than equity this can be a sign that the equity is at risk if the ability to pay debts becomes more difficult. Marston’s has a lot of debt based on looking at its borrowings as a percentage of equity, total assets and property. The debt levels are stable year on year.

Many people use net debt as a measure of indebtedness by netting off cash balances. I do not, as the cash is often not available to repay debt but has to be used elsewhere – such as paying suppliers. Using gross or total borrowings is much more prudent.

 

Marston’s debt ratios

£m

2018

2017

Total borrowings

1547.4

1503.7

Equity

957.6

931.4

Total assets

3046.8

2995.4

Property, plant & equipment (PPE)

2408.1

2360.7

Average borrowings

1525.55

 

Interest paid

78.9

 
   

Debt to equity

162%

161%

Debt to total assets

51%

50%

Debt to PPE

64%

64%

Interest rate on average debt

5.2%

 

Source: investors Chronicle

 

Another useful thing to do is calculate the average interest rate on debt. This is because balance sheets are only a snapshot of one day. Companies tend to give the most favourable impression they can by showing their finances at their strongest. Average debt levels can often be a lot higher than those at the year end. You can potentially spot this if the interest rate on average debt is very high. This does not seem to be the case with Marston’s.

From 2019 onwards, companies will have to show their future rental obligations on assets as debt, which could see big increases in their balance sheet debts. This is worthy of a separate article in itself and won’t be discussed here.

 

Equity

Equity shows the accounting value of the shareholders’ interest in the business. In its most basic form it is calculated from the amount of money shareholders have invested and the profits that have been retained (not paid out as dividends) throughout its life. In practical terms, it is more complicated than this.

Share capital refers to the nominal value of shares bought by shareholders at £48.7m. This is made up of 660.4m shares with a nominal value of 7.375p each. The share premium account tells you the value invested in shares above their nominal amount of £334m. So in total shareholders have invested £382.7m in the business. 

A large chunk of equity has come through the revaluation reserves. This has come from an uplift in the value of the company’s properties above their original cost.

We can also see reduction in equity. The hedging reserves show losses from hedging activities such as derivatives. The own shares reduction of £112.3m relates to shares that have been bought by the company and held in treasury. This is often used for share awards in the future.

Retained earnings represent the cumulative post-tax profits of a company that have not been paid out to shareholders. A company must have sufficient retained earnings to pay dividends to shareholders – 2018 saw an increase in Marston’s shareholders’ equity which came through higher retained earnings. This is a positive development.

 

Using balance sheet numbers to calculate investor returns

One of the best uses of a balance sheet is that it allows you to see the amount of money invested by a business. This can be compared with the profits it makes to see what kind of return a business is making.

Return on capital employed (ROCE) looks at the returns made to all providers of capital to a business (lenders and shareholders). It shows the operating profit as a percentage of total capital invested. It is my preferred measure of return as it is not distorted by how a company is financed. Return on equity (ROE) looks at profit for shareholders as a percentage of equity invested. This ratio is heavily distorted by debt, which inflates the ratio. This happens because equity is reduced by the whole amount of debt whereas profits are only reduced by the interest paid on it.

As a rough rule of thumb, very good businesses have a ROCE that is consistently more than 15 per cent. Marston’s looks to be a very modest business on this measure.

 

Marston’s investor returns

£m

2018

2017

Total assets

3,046.8

2,995.4

less current liabilities

-446.3

-440.4

plus s-term debt

158.4

148.8

Capital employed (A)

2,758.9

2,703.8

Equity (B)

957.6

931.4

Op profit (C)

182.5

174.5

Post-tax profit (D)

87.9

84.5

   

ROCE = C/A

6.6%

6.5%

ROE = D/B

9.2%

9.1%

Source: Investors Chronicle

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