Friday, 3 June 2011

An Amazing Balancing Act

Conscious that my last few posts have been somewhat generic, I thought today I should get a little more specific.  Apologies for the cryptic post title, but today I’m going to explain why I think Balance Sheets are great (and I doubt you’d have reached this far if I had mentioned Balance Sheets in the title).  

I’ll try and tread the fine line here of not losing those who have no financial training whilst hopefully providing some interesting perspectives for the more financially literate – forgive me if I this over-simplifies or over-elaborates.

This may be a statement of the obvious but I am often surprised by how few people recognise what a Balance Sheet fundamentally represents:  it’s the running total of all the financial activities of the business since inception.

This makes balance sheets particularly valuable when looking externally at other (young) companies’ financials;  the Profit  in any one year may come or go, but you can’t hide from the running total in the balance sheet.

Let me illustrate with some (rounded) real figures from an online company that is broadly a competitor of mine and has been around for a little over 10 years (I won’t name them as this is an illustrative exercise, not a judgement on any one business);

The Profit & Loss (P&L) Statement tells one story:  Loss making in the last few years (up to £1m loss), they show a modest c.£100k profit in the most recent year. Fair enough, not a great story but trending the right way and making money now, right?

The Balance Sheet tells a rather different story:
  • P&L Reserve Account (the cumulative total profit ever) shows over £11m of losses. Puts the c.£100k profit this year in perspective doesn’t it?
  • Stock value is £1.4m and has increased every year despite revenue being up and down.  In fact over the last 4 years stock value has increased by >80% whilst revenue has only increased by <20%; does that seem strange?  A balance sheet being what it is we know that £1.4m is the cumulative amount they have spent on stock that they have not yet sold (i.e. money spent that is reflected in the balance sheet but has not yet made it to the P&L). Do you think there’s a chance that the stock may not really be worth £1.4m? Maybe some of that stock is not in saleable condition or is commercially worthless? You would only need to write-off 10% of the stock value (a figure which would then appear as a cost in the P&L) to wipe out this year’s profit figure completely.  The fact that the stock figure has grown so dramatically would certainly make me wary that the accounts may be somewhat optimistic.
  • Trade Creditors (the amount owed to suppliers) is almost the same as the stock value. As a crude simplification that means all that stock has been ‘bought but not paid for’.  Bank Loans & Overdrafts are nearly £1m, Cash is only £200k.  Would you start to worry about the financial stability of the business?
  • Trade Debtors (money owed by customers) is over £0.5m.  This means the revenue from these customers has been taken though the P&L (so has contributed to the modest profit) but the cash has yet to be received.  You don’t know this business, but I can tell you it is ostensibly a consumer retail business and such significant debtor figures are strange

I could go on but this is intended as a thought stimulator not an essay. Hopefully I have illustrated that the Balance Sheet tells you so much that the P&L doesn’t; that’s why I think Balance Sheets are great.

1 comment:

Kelvin said...

Good points Kevin, thanks for sharing! Kelvin