How to read financial reports for the novice – Part 2: Balance Sheet

Balance sheet is contained in section 1(b)(i) A statement of financial position (for the issuer and group), together with a comparative statement as at the end of the immediately preceding financial year in Old Chang Kee’s FY14 report.

Before I go through individual items in the balance sheet, let me explain a few things to give you a more complete picture.

There are two main columns in the Balance Sheet; i.e., The Group and The Company.  Apart from the company that sells curry puffs and other snacks, Old Chang Kee have subsidiaries, associated companies and joint ventures that are involved in other F&B businesses, e.g., Pie Kia, Take 5!, Curry Times, Mushroom Café, DipnGo, and My Darling (which can be found from its 2014 Annual Report).  A subsidiary is an enterprise that is controlled by another enterprise known as the parent; typically it means the parent company owns more than 50% of the stake. An associate is an entity which a company has significant influence but does not have the controlling right.  Significant influence usually means having more than 20% but less than 50% of voting power.  A joint venture (JV) is a contractual arrangement whereby two or more parties undertake an economic activity that is subject to joint control.  If a company holds between 20% and 50% of stake in a JV, the JV is considered an associate company and if it holds more than 50% stake, it will be considered a subsidiary.  The Group encompasses the company, subsidiaries, the associate companies and other JVs; hence, it is usually more meaningful to look at the balance sheet of the Group as a whole.

The annual report of a listed company contains much more detailed information about its business.  It was shown in Old Chang Kee’s 2014 Annual report (extracted and shown in the figure below) that the holding company has four 100% owned subsidiaries (one is dormant) and two 40% owned associates (one is dormant).  We normally have to review the annual report and past quarterly or half-yearly reports to have a complete picture of a listed company.

Assets are what a business owns and liabilities are what it owes.  Assets are classified as fixed assets and current assets.  A fixed asset is an asset of a business intended for continuing use in the production of income and is not expected to be consumed or converted into cash any sooner than at least one year’s time. Fixed assets must be classified in a company's balance sheet as intangible, tangible, or investments. Examples of intangible assets include goodwill, patents, and trademarks; tangible assets are basically property, plant and equipment.  In the case of Old Chang Kee, property, plant and equipment is worth $21,522K.  Note that that both freehold and leasehold properties could be re-valuated while plant, equipment, furnishing have to be depreciated year by year.  Normally leasehold properties will also have their values depreciated but their values could also be re-valuated which may result in the appreciation (instead of depreciation) in book value. 

The intangible asset is negligible in the case of Old Chang Kee and hence no cause for concern.  Typically an investor has to be wary when the intangible asset is very high because the true value of intangible asset may be very low or zero if a business needs to be liquidated.  When a business A makes an acquisition of another business B, the premium business A pays above the book value of business B is registered as goodwill in its balance sheet under fixed assets.  Normally this goodwill is amortized over a number of years.  In some rare cases, the goodwill may be written off in one go.  In the latter case, the profit and loss will be negatively impacted significantly as the goodwill will be deducted from the profit in one lump sum for the financial period concerned.  Amortization of goodwill will resulting in a smaller sum to be deducted from the profit over many financial reporting periods; hence, their impact on the profit for each reporting period will be less.

The fixed asset section shows that Old Chang Kee also invested in one or more companies that are not public listed and the invested amount is $273K.  It also shows that Old Chang Kee has long term deposits (mature in more than a year’s time) of $1.783m.

Some businesses own properties whose book values may not reflect their true values because the book values were registered at costs or that the properties were last valuated many years ago and the property prices have risen substantially.  Some value investors like to look for hidden values in businesses which own properties whose values are under-reported. I do not normally follow this investment strategy as small investors have no control over when the controlling shareholders will unlock the values of these properties and sometimes it takes many years (or forever) for the property value to be unlocked and the opportunity cost is considered too high for me.

Current assets are assets that are reasonably expected to be converted into cash within one year in the normal course of business. Inventories may include curry puffs that have already been made and waiting to be fried and then sold, the raw ingredients for making the curry puffs, cooking oil and paper bags etc.  Trades and other receivables are basically goods sold and service rendered and the customers have been billed but money has not been collected.  Deposits are basically bank deposits that will mature in less than one year.  Prepayments are money paid before goods or services have been received.  Amounts due from subsidiaries and associate companies are money (typically share of profits in the form of dividends, or repayment of loan) expected from the subsidiaries and associated companies.  Cash and bank balances for Old Chang Kee is a hefty $20.379m. 

Current liabilities are the company's debts or obligations that are due within one year.  Trade and other payables are what a business needs to pay within a year.  They could include what it owes the suppliers, contractors and landlords.  Other liabilities are the other payments which it is liable to pay.  Bank loans are the loans it needs to pay the bank within a year.  Finance lease are basically equipment, vans or other items that it procures via instalments or hire purchase.  Provision for taxation is the taxes it expects to pay within a year.

Some listed companies show the net current assets in their balance sheets while others do not.  As current assets and current liabilities are all expected to be settled within a year, net current assets indicate how much capital is being generated or used up by day-to-day activities for the reporting period. If net current assets are negative, the business may have difficulty financing its day-to-day operations and this will be a big cause for concern. An investor can compute the current ratio, which is also known as the liquidity ratio, by using current assets to divide by current liabilities. The current ratio measures a company's ability to pay short-term obligations.  In most cases, current assets are higher than current liabilities.  In the rare case that a business’s net current assets are negative (current ratio < 1.0), an investor has to be very careful.  In general, an investor should avoid investing in a business in which the net current asset is negative as a business can go bankrupt if it does not have enough money to pay its debtors.  Even though a business may have a lot of fixed assets, it has to do a fire sale for the assets and/or issue new shares at a huge discount to raise cash when it needs to pay debts urgently.  The consequence is very unfavorable to the existing shareholders.

In the case of Old Change Kee, its long term liabilities consist of bank loans, financial liabilities and deferred taxes that need to be paid in more than a year’s time.  The total long-term liabilities are quite small compared to its current assets and fixed assets and, hence, no cause for concern.

Basically the balance sheet tells an investor the financial health of the business.  An investor can make use of the information to do the following:

·        Compute the net cash/debt of the business.  In the case of Old Chang Kee, the cash or cash equivalents it has at the end of FY14 is: $1,783K (Long-term deposits) + $1,279 (Deposits) + $20,379K = $23,441K.  Old Change Kee’s total liabilities are: $10,198 (current liabilities) + $4,841 (long term liabilities) = $15,039.  Even a conservative investor would be happy to see that Old Chang Kee has enough cash to pay off all its current and long-term liabilities in excess of $23,441K - $15,039K= $8,402K.  The total number of issued shares for Old Change Kee is 121,374,700; hence, $8,402K works out to be 6.92 cents per share.  At Old Change Kee’s last closing price of 92.0 cents on 18 July 2014, 6.92 cents is about 7.5% of its share price.  In a handful of cash rich company listed on SGX, the net cash could exceed 50% of its share price. 

·        Unlike Old Chang Kee, many businesses are in net debt position; hence, it is advisable that the investor look at the debt to equity ratio.  Equity is simply equal to the net asset; and debt to equity ratio is simply equal to total liabilities divided by net asset.  For the case of Old Chang Kee, total liabilities is $10,198K (current liabilities) + $4,841K (Long-term Liabilities) = $15,039. Hence, the debt to equity ratio is $15,039/$31,502 x 100% = 47.7%.  Some investors (including myself) find it more meaningful to compute the net debt to equity ratio.  In this case, cash and cash equivalents and short-term investments are deducted from the total liabilities to determine the net debt before dividing it by the equity.  In the case of Old Chang Kee, the net debt is zero; hence, net debt to equity ratio is zero.  Most companies I invested in have low or zero net debt with the exception of property developers.  By nature of their businesses, property developers have to borrow money to build houses; hence, they are usually in debts.

·        For businesses that have high debt levels, it is also important to compute the interest cover (also known as interest coverage ratio).  Interest cover is a ratio used to determine how easily a company can pay interest on outstanding debt. The interest cover is calculated by dividing a company's earnings before interest and taxes (EBIT) of one period by the company's interest expenses of the same period.   In the case of Old Chang Kee, EBIT for FY14 is $7,244k and interested paid is $66K (see Profit and loss statement on Page 1 and Cash Flow statement on Page 5).  As Old Chang Kee has fixed deposits that earn $38K of interest (see Profit and loss statement on Page 1 and Cash Flow statement on Page 5), the net interest payment is $66K - $38K = $28K.  Hence, Interest cover for Old Chang Kee is $7,244K/$28K = 258.7 times. This means what Old Chang Kee earns in a year is 258.7 times more than the net interest it has to pay; hence, interest payment will not be a drag in its performance.