QUALIPORT
The Basics Of A Balance Sheet

By Maynard Paton (TMFMayn)
March 11, 2004

Financial commentators often refer to balance sheets as 'strong' or 'weak'. But as with most well-worn investing terms, such definitions cannot be applied easily to every quoted business. What at first glance looks to be a flimsy balance sheet can sometimes prove attractive to shareholders, while those that appear solid have been found in many a troubled business.

Today's Qualiport will review the basics of balance sheet accounting and define all the main components. Future articles will highlight certain 'strong' and 'weak' balance sheets and the bookkeeping tricks and treats to look out for in this important financial statement.

Definition

The balance sheet is an accounting statement that summarises the various assets and liabilities held by a company. It is always drawn up at the close of business on the last day of the company's accounting period (the balance sheet date). The 'net' -- or 'book' -- value of the assets and liabilities is also shown to 'balance' against shareholders' interests in the business.

Annual reports contain two balance sheets. There's the consolidated (or group) balance sheet, which represents the combined assets and liabilities of all the company's subsidiary operations, and is the most important to investors. The other is the company balance sheet, which reflects the assets and liabilities of the parent holding company and can very often be ignored.

Balance sheet

Balance sheets have a traditional presentation format. Assets are listed first, in order of 'illiquidity', followed by short-term liabilities and then long-term and other liabilities. Last week's full-year results from Qualiport watch list share Gallaher (LSE: GLH) included a balance sheet with most of the common asset and liability components:

Year to December 31	2003     (£)	2002     (£)
Fixed assets:
Intangible assets	1,399	1,375
Tangible assets	595	575
Investments:
- Investment in joint ventures	6	6
- Investment in associate	112	109
- Other investments	19	17
	2,131	2,082
Current assets:
Stocks	504	466
Debtors	783	788
Non-liquid investments	1	1
Cash and liquid investments	116	95
	1,404	1,350
Creditors: amounts falling due within one year:
Borrowings	(139)	(201)
Other	(1,117)	(1,044)
	(1,256)	(1,245)
Net current assets	148	105
Total assets less current liabilities	2,279	2,187
Creditors: amounts falling due after one year:
Borrowings	(2,429)	(2,387)
Other	(5)	(6)
	(2,434)	(2,393)
Provisions for liabilities and charges	(53)	(49)
Net retirement benefits liability	(68)	(82)
Net liabilities	(276)	(337)

Here are the definitions to the entries:

Assets: Items that the business owns and on which a value can be placed.

Intangible assets:'Non-monetary' but 'identifiable' assets that have no physical substance. Current accounting guidelines mean they almost always relate to goodwill, though may include patents, licenses, trademarks and so on. Read more on goodwill and some more.

Tangible assets: 'Long-lived' physical items held for the purpose of earning revenue. Typically include land, property, plant, machinery, fixtures, fittings and motor vehicles. Many companies adopt a 'modified historical cost' convention, whereby assets are stated at actual cost less depreciation, but revaluing certain assets (usually land and property) from time to time. Read more on tangible assets.

Fixed asset investments: Long-term investments, including 'ownership interests' held in other companies. For joint ventures and associates (i.e. entities where 'significant influence' can be exerted, but not full control), the company's share of the entity's assets is shown. Other long-term 'minority' investments held can be shown at historical cost or current valuation, though the accounting notes must declare which.

Current assets: Cash in the bank and 'temporary' assets that the company expects to turn into cash. Stocks represent (at the lower of either cost or net realisable value) any goods held for resale, raw materials to be used in manufacture and work in progress. Debtors reflect the amounts owed to the company, with an accounting note itemising the entry (money owed by customers ('trade debtors') is usually the largest). Current asset investments are those investments held with only a short-term intention. Read more on stocks and debtors and some more.

Liabilities: Amounts owed by the business.

Current liabilities: Liabilities the company expects to meet within twelve months of the balance sheet date and usually described as creditor amounts falling due within one year. An accounting note breaks the figure down, with money owed to suppliers ('trade creditors'), taxes and proposed dividends among the more significant sub-entries. Bank loans, overdrafts and financial lease obligations due within a year will be found in the same accounting note. (Note: Gallaher commendably places its short-term borrowings figure on the balance sheet proper as well.) Read more on creditors and some more.

Net current assets: Current assets less current liabilities.

Creditor amounts falling due after one year: Almost always bank loans and debts due for repayment at least one year after the balance sheet date. Read more on debt.

Provisions: Technically defined as amounts retained to provide for a liability or loss which is either likely to be incurred, or certain to be incurred but uncertain as to the amount or as to the date on which it will arise. Read more on provisions.

Net retirement benefits asset/liability: Shows the company's pension surplus/shortfall according to FRS 17 reporting standards. Businesses fully adopting FRS 17 (such as Gallaher) place the figure in the consolidated balance sheet. Those firms keeping to the 'transitional' FRS 17 guidelines reveal their pension details in the back of the accounts, which outline the effect of a full FRS17 adoption anyway. Read more on FRS 17.

Net assets/liabilities: Total assets less total liabilities.

Reserves

After presenting the balance sheet items, annual accounts then have to show how the company's net assets (or liabilities) 'balance' with shareholders' interests. Gallaher's 'reserves', which effectively reflect how the company has been funded, match the balance sheet's £276m net liability:

Year to December 31st	2003     (£m)	2002     (£m)
Capital and reserves:
Called up share capital	65	65
Share premium account	125	117
Capital redemption reserve	8	8
Merger reserve	146	146
Other reserve	(911)	(911)
Profit and loss account (including retirement benefits reserve)	260	213
Equity shareholders' deficit	(307)	(362)
Equity minority interests	31	25
	(276)	(337)

Here's what the most popular entries mean within the 'reserves' part of the balance sheet:

Called-up share capital plus share premium: The total money given by shareholders to allow the company to trade. Reflects the original start-up capital and subsequent sums raised from rights issues etc.

Profit and loss reserve: The cumulative amount of post-tax profits and losses, after dividend payments, since the company's formation. Dividend payments can only be taken from this reserve, and only if it contains a sufficient 'distributable' sum.

Capital redemption reserve: Reflects the value of shares redeemed or purchased by the company from distributable profits.

Revaluation reserve: Any surplus (or shortfall) following a revaluation of tangible assets (usually land and property) is credited to (or debited from) the company's revaluation reserve.

Minority interests: Occurs when the company has one or more controlled subsidiaries that are not wholly owned. Assets relating to part-owned subsidiaries are apportioned to the minority and separated from shareholders' interests. Read more on minorities.

Gallaher's reserves also include a merger reserve and an other reserve.

The former can be created in certain obscure circumstances when shares are issued to fund an acquisition. Details of other reserves will be found in the relevant accounting notes. In Gallaher's case, its other reserve resulted from 'a capital reorganisation that included a purchase of own shares out of capital' on the demerger from Fortune Brands in 1997.

Reconciliation

Finally, annual accounts have to reconcile how the company's final net asset (or liability) value has altered over the period under review. This next table explains the movements within Gallaher's shareholders' deficit, which went from £362m to £307m during 2003:

Year to December 31st	2003     (£m)	2002     (£m)
Profit for the financial year	247	255
Dividends	(193)	(179)
Actuarial loss recognised on retirement benefits	(4)	(108)
Movement on deferred tax relating to actuarial loss on retirement benefits	1	30
Exchange adjustments on foreign currency net investments	(4)	(22)
Amounts deducted from profit and loss reserve in respect of shares issued to the Qualifying Employee Ownership Trust	-	(5)
Issue of ordinary shares	8	12
Net decrease/(increase) in equity shareholders' deficit	55	(17)
Opening equity shareholders' deficit	(362)	(345)
Closing equity shareholders' deficit	(307)	(362)

Common reconciliation entries include:

Reported profits and dividends: The former minus the latter equals the retained earnings for the year, which accumulate in the profit and loss reserve. Retained earnings (or losses) will usually be the dominant figure in the reconciliation.

Foreign exchange movements: Overseas assets are translated into sterling at the exchange rate prevailing on the balance sheet date. Differences arising from the translation at the previous year-end are accounted for in the profit and loss reserve.

Revaluations: Unrealised profit (or deficit) from fixed asset revaluations made during the year.

Issue of new shares: Amounts raised from rights issues etc., which accumulate in the called-up share capital and share premium accounts.

Prior year adjustments: Amendment to the previous year's balance sheet following a change in accounting policy during the latest period.

Retirement benefits: The net change to the 'actuarial' value of the company's FRS17 pension scheme.

Limitations

That concludes the main points and definitions to balance sheet accounting. In fact, Gallaher presents a good example of the difficulties of evaluating a company solely by its balance sheet. The tobacco group has net liabilities of £276m -- a seemingly precarious financial position -- yet it continues to churn out regular profit and dividend growth. Future Qualiport articles will therefore examine the limitations of some popular balance sheet investment principles, and follow it up with some of the bookkeeping issues to look out for.