A company’s balance sheet gives information to enable investors, lenders, financial analysts, etc, assess a company’s financial health. To assess a company’s present and future performance, the balance sheet is analyzed alongside the other elements of the financial statement namely; the Income statement, Statement of Cash flows, Statement of Changes in Equity and more importantly, the Notes to the financial statements. For purposes of this article, the focus will be on the Balance sheet.

A balance sheet, in simple terms, is a statement which shows how much a company owns and how much it owes at a given point in time. How much an organization owes is captured as either Capital or liabilities on the balance sheet. Capital includes owners’ contribution into the business and company profits retained over the years. It may also include other reserves (capital, revaluation, statutory etc). Beyond this, the organization may incur obligations during the course of its operations in the form of trade creditors, tax payables or exposures to financial institutions. These items, though not exhaustive, are termed Liabilities and could be short term or long term in nature.

Companies utilize their capital and liabilities to acquire assets which are employed to generate revenue for the company. Assets could also be short term or long term in nature.

To sum up on the overview, one can safely conclude that a balance sheet will show Capital, Liabilities, and Assets. By principle, an organization’s capital and liabilities are used to fund the assets hence, must be equal to total assets at any point in time (ie Assets = Capital + Liabilities).

Most often, the idea of a big balance sheet is misconstrued: it is said that a big balance sheet will either support the lending activities of financial institutions or the borrowing requests of organisations. Undoubtedly, it is advantageous for companies to have big balance sheets. However, the term ‘big balance sheet’ is gradually becoming a financial jargon though many do not consider the quality of the individual components of such balance sheets.

In commenting on a balance sheet as being big, what really are the parameters? Are we looking at absolute total assets or are the qualities of the individual components being assessed? For certain, if it were for the former, most companies could pride themselves with ‘bloated’ balance sheets and be able to raise or lend funds with significant ease. Unfortunately, we are witnesses to the numerous huge companies abroad, who were regarded as financial kingpins per their ‘balance sheet size’ but collapsed in the midst of the global credit crunch.

 Assets could be categorized into earning and non earning assets. For a typical balance sheet, what is the weighting of earning assets to total assets? Do companies really own most of their assets or are these assets already pledged to existing loans thereby reducing the company’s future borrowing capacity? What other covenants underlying existing loans tie the borrowing hands of a company? What is the trend of the loan balance year on year? Is the loan balance hardening up or it is being serviced regularly? Take note, a mounting debt balance can lead to a “big” balance sheet.

A company’s liabilities cannot be left without mention in this discussion. One needs to critically identify and evaluate its makeup. Is the company struggling with debt or does it have a tolerable financial leverage? Is the company in a position to pick up more debt to fund its business in future? There are still some other liabilities which are contingencies hence, cannot be recognized on a balance sheet. Contingent liabilities are liabilities of uncertain timing and amount. They are required to be disclosed in the notes of the financial statements. What are the contingent liabilities surrounding a typical big balance sheet? Should these liabilities crystallize, how will the resultant balance sheet look like?

The last set of items in a balance sheet is the shareholders’/ owners’ funds made up of the stated capital, share premium (if any), retained earnings and reserves. Over the years, have the owners injected new funds by way of increasing stated capital? Is there a progressive growth of retained earnings or are yearly losses depleting shareholder’s money? What percentage is equity to total liabilities and total shareholder’s funds?

Flipping the coin to financial institutions, there is the need to assess the quality of their loan portfolio, which is a significant element on the asset side. One key balance is the accumulated provision on the loan book. This should be weighed to the total loan book to see if it is significant. Another indicator for an attractive or quality balance sheet, as opposed to a big balance sheet, is by way of computing some utilization ratios. This will determine if our assets are indeed being churned into revenue or our capital is simply being tied up in “hard” or non-earning assets?

In conclusion, balance sheets could be big at first glance but a closer look at it by way of detailed analysis can reveal how little one can leverage on it to support lending and borrowing activities. This discussion should set the tone for real thinking on what a big balance sheet really is. In my personal view, a balance sheet is first and foremost as big as its net worth (Total assets less liabilities). More so, a critical study of notes to the Balance sheet is very key in putting into context how big a balance sheet is. We can never discount that a company’s balance sheet needs to be big. The issue is how healthy and beneficial is such a balance sheet? 

By Joseph Arthur