Understanding a balance sheet: from accounting to financial diagnosis

What is a balance sheet?

A balance sheet is a snapshot of the company at a given date, usually 31 December. The right-hand side, equity and liabilities, describes where the resources come from: what shareholders have contributed or left in the company and what it owes to third parties. The left-hand side, assets, describes how those resources are used. Every resource has a use and every use has a source: total assets always equal total equity and liabilities.

The balance sheet is one of three financial statements and it is not enough on its own. The income statement is a film: it traces the sales and expenses of a period down to net profit. The cash flow statement traces the cash coming in and going out over the same period, split into operating, investing and financing activities. A sound financial diagnosis needs all three.

The equality holds by construction, through double-entry bookkeeping: every transaction affects at least two accounts. A company that borrows €200,000 sees its debts and its cash increase by the same amount. When it then pays for a machine with that money, one asset (the machine) replaces another (cash): the total does not move.

A balance sheet does not give the value of the company. Assets are in principle carried at historical cost, less depreciation and write-downs: a building bought twenty years ago may be worth far more than its book value, a fully depreciated machine may still be sold. Book equity therefore differs, sometimes widely, from the market value of the shares.

Assets: what the resources were used for

Assets fall into two blocks. Fixed assets are meant to stay in the company and serve its business for more than a year. Current assets are meant to be held for less than a year and turn over with the operating cycle. In Belgium, as in France, assets are listed by increasing liquidity: the least liquid at the top, the most liquid at the bottom.

Fixed assets include tangible assets (land, buildings, machines, vehicles, furniture, computers), intangible assets (research and development, patents, licences, brands, goodwill arising from an acquisition, such as the purchase of a business) and financial assets (holdings in subsidiaries or other companies). Current assets include inventories and work in progress, trade receivables (sales invoiced but not yet collected), short-term investments and cash at bank and in hand. Deferred charges and accrued income close the assets side: an insurance premium paid in advance for the next financial year, for example.

Saying that assets are “what the company owns” is a shortcut. An asset held under a finance lease appears on the balance sheet without legally belonging to the company. More precisely, assets show what the resources were used for.

The value of a fixed asset falls every year through depreciation. Depreciating is not about setting money aside to replace the asset: it spreads its purchase cost over its useful life, so that the expense matches the revenue it generates. Equipment costing €25,000 and used for five years leads to an expense of €5,000 a year in the income statement; on the balance sheet, its net value drops to €20,000, then €15,000, down to zero. Land is not depreciated, but it can be written down.

Two reading precautions. The order described here applies in Belgium and France: Anglo-Saxon countries often present assets the other way round, from most to least liquid. The same item may also move between categories depending on the company, the sector or the country: understanding the logic of an item is worth more than memorising its label.

Equity and liabilities: where the resources come from

The right-hand side splits into equity, contributed or retained by shareholders, and debts, provided by third parties: banks, suppliers, the State, staff. It is listed by increasing exigibility, from the most permanent resources to those due soonest: equity at the top, short-term debts at the bottom. Shareholders are repaid only after every other provider of capital: equity is the residual share, equal to total assets minus everything owed to third parties.

Equity includes shareholders' contributions (share capital and share premiums in a public limited company, SA/NV; available or unavailable contribution in a private limited company, SRL/BV, which no longer has share capital), revaluation surpluses (unrealised gains on revalued fixed assets), reserves (profits of past years kept in the company), profit or loss carried forward (awaiting allocation) and capital grants. Reserves and profit carried forward link the balance sheet to the income statement: the part of the profit that is not distributed increases equity, a loss reduces it.

Then come provisions and debts. A provision announces a probable future expense, which can be estimated fairly precisely and relates to current activity: pending litigation, pensions to be paid. Amounts payable after more than one year are mainly bank loans or bonds. Amounts payable within one year include trade payables (unpaid supplier invoices), tax, payroll and social security liabilities (VAT, taxes, wages and contributions due) and short-term financial debts: credit lines and the part of long-term loans repayable within the year. Accrued charges and deferred income carry the expenses of the year that are not yet paid, such as accrued interest, as well as income received in advance.

Four misconceptions to set aside:

• Reserves are not cash. They say that profits were retained, not where they are: they may have financed a machine, inventories or customer receivables. Cash is read on the assets side.
• A provision is not money set aside. It reports a future expense: no amount is locked away to pay it and recording it takes no cash out of the company.
• Equity does not move only with capital. A retained profit increases it, a loss or a dividend reduces it, a revaluation changes it without any cash movement.
• The liabilities side is not money available. It says where the resources come from; what became of them is read on the assets side.

Profit and cash: what the balance sheet reveals

Net profit and cash do not measure the same thing. The income statement records a sale when it is earned (goods delivered, service performed) and an expense when it relates to the activity of the period, not when money comes in or goes out. Much of the gap can be read in the balance sheet: inventories, customer receivables, supplier payables. The rest comes from non-cash expenses (depreciation, provisions) and from investing and financing flows, which the income statement does not show. That is why a company can report a profit while its bank account empties.

A fictitious example. A company starts with €100,000 of capital paid in cash. It buys €60,000 of goods paid in cash and then sells half of them for €50,000, invoiced at 60 days. The income statement shows revenue of €50,000, cost of sales of €30,000 and a profit of €20,000 (taxes and other expenses ignored for the example). Yet cash has fallen from €100,000 to €40,000.

The balance sheet explains the gap. The €20,000 profit is there, in equity, but the money went elsewhere: €30,000 sits in inventory and €50,000 is owed by customers. Cash fell by €60,000, that is the profit (+€20,000) minus the €80,000 tied up in operations. Those €80,000 have a name: the working capital requirement, zero at the start, which has therefore increased by that amount.

The managerial balance sheet: net working capital, WCR and net cash

To make decisions, balance sheet items are regrouped by economic nature. On the left: fixed assets, the working capital requirement tied to operations, and cash. On the right: equity, provisions and financial debts, that is interest-bearing debts. This managerial balance sheet brings out three figures linked by an equation that structures the whole reading of the balance sheet: net working capital = working capital requirement + net cash.

The WCR depends on day-to-day management and on the sector. Customers who pay later, heavier inventories, suppliers paid sooner: each time, the WCR rises and has to be financed. In mass retail, customers pay cash while suppliers are paid on credit: the WCR is often negative there, and operations release cash instead of consuming it.

The equation reads both ways: that is what corrects hasty readings. A positive net working capital is not enough to protect the company if the WCR is even higher: the difference is financed short term and net cash turns negative. Conversely, a negative net working capital is not a danger in itself when the WCR is even more negative, as in retail. What matters is never net working capital alone, but how it compares with the WCR.

Very comfortable net cash is not a goal in itself either. It is money not invested in potentially more profitable assets. A high net working capital also finances operations with long-term resources, generally more expensive than operating debts, which carry no explicit interest.

Four typical profiles, in millions of euros:

• NWC (−5) = WCR (−10) + net cash (+5): operations finance the company, a common profile in mass retail.
• NWC (+10) = WCR (+4) + net cash (+6): long-term resources amply cover the operating cycle, at the risk of idle cash.
• NWC (+5) = WCR (+10) + net cash (−5): long-term resources are not enough to finance operations, the balance relies on short-term credit.
• NWC (−5) = WCR (+10) + net cash (−15): part of the fixed assets and the whole WCR rely on short-term debts. This is the configuration most exposed to a refusal to renew.

Ratios: useful, provided they are read critically

Ratios answer three questions: is the company profitable, liquid, solvent? They are quick to compute from public data and make comparisons easier. But a ratio cannot give a simple answer to a complex problem: it only makes sense when compared, over time or with genuinely comparable companies, computed with the same definitions and placed back in the company's business model.

The current ratio does not measure liquidity. A current ratio above 1 only says that net working capital is positive. A company with net working capital of 5 million and a WCR of 9 million has net cash of −4 million: a reassuring ratio, cash under strain. Conversely, a supermarket can show a ratio below 1 without the slightest payment problem. The quick ratio, which leaves out inventories, suffers from the same flaw. To judge liquidity, look at net cash and the cash flow statement.

A high ROE is not necessarily good news. It rises with debt as long as the return on invested capital exceeds the after-tax cost of debt; otherwise, debt pulls it down. It can therefore climb with risk, without any improvement in operations. It also rests on the book value of equity, not on its market value.

Finally, beware of universal thresholds such as “equity should be at least a third of total assets”: a healthy level in one sector is not healthy in another. Ratios are computed on past data: on their own they predict nothing and they must be read together, like the indicators of a medical check-up.

Solvent, liquid, profitable: three separate questions

A profit does not guarantee survival and a loss does not doom a company. Solvency, liquidity and profitability answer different questions: a company can be solvent but illiquid, profitable but short of cash. It can also show negative equity without being bankrupt.

Solvency measures whether the company is “rich” enough to meet its commitments: in accounting terms, it is insolvent when its debts exceed the value of its assets, that is when its equity is negative. Liquidity measures whether it can pay each debt when it falls due. A solvent company can run short of cash for a while; a liquid company can pile up losses that make it insolvent.

Negative equity does not mean bankruptcy. Under Belgian law, bankruptcy requires a persistent cessation of payments and impaired creditworthiness: the company no longer pays its debts and has lost the confidence of its creditors. Company law, however, requires action much earlier. In a private limited company (SRL/BV), two situations require the management body to hold a general meeting within two months of their being established: net assets that have become negative or are at risk of doing so; uncertainty about the company's ability to pay its debts as they fall due over at least the next twelve months (article 5:153 of the Companies and Associations Code). In a public limited company (SA/NV), the procedure applies when losses bring net assets below half of the share capital (article 7:228). Net assets are understood in the sense of the Code: equity minus unamortised formation and expansion costs and research and development costs, a stricter test than equity alone. The same notions govern dividends: in an SRL/BV, a distribution must pass a net asset test and a liquidity test (articles 5:142 and 5:143).

A profitable company can go bankrupt. If growth inflates inventories and receivables faster than its resources, the WCR absorbs all the cash generated: the income statement shows a profit while cash drains away. That is why the diagnosis does not stop at the balance sheet. The cash flow statement shows whether operations generate cash, how much the company invests and how it finances the gap.

Reading a Belgian balance sheet: annual accounts at the Central Balance Sheet Office

Belgian companies in principle file their annual accounts with the Central Balance Sheet Office of the National Bank of Belgium (NBB), where they can be consulted free of charge by name or company number. It is the first source for analysing a customer, a supplier, a competitor or a target before committing.

The accounts follow a standard format (full, abridged or micro depending on the size of the company) in which each item carries a code that is the same from one company to the next. These codes make it possible to rebuild the managerial balance sheet:

• Long-term resources: equity (10/15), provisions and deferred taxes (16), amounts payable after more than one year (17).
• Fixed assets: items 21/28, plus formation expenses (20) if any.
• WCR: inventories and contracts in progress (3), trade receivables (40) and deferred charges and accrued income (490/1), minus trade payables (44), tax, payroll and social security liabilities (45), advances received on contracts (46) and accrued charges and deferred income (492/3).
• Net cash: short-term investments (50/53) and cash at bank and in hand (54/58), minus amounts payable after more than one year falling due within the year (42) and financial debts payable within one year (43).
• Other receivables (41), other debts (47/48) and receivables after more than one year (29): to be classified case by case, depending on whether they relate to operations, investment or financing.

The notes and, where they exist, the directors' report and the auditor's report complete the figures: valuation rules, off-balance-sheet commitments, events after the closing date. The notes are largely standardised; valuation rules and free-text disclosures much less so, yet they are often decisive. Belgian annual accounts contain no cash flow statement: it has to be rebuilt from two successive balance sheets, the income statement and the notes. The Sagora Analytics report starts from these filed accounts: it computes net working capital, the WCR and net cash, then rebuilds a cash flow statement that is not a statement published by the company.

Worked example: two balance sheets, two diagnoses

Two fictitious companies, figures in thousands of euros. The first, an industrial SME, shows a reassuring current ratio. The second, a retail chain, ratios that would worry a hurried reader. In both cases, the managerial balance sheet tells another story.

The SME passes the current ratio test (1.20); only the quick ratio (0.70) gave a warning. Its net cash is −150: its long-term resources exceed its fixed assets by only 100, against a WCR of 250. The gap of 150 is financed by 200 of short-term credit, of which 50 remains in cash. If the bank cuts that credit, the company runs into payment difficulties, whatever its ratio.

The levers can be read in the same table. On the operating side, reduce the WCR: sell inventories faster, collect from customers sooner. On the financing side, convert part of the short-term credit into long-term debt or equity, which increases net working capital.

The retail chain shows a ratio of 0.67 and negative net working capital, but net cash of +250. Its customers pay cash, its suppliers are paid on credit: its WCR of −450 finances part of its stores and leaves a cash surplus. Its point of vigilance lies elsewhere: if business declines, this supplier financing shrinks with it.

In both cases, a single balance sheet is not enough: you need to follow the WCR and cash flows over several years to know whether the situation is getting worse or better.

Six questions to test your reading

Six common misconceptions, drawn from the review questions of the “Financial diagnosis and planning” module. Open each question to read the answer.