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Red Flag Alert: Balancing act
Balancing act
How to assess risk using a company’s annual accounts
Mark Halstead Deputy Chairperson Red Flag Alert
For brokers with clients who operate using a private limited company, annual accounts are an interesting and necessary piece of the due diligence jigsaw. By law, companies are required to publish a summary of their finances every year. These annual accounts reveal more about a company’s finances than any other public source. Current assets and liabilities are those items which the company expects to sell/dispose of or pay off within a year.
The higher the number the greater the liquidity of the company. Cash is the best current asset, followed by the strength of debtors and stock, although this will depend on the industry in which the company operates. For example, debtors in the construction industry are notoriously unreliable so take this into consideration. Also, the value of stock can also be misleading, as some stock is worth less than recorded on the balance sheet or can be very hard to sell. Again, remember to consider the wider picture.
Leverage
Copies of company accounts can be obtained online from Companies House. For many companies, the accounts held will be abbreviated accounts and whilst these may provide some useful information, they are likely to limit the amount of digging that can be done.
Before you start reading the actual accounts in any detail, take a look at whether they have been filed on time. Late filing is well known to be correlated with later insolvency. You should also look for any changes in directorship as this can show instability within the business. However, as with all measures they should be viewed as part of a wider picture.
When reading the accounts, focus on the balance sheet and the company’s profit and loss (P&L). The balance sheet will help you to understand the company’s cashflow and leverage.
Cashflow
You can get an idea of the company’s ability to pay their short-term debts using what’s known as the current ratio. This is calculated by dividing the company’s current assets by its current liabilities. Financial leverage is the use of debt to acquire additional assets or fund projects and will be the reason that the client has approached you. The balance sheet will help you to understand the company’s long-term liabilities, i.e., how it is funded. Looking at whether the company is funded by debt or equity allows you to see whether they
“When reading the accounts, your primary focus should be the balance sheet where you can understand the company’s cashflow, leverage. Also look at the company’s profit and loss
are tied into repayments which can put a strain on the business – such as mortgages. In abbreviated accounts it’s not always clear what everything is but it’s a good starting point.
Profit & Loss
The P&L account shows transactions made in the course of a company’s everyday operations, i.e., the total amount of sales and expenses ‘turned over’. The difference between the two is the company’s profit or loss for the year. The P&L does not include money a company has borrowed or that shareholders have invested as this is classed as capital not revenue. Looking at the P&L can help you to spot trends over time. What is happening to revenue is important: steadily growing or stable revenue over many years indicates the safest proposition. Variable, declining or spikes in revenue can mean the company is inconsistent, struggling or expanding quickly. Expansion sounds good but a lot of companies can run into problems by overtrading and getting into financial difficulties trying to grow too fast.
Looking at accounts is one part of the picture which should feature in your due diligence. Remember, don’t take the numbers at face value – contextualise them with the type of business you are assessing.
