Can you rely on a Balance Sheet for valuing a company?

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Think about numbers as stars, each with its own story to tell!

Look at this Bright Sky at night, away from the town lights, no clouds or moon to restrict our view; each beautiful and shining star is in its place. The sky gives us a magnificent view, doesn’t it?

Some of the stars you are viewing now may have collapsed millions of years ago: their light is still travelling towards Earth and that is why we can still see them! Conversely, there are also newly born stars out there that we do not see because their light has not reached us yet.

Back on Earth, we argue that the Bright Sky resembles the Balance Sheet (BS) – where you get a total and magnificent view of a company. But look closely enough and you will notice that you may be looking at stars that do not exist anymore, or that some stars are barely visible.

Balance Sheet

XYZ Group – Statement of Financial Position as at 31 December 2037

(in millions of Earth currency units)

Highly Visible Stars: Assets

We know from previous articles and i-learning courses that an asset in a balance sheet represents resources that are expected to bring future cash flows to the company. So, property, plant and equipment, for example, are expected to bring a minimum of 493,200 million Earth Currency Units in the foreseeable future. This is according to the Balance Sheet.

We also know that this is arrived at by using judgment. Whose judgment? The management of the company of course. They look into the future and they make estimates. They estimate the Economic Useful Life of the asset and its residual or scrap value and they determine a way to depreciate the asset on an annual basis. So, the 493,200 million has already been spent when the asset was probably acquired, and we show it as a future cash generating item!

We also know that under certain accounting standards it is possible to revalue our assets! So overnight the value, or rather the future cash flows, may increase! 

Intangible Assets

Let us look at the other asset stars: Goodwill, or intangible assets like brands or patents or football players. These values arise when a company is bought, or a brand or footballer are bought at a price higher than their book values, and this relates to the good name or reputation or uniqueness of the company. These are therefore assets like any other, as they are expected to generate future cash flows.

However, how sure are we that Goodwill is what we think it is? We were willing to pay a certain amount for an asset yesterday, but what if we realise today that that was an incorrect amount? If the footballer gets upset with the manager or if the brand is now out of date due to new developments in technology, they will probably not generate the kind of cash flows we would expect. The question is therefore, “have the values been adjusted to reflect any sudden changes or news?”.

Trade Receivables 

Let us take one last star in the sky, trade receivables. We keep selling on credit giving our customers attractive credit periods and we call this aggressive selling! Are we also looking into the future to estimate the possible bad debts? In other words, are we making sufficient provisions to show to the readers that this star may not fetch what we originally expected. And do we know how these estimates were made? By definition, estimates are based on judgment! And judgment is based on what telescope we are using to look into the future. 

Black Holes: Where are the Liabilities? 

One last item is the invisible stars: We know today that black holes exist and they are detectable but not to the naked eye. So, are there any liabilities that are not included? You will remember that certain derivatives, or lease agreements could stay out of the accounts!

Be aware Analysts, Investors, Auditors! The bright sky of the Balance Sheet requires careful reading if you are to catch all stars and what they are saying!

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