When it comes to balance sheet quality, clarity matters. Unfortunately, this is not always what we get.
We’ve all come up against company accounts that we just don’t understand. That’s not to say the investor is not good enough for those accounts. It sometimes means that those accounts aren’t good enough for investors. They lack transparency or an appropriate level disclosure.
Admittedly, it is impossible to know everything about a company when you are looking from the outside in, as retail investors invariably are. We try our best with the information we get and, sometimes, as in the case of an early stage roll-out, there just isn't much information to go on.
This article is the final one in a loose series to do with accounting quality in general. The other articles are A Quick and easy cash flow checklist and Identifying high quality earnings.
On that note, it helps to assess financial reporting quality, earnings quality and cash flow quality in tandem. Poor financial reporting quality, poor earnings quality, and poor cash flow quality is a combination of red flags that should not be ignored.
Balance sheet analysis does not have to be intimidating and a few simple checks go much further than no checks at all. Paul Scott has kindly provided an insight into how he looks at a balance sheet (towards the bottom of this article) - his comments are always worth reading.
Financial reporting quality
Here are two areas that can impact financial reporting quality:
Off-balance sheet liabilities
Off-balance sheet items can understate a company’s true leverage.
The most common type of off-balance sheet item is probably the operating lease commitment. Operating leases - unlike capital (finance) leases - are not required to be shown on the balance sheet. Only the associated periodic rent expenses is reported.
This will all change with the introduction of IFRS 16, which companies are currently adopting and will eliminate nearly all off-balance sheet accounting for lessees.
For those companies with a lot of operating leases, financial metrics such as the gearing ratio and EBITDA might change as a result. This will increase comparability, but may also affect covenants, credit ratings, borrowing costs and perception of financial strength.
Other types of off-balance-sheet obligations include purchase contracts, which may be structured as take-or-pay contracts, and joint ventures or equity investments. These…
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