Investors considering buying shares in a company have a wealth of information available to help their decision-making.
Company specific news, market updates and financial statements are all available at the click of a few buttons – or a trip to WH Smith or Sainsbury’s to buy Shares. Armed with all this information, how can investors make sound choices when selecting stocks?
Here, we look at how to read financial statements, specifically a company’s balance sheet. In the first of a two-part series, we look at the key components, what they mean and consider the conclusions investors can draw from them. Astrazeneca’s (AZN) balance sheet at its half-yearly report date is a good place to start. Rated at AA- by credit analysts at Standard & Poor’s, it has one of the best credit ratings among UK listed-companies, so is likely to have a strong balance sheet.
The balance sheet is a key piece of information laying out the majority of a company’s assets and liabilities. It is split into three sections: assets, liabilities and equity: Equity is simply the component left over after subtracting liabilities from assets.
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Around 56% of Astrazeneca’s total assets are intangible assets and goodwill. This is fairly typical for a research and development-driven (R&D) business: it is an asset-light, technology intensive model. Intangible assets at pharmaceutical companies are usually from the ‘capitalisation’ of research and development costs in one form or another. Some of Astra’s intangibles, for example, relate to the purchase of third-party intellectual property on drugs which have received regulatory approval. This means when Astra pays the third party, the cost is not expensed in its income statement. Instead, it is charged only as a cash outflow (cash flow statement, investing cash flows) and the expense becomes an intangible asset, which are itemised in the notes to the accounts. The asset is charged off when sales of the drug are made, a process known as amortisation.
The process essentially smoothes income statement profitability, as compared to the lumpy up front cash outflows and longer term inflows.
Goodwill represents the amount paid for an acquisition over and above the ‘identifiable’ assets and liabilities of a company. Recall, assets minus liabilities equals equity, also known as book value. The presence of goodwill on Astrazeneca’s balance sheet indicates it has paid more than book value for some of its acquisitions (Astra itself trades at 3.9 times book value, so this is understandable).
Alex Morozov director of equity research at data provider Morningstar, says research and development costs and goodwill can be considered quite similar at pharmaceuticals companies. Broadly, the difference between them is simply an intangible asset (R&D) generated in-house or one resulting from an acquisition. In either case, the costs of generating those assets (outlays) are expected to be lower than the longer-term profitability of the internally developed or acquired drug.
Intangibles and goodwill are considered non-current or longer-term assets. Other examples of non-current assets on Astra’s books include property, plant and equipment, which make up around 11% of its assets.
Current assets are considered to be more ‘liquid’ than non-current assets. They include the most liquid asset, cash and equivalents, which at just under $5 billion (£3.1 billion), makes up around 8% of assets. Subtracting cash from ‘interest-bearing loans and borrowings’ in the liability section of the balance sheet ($10.1 billion), gives the figure for net debt: $5.1 billion. This is still considered a relatively minor amount of debt for a business with the cash generating powers of Astrazeneca, though the figure jumped around $3 billion, from $2.1 billion, in the six months to June.
‘Trade and other receivables’ is another large item on the assets side of the balance sheet, at 13.3% of assets. This refers to money owed to a company, usually from customers, which are expected to be settled within at least 12 months. ‘Other receivables’ in Astrazeneca’s non-current assets section refers mainly to a prepayment of royalties to another drug company for the distribution of cholesterol drug CRESTOR. This means it has paid the royalties before distributing the drugs, a standard arrangement.
Of Astra’s $32.6 billion of liabilities, debt makes up around a third. The next biggest item is current trade and other payables, at 32%, which represents the opposite of ‘trade and other receivables’, essentially money that Astrazeneca owes to its suppliers.
There are some components of assets and liabilities not recorded on the balance sheet. Operating leases are a good example. For example, Astrazeneca indicates in Note 26 to its accounts that its future minimum operating lease payments are around $450 million. Credit rating analysts often adjust financial statements to include operating leases on the balance sheet, as the leases have debt-like characteristics.
Some companies also have assets which are not recognised on their balance sheets. For example, mining companies’ reserves are not included as assets, though costs can be capitalised as the resources are developed – broadly similar to the way R&D expenses are treated.