Insolvency. It is the word most dreaded by pretty much everyone in the business world, unless of course you are an insolvency expert, in which case it means you may have another job coming in.
For an investor, it can be a disaster. If the company into which you’ve invested your hard earned goes belly-up, as a shareholder you stand last in line. The tax man cometh first, quickly followed by the employees and the creditors, those who’ve lent money to the company.
The annual report can give you a pretty good indication of a company’s solvency. It’s not perfect because it generally reflects the situation on June 30, at the end of the previous financial year. But it is a good first step in figuring out just how healthy your company is.
A solvent company has more assets than liabilities. It is that simple. And that information is contained in the balance sheet, the first page of the accounts that gives an overview of the company’s financial situation.
All you need to look for is the item listed as Total Liabilities and the corresponding column listed as Total Assets. The accountants deduct the liabilities from the assets to come up with net assets. But the more important measure is to simply look at how the liabilities stack up to the assets.
A simple way to do this is to calculate a percentage. This is often called gearing. If liabilities are only 5 per cent the size of the assets, the company has minimal gearing and debts shouldn’t be a problem. At the other extreme, if liabilities are running just a smidgen under the size of the assets, this is a highly geared company that is running close to the wind and leaving little margin for error.
Bear in mind that it is not necessarily a bad thing for gearing to be high. The company may have borrowed heavily to finance an acquisition or expansion that will generate a lot of cash in the future.
It is also worth comparing the situation with that of a year earlier. All balance sheets of public companies run that comparison, giving you an indication of whether things have changed.
This isn’t a fool proof measure of corporate health. But it is a quick and easy way to get a grip on just how your company is being run and provides you with enough information to ask a legitimate question at the annual meeting.