Serious stock investors know they need at least a basic understanding of how to read a company’s financial statement including the balance sheet.
While the inner workings can get complicated – and fortunately there are numerous sources available to help you sort all that out – the basics of the balance sheet are not that difficult to understand.
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Balance Sheet Structure
There are 3 components to a balance sheet – assets, liabilities and equity. Assets are the things of value a company owns or that will be received and can be measured objectively. Liabilities are the opposite. They represent what the company owes to others – creditors, suppliers, the government (taxes), employees and so forth. Equity represents retained earnings and money contributed by shareholders or investors.
The fundamental balance sheet equation, then, looks like this: Assets = Liabilities + Equity. Assets tend to grow in concert with liabilities and/or equity. Or vice versa. They are tied together because as assets grow on one side of the equation, liabilities and/or equity grow to keep the equation – and the company’s financial position in balance.
It’s important to realize a balance sheet represents a company’s financial position at the end of one day at the end of the company’s fiscal year. This “balance” can be contrasted or compared with the “income and cash flow” statements, which represent operations for the entire year. One way to look at the difference is that a balance sheet is a photograph. Income and cash flow statements represent a movie.
For this reason, analysts like to use an average number (called “averaging”) in which they take the year-end balance sheet numbers (assets, for example) for 2 consecutive years, add them together and divide by 2. This provides a better sense of the balance sheet amount for the entire year in question.
Breaking Down Assets
Assets come in two flavors – current assets and non-current assets. Current assets have a life span of 1 year or less and can be converted easily into cash. These types of assets include cash and cash equivalents, accounts receivable and inventory on hand. Inventory can be finished products, work-in-progress or even raw materials. It can also consist of goods purchased from others.
Non-current assets are those that are not easily turned into cash and have a life span of more than a year. This can include tangible assets like machinery, computers, buildings and even land. Non-current assets can also be things like goodwill, patents or copyrights owned by the company. Another important non-current asset is the company’s brand name and the value that implies.
Breaking Down Liabilities
On the other side of the equation live liabilities. Liabilities can also be current and long-term (non-current). Long term liabilities are debt and other non-debt obligations all of which are due more than a year away.
Current liabilities are those that must be paid within a year. This would include short-term borrowing, accounts payable, current salaries and so forth.
Breaking Down Equity
The final component on the right side of the equation is equity. For the most part, this is shareholder equity and represents the money invested in the business. If, for example, at the end of the fiscal year, a company decides to reinvest its net earnings in the company (after taxes) those earnings will be moved from the income statement to the balance sheet and into the shareholder’s equity account.
This represents the company’s total net worth. For the equation to balance, total assets must equal total liabilities plus equity (net worth).
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Analyzing The Balance Sheet
Hallmarks of a weak balance sheet are - Negative or deficit retained earnings; Negative equity; Negative net tangible assets; Low current ratio and Negative or deficit retained earnings.
A strong balance sheet isn’t simply one with none of the issues plaguing a weak balance sheet. Instead look for - Cash and short-term investments; Low or no long-term debt and Undervalued assets.
There’s another type of balance sheet known as a “work-in-progress.” A work-in-progress can be identified by management focus on change, especially regarding the financial condition of the company. Paying down debt and accumulating cash is another positive sign.
Overall, when reviewing balance sheets look for lots of cash and low levels of debt along with other factors. The more cash and the less debt the better. While you are at it, check out the various balance sheet widgets available on FinanceBoards.