The Balance Sheet
The Importance of Understanding and Interpreting the Balance Sheet
The balance sheet provides the investor with a snapshot of the financial condition of the company. It shows the company’s assets, what it owns, and the liabilities, what it owes. The difference between the assets and the liabilities is the known as equity (stockholder equity) or net worth.
Equity = Assets – Liabilities
As the name suggests, the balance sheet must always be balanced. When you look at a balance sheet you will notice that assets always be equal to the sum of liabilities and owners equity. If assets increase then the total of equity and liabilities will have to increase by the same amount to keep the balance sheet in balance.
Let’s take a closer look the different sections of the balance sheet
Assets can be classified as current assets or non-current assets.
Current assets refer to those assets that can be converted into cash within one year. Current assets include items such as cash and cash equivalents, short-term investments, account receivables and inventory. Since account receivables refers to cash the company expects to receive in the future from the sale of a good or service it has provided, if it grows at a much higher rate than sales, this is a potential red flag because the company might end up not being paid (i.e., the company might be facing trouble collecting the cash for the good or service already provided). Another area to pay attention to is the inventory level. You want to make sure it inventory is turned over quickly because inventory means tied up capital for a company. If inventory levels keep growing relative to the sales it is another area you will want to investigate because it might mean the company has a lot of inventory that customers will only purchase if the price is dropped.
Anything that does not fall into the current asset category is considered a non-current asset. Long-term investments and property, plant and equipment are examples of non-current assets.
Similar to assets, liabilities are commonly classified as current and non-current liabilities.
Obligations the company is required to pay within one year are called current liabilities. Examples of current liabilities include shortterm debt and an account payable. Investors should determine if the company has sufficient current assets available to pay its shortterm obligations in a timely manner. You can determine this by calculating the working capital which is the difference between the current assets and the current liabilities. Divide current assets by current liabilities to come up with a ratio. The higher the ratio the better.
Obligations that are due one year or more in the future are classified as non-current liabilities (long-term debt).
The owners equity or net worth is equal to total assets minus liabilities and refers to the part of the company that is owned by the shareholders. The two main types of equity are paid-in capital and retained earnings.
Paid-in capital refers to the amount of money the company received when it sold shares of its stock directly to investors. Retained earnings refer to total profits the company has generated since it started minus any dividends that have been paid out to the shareholders.
When buying stocks you should also consider the amount of financial leverage the company is using. Leverage is calculated by dividing assets by owners equity. The higher the ratio, the more the company is financing its operations through debt. Keep an eye on the trend of this ratio because if it increases significantly over time the company is increasing financial leverage which can increase risk, If the company enters a period of reduced sales and profitability and can no longer service its debt obligations it could be forced into bankruptcy.