If you’re interested in investing, you’ve probably read quite a few articles that say “do your homework” before buying a stock.
Reading and understanding a balance sheet is part of that homework. Taken together with the income statement and cash flow statement, the balance sheet provides investors with an idea of the worth of a company, says Robert Johnson, finance professor with Creighton University.
“Investors with a practiced eye and attention to detail can take a quick glance at a balance sheet and identify a company’s financial strengths and weaknesses,” he says.
To understand the fundamental components of a balance sheet, along with the financial position a balance sheet can convey, investors should ask the following questions:
— What is a balance sheet?
— What’s on a balance sheet?
— What is a balance sheet used for?
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What Is a Balance Sheet?
Investing experts view the balance sheet as a snapshot of a company’s health at a certain point in time. It’s a summary of how much a company owns in assets, owes in liabilities and the difference of the two, which is shareholders’ equity.
The balance sheet is so named because all of the assets have to equal, or balance out to, the liabilities and shareholder equity.
Internal accounting departments typically prepare large-company balance sheets, which are then audited by an independent accounting firm. Smaller companies might have an outside accountant who helps them prepare the balance sheet, or the task might fall to an internal bookkeeper.
What’s on a Balance Sheet?
While you can drill down as far as you’d like into accounting definitions — this is homework, after all — here’s a basic primer on what you’ll find on a balance sheet:
Assets: Assets include cash, investments, accounts receivable, inventory, land and buildings that are grouped from most liquid to least liquid. So cash would come first and buildings would come last on this list. Intangible assets lack physical substance. The full amount of assets owned by a company is know as total assets.
Liabilities: Liabilities, such as accounts payable, short-term and long-term debt, capital leases and pensions or other retirement benefits are listed in order of when the debts come due, from sooner to later. Long-term liabilities are due at any point after a year in the future. A company’s total liabilities are the combined debts and obligations owed to other parties.
Equity: This is probably where you come in as an investor. Common or preferred stock are types of shareholders’ equity. You may hear the term “book value” thrown around in place of shareholders’ — or stockholders’ — equity, but more on book value will follow.
What Is a Balance Sheet Used For?
A balance sheet is often used in conjunction with other documents, such as an income statement, which demonstrates profit or loss, and a cash flow statement that lists how a business has spent and received money. Taken together, these documents can help you decide whether or not to buy shares.
“Balance sheets can help investors understand companies by providing them with some of the building blocks needed to look at key financial ratios one might use to assess a company’s overall health and to compare one company to another within the same industry,” says Cassandra Kirby, private wealth advisor with Braun-Bostich & Associates.
Ratios to look out for include a company’s debt-to-equity ratio, which can tell you whether a company has taken on too much debt.
“The more leveraged a company is (…) the more investors worry about a company’s probability of default,” says Mayra Rodriguez Valladares, managing principal with MRV Associates.
[Read: How to Build an Investment Portfolio.]
Another key ratio is a metric known as the current ratio, which divides current assets by current liabilities.
“Companies with current assets that are barely greater than current liabilities typically need to fund working capital via a line of credit or other debt financing, which puts a strain on the company’s cash flow and can cause problems such as an inability to purchase products or pay for top talent and in some cases can lead to bankruptcy,” says Sam Brownell, founder of Stratus Wealth Advisors.
Financial ratios can track progress over a period of time and can be used to compare the company’s balance sheet against industry benchmarks, says Jessica Distel, director of tax and business services with Buckingham Advisors.
Looking at a balance sheet can help also investors find bargains.
“Book value is roughly designed to give investors an idea of what a company would be worth if all its assets were (…) sold off,” Johnson says. “Some investors look for undervalued companies by looking for where stock prices are below a company’s book value.”
The Bottom Line
Investors using broad-based index funds probably don’t need to be obsessed with monitoring the balance sheets of companies because their holdings are going to be quite diversified, says Brownell.
If you’re purchasing funds with concentrated positions or buying individual stocks, then you’re definitely going to want to know how to analyze a balance sheet, he says.
“Everyday retail investors probably do not need to be overly consumed by balance sheet analysis,” Kirby says. “However, having a general understanding of the variables that factor into a balance sheet and how to analyze certain key financial ratios may help a retail investor to better understand a potential investment and to be able to calculate some of these ratios and compare them to a possible alternative.”
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Understanding a Balance Sheet: Assets, Liabilities and Equity originally appeared on usnews.com
