Ever wonder what people are saying when a company has a “rock-solid balance sheet”? Balance sheets display a company’s assets and liabilities, and how much equity you the shareholder have. On one side of the scale is are assets, and the other displays liabilities and shareholder equity. In total, the equation always ends up as Assets = Liabilities + Shareholder Equity. Through this article, we’ll go into detail on how to read a balance sheet.
Think of a balance sheet as a company’s medical record, it can display how financially healthy a company is. Being able to read a company’s balance sheet for yourself will help you discover if you are making the right decisions with your money when choosing to invest.
Balance Sheets have three high-level categories that they are broken into:
- Total Assets – The sum of everything that the company owns. This includes everything from cash to machinery to intellectual property. Assets can be broken into two subcategories
- Current Assets – These are the assets that a company expects to be sold or used over the next 12 months.
- Non-Current Assets – As opposed to Current Assets, Non-Current Assets are long-term investments that are not to be fully utilized within one year.
- Total Liabilities – The sum of the debts the company owes. This includes everything from open invoices from suppliers to open loans to dividends yet to be paid.
- Current Liabilities – All debts a company owes that must be paid off in the next 12 months.
- Non-Current Liabilities – All debts a company owes that are not due in the next 12 months.
- Shareholder Equity – This is where the term “Balance” comes into the Balance Sheet. Shareholder Equity is calculated by subtracting the Total Liabilities from Total Assets. This is the value of a companies shares if all assets were sold and liabilities paid. This metric is often referred to as “Book Value”.
Each of these categories has further subcategories that get more into the details about a company’s financials. Many times, there are hidden costs or misleading information that can be identified by looking a little deeper.
Now that you have an understanding of the different categories on a Balance Sheet. You might be wondering how it all ties together? What should you be looking for? What makes a solid balance sheet? All good questions that don’t take a CPA to answer. Let us look at 3 items that can easily show if a company is financially strong:
1. Current Ratio (Current Assets / Current Liabilities)
This is a metric that identifies if the company has enough assets on hand to pay for all of its expenses it will have in the next year. If Current Liabilities are greater than Current Assets (ratio of less than 1) the company will either rely on future income to pay off debts, take out a loan to pay off current obligations, or default on some of these payments. None of the mentioned are ideal, and if the company hits hard times (let’s say a pandemic) there could be some consequences for you as an owner. Warren Buffet always likes to have a current ratio of greater than 1.5 before he invests.
It’s also smart to look at this ratio over time to identify any possible trends. If this ratio is less than 1 but has been increasing over the past 5 years, this may display that the company is recovering from a past financial hardship. If the opposite were to occur where the company has a ratio of greater than 1 and has been decreasing over the past 5 years, the company might be headed towards a gloomy future and needs to be investigated further.
2. Total Assets – Goodwill – Total Liabilities = Revised Book Value
A company’s book value is shown as how much a corporation would be worth if it is completely dissolved on the spot. If we dig a little bit deeper, we can see that sometimes this number can be flawed.
Goodwill is an intangible asset that is defined as the amount a company pays over book value to acquire another company. This can cause the Total Assets portion of a Balance Sheet to be misleading as a firm could have overpaid for an acquisition. Taking these out Book Value will give you (the investor) a better idea of what you are paying for.
Using this revised Book Value you can then calculate the revised Price/Book Value metric. Values of less than 1 can indicate a bargain stock and less than 3 can be considered a good value. This can help you from picking widely overvalued stocks.
3. Minimal Long Term Debt
A company with large amounts of debt will have to prioritize paying it off as opposed to investing for future growth. Loans with low interest can be a way to provide financing for investments, but too large a balance can bog a corporation down. In your own life, think of having a mortgage of $200,000 vs. $2,000,000. A mortgage is a useful tool to gain wealth, but the payments for a large enough mortgage can be unsustainable.
A way we can measure a corporation’s debt and see if they are financially stable is the Debt-to-Equity Ratio. Debt to Equity = Total Liabilities/Shareholder Equity. Ratios under 0.5 represent companies that are not overloaded with debt and should have the ability to be flexible in today’s environment.
The Devil is in the Details
Sometimes a deep dive finds hidden opportunities. For those who want to learn more about the details on a Balance Sheet, I have some further explanations on what the subcategories mean below. Keep in mind some organizations may include even more details that may be specific to their business.
Current Assets
Cash and Cash Equivalents – Pretty self-explanatory right? This is the amount of cash a company has on hand or in the bank. Lots of cash can show a company’s strength and ability to invest in the future.
Short Term Investments – This includes any investment that will come to maturity in the next 12 months that is not cash.
Net Accounts Receivable – In the business world there are rarely ever times when payments are made the same day the good/service is received. There are usually payment terms that can vary from 30 to 120 days. This category is outstanding funds the company is owed for goods already provided to the customer.
Inventory – The value of raw materials, goods in production (work in process), and finished goods the company has at the date the Balance Sheet was made.
Deferred Cost – A cost that a company has already incurred that will not show up as an expense until sometime in the next 12 months (think of this as a prepaid liability). This will show as an asset until the period when the expense was originally supposed to be realized.
Prepaid Assets – Payments made for assets before they are realized. An example may be equipment ordered and paid for before it arrives at a factory.
Non-Current Assets
Net PPE (Property, Plant, and Equipment) – This is the sum of the value of land, buildings, and equipment minus the depreciation of assets from when they were originally purchased. A good example of depreciation of an asset would be your car after you have owned it for a few years. It starts to lose its value after use and time. The same would apply to equipment that a company uses for manufacturing or even office furniture.
Goodwill – Is an intangible asset that is defined as the amount a company pays over book value to acquire another company. In my opinion, this can be misleading. Goodwill can often make a company’s assets seem much larger than they are. A company could have a large Goodwill value if they overpaid to acquire a competitor. Take this metric with a grain of salt when valuing a company.
Intangible assets – Assets that are not physical ones. Examples of these may include a company’s patents, intellectual property, and brand name.
Investments and Advances (sometimes shown as Marketable Securities) – These are liquid and long-term financial assets that the company owns.
Deferred Income Tax – Taxes a company may have paid in the previous tax period that they can deduct from their next tax bill.
Other Non-Current Assets – Everything else that is not included in the above buckets.Current Liabilities –
Current Liabilities
Accounts Payable – Just as in the current assets section you have “accounts receivable” accounts payable would be the opposite. This is what the company owes to its suppliers for goods/services already received that it has not yet paid.
Income Tax Payable – What the company owes in income taxes over the next 12 months.
Dividends Payable – Total dividends to be paid in the next 12 months to shareholders.
Other Payable – Includes other types of payables that would be due within the year that are not mentioned above.
Current Accrued Expenses – Liabilities that may have built up over time and will be due within the next 12 months.
Pension & Other Post Retirement Benefit Plans Current – Funds that a company puts into a pension or retirement plan for employees. This is the cost that the company plans to deposit over the next 12 months.
Current Capital Lease Obligations – Amount due in the next 12 months for any long-term lease agreements.
Current Deferred Revenue – Money received for services or goods that are yet to be performed or delivered and will be in the next 12 months.
Other Current Liabilities – Any other debt that will be due in the next 12 months that is not included in any of the above buckets.
Non-Current Liabilities
Long Term Debt – Any outstanding debt that will not fully mature until 12 months or longer.
Long Term Capital Lease Obligation – Amount a company owes for any lease agreements that will not be due until after 12 months.
Non-Current Deferred Taxes Liabilities – Taxes that will be due after the next 12 months that have not yet been paid.
Non-Current Deferred Revenue – Money received for services or goods that are yet to be performed or delivered and will be in the next 12 months.
Non-Current Trade and Other Payables – Any payments due to a company’s suppliers that will not become due until after the next 12 months.
Other Non-Current Liabilities – Any other debt that will become due after the next 12 months
Shareholder Equity
Retained Earnings – Amount of net income that a company is held and not paid out to investors at the end of a given time. A company can use this to further invest into the business or payout to investors.
Outstanding Shares – Number of shares that a company has issues with its stock. This can be used to calculate different ratios that need this value (such as Earnings Per Share).
Additional Paid-In Capital – The value of share capital sold to shareholders above its par value. This number can show what a company has raised from a new stock offering.
Treasury Stock – Number of shares a company holds of its own shares. This is often the amount the company has repurchased over time.
Now you should have a much better understanding of what every line of the Balance Sheet means, and some high-level things to look for on a company’s balance sheet. They can be useful tools to do your own research instead of having to take someone else’s advice.
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