A balance sheet is a financial statement that lists what a company owns, called assets,
what it owes, called liabilities, and what’s left over, called shareholders’
equity. It’s basically a snapshot of a company’s financial situation at a certain moment in time.
Investors often use it for stock analysis because it documents how capital is invested
and can help determine a company’s book value, one measure of what a company is worth. In general,
a growing balance sheet often signals a growing company. The balance sheet can show whether a
company is growing through its normal business functions or taking on massive amounts of debt.
Additionally, the balance sheet provides a lot of information for other fundamental analysis tools,
including financial statements like the income and cash flow statements
and financial ratio analysis. Let’s break down the balance sheet and discuss how investors can
analyze it to help make stock investing decisions. The balance sheet is based on a simple equation:
assets equals liabilities plus shareholders’ equity. In other words, what does the company own,
and what’s the value of what it owns versus what it owes? Assets have a corresponding liability
or equity item that shows how it was acquired in order to create balance in the statement,
thus the name balance sheet. Assets are things the company
owns that have value or an economic benefit. This includes tangible items like property, factories,
equipment, and inventory. Assets also include intangible items like patents and trademarks.
Cash and investments are assets too. If you look at the other side of the
balance sheet, you’ll see liabilities and equity. By rearranging the formula
to assets minus shareholders’ equity equals liabilities, we can see the total liabilities.
Liabilities are money or items of value a company owes to others, but it also includes rent for
buildings, money owed to vendors, or taxes due. If you subtract liabilities from assets, you’re
left with shareholders’ equity. Often called book value, it’s the amount of money that would
be left to shareholders if the company shut down and sold its assets and paid all its liabilities.
A company releases its balance sheet every quarter as it reports its earnings as well as annually as
part of its 10-K reporting a comprehensive and in-depth financial report required by
the Security and Exchange Commission, or SEC. Now that you’re familiar with the basics of
balance sheets, let’s look at some ways investors can analyze them.
Because balance sheets are just a snapshot in time, investors often evaluate a company
by analyzing how its balance sheet has changed over time. For example, one way you can follow
the growth of a company’s value is by looking at the shareholders’ equity year over year.
Investors generally want to see increasing assets and equity and
decreasing or relatively slow-growing liabilities. Let’s look at an example. Here is a tech company’s
balance sheet data from 2015 to 2020. You can see total assets, liabilities, and equity all grew,
with liabilities rising at the highest rate. Historically, liabilities outpacing equity
would be a bad sign. However, in a low interest rate environment like the late twenty-teens,
this may be less of a concern because it’s cheaper to borrow. But if interest rates rise,
that debt could become a problem. In addition to evaluating a company’s
balance sheet over time, many investors use the balance sheet to compare one company to another.
Just keep in mind, what’s normal may vary between industries. Comparing a tech company to an energy
company wouldn’t make sense because the two companies have very different businesses.
Energy companies may typically carry more debt because they tend to have a lot of
capital expenditures on equipment. So, investors typically compare a company to another company
in its industry or an industry group average. One way to do this is using financial ratios.
Using ratios instead of raw numbers makes it easier to compare companies of different sizes.
For example, the quick ratio measures a company’s ability to pay its short-term bills,
which is why it’s called a liquidity ratio. This is done by adding cash and cash equivalents,
short-term marketable securities, and accounts receivable, and then dividing
the sum by the total current liabilities. Generally, a quick ratio of one is normal.
Ratios less than one may be a sign that the company can’t pay its bills. The higher the ratio,
the higher the financial strength. Keep in mind, what’s normal may vary between industries.
In 2020, the previously mentioned tech company had a quick ratio above one
and above its industry average. This suggested that it had enough cash to pay its bills.
Another useful balance sheet ratio is the total debt to total capital ratio.
This ratio measures the company’s use of financial leverage by comparing its total
amount owed to its total capital. Capital is the combination of debt and equity. Generally,
the higher the ratio, the higher the level of debt and the greater the risk to the company.
This tech company had a debt-to-capital ratio that is right around its industry average.
So, in this example, there are no red flags. There are numerous other financial ratios
that draw from the balance sheet and other financial statements like the income and cash
flow statements. These ratios measure a stock’s valuation, profitability, dividends, growth rates,
effectiveness, and financial strength. Investors typically draw from a number of these ratios
to determine if they want to invest in a stock. Financial ratios can help identify profitability
trends, compare and contrast companies, and be used in conjunction with other analysis.
The balance sheet is usually the first financial statement accountants draw up,
and it’s where financial analysis begins but not where it stops. Looking at a company’s financial
statements can help you as you evaluate if it’s potentially a good investment.