Confident investors understand the business they’re buying shares in. This conviction often comes from studying company financial statements. The balance sheet is one of these statements, usually read after the cash flow statement and before the income statement.
The balance sheet shows us a snapshot of the company’s assets and liabilities at a specific point in time. Investors look at the balance sheet to find out how the company is faring financially.
The way the balance sheet is presented varies from company to company, but if you want to learn how to read a balance sheet, here are the key sections to look out for:
Assets and Liabilities
When reading a company's balance sheet, paying attention to both the assets and liabilities sides is essential. These two sides balance up with assets on one side and liabilities combined with shareholders' equity on the other side.
The assets side includes all company resources such as cash, investments, and physical assets (property, equipment, etc.). While the liabilities side includes company debt.
Inspecting both sides of the balance sheet gives us an understanding of the company’s overall financial health and ability to pay its debts.
Assets
On the assets side of the balance sheet, we see current assets and long-term assets.
Current assets include cash, money owed by customers, inventory, and pre-paid expenses such as insurance, rent or subscriptions.
Long-term assets include investments that mature more than a year into the future, fixed assets such as land, buildings, machinery and equipment, goodwill (a premium paid for acquisitions), and intangible assets such as intellectual property, patents and trademarks.
Liabilities
Similar to assets, on the liabilities side of the balance sheet, we see current liabilities and long-term liabilities.
Current liabilities include short-term debt, accounts payable (payments due in under a year), and accrued expenses such as dividends, interest, taxes, and wages.
Long-term liabilities include debt or taxes due more than a year ahead and deferred revenue.
Shareholder equity also appears on the liabilities side of the balance sheet. It includes stock in the company, such as preferred stock, common stock, additional paid-in capital, retained earnings, and treasury stock.
Liquidity
Poor liquidity means the company doesn’t have much cash and may struggle to pay its debts. Good liquidity means the company can pay its debts in a timely fashion and maintain stability.
On the balance sheet, you can gauge a company's liquidity by looking at its current ratio.
Current Ratio = Current Assets / Current Liabilities
A good current ratio tends to sit between 1.5 and 2.
The current ratio is just one measure of liquidity. Other factors can affect a company's ability to pay off its debts, such as cash flow and access to credit.
Investors want to see good liquidity because it gives confidence in the company’s ability to pay its debts.
However, too much liquidity can sometimes be a problem, as it may mean the company is not operating its assets efficiently and could miss out on potential growth opportunities. That’s why investors seek balance when it comes to liquidity, as it suggests the company can meet its short-term debts and invest in long-term growth.
Debt Levels
The debt-to-equity ratio is a useful calculation that investors use to gauge a company’s debt levels.
D/E Ratio = Total Liabilities/Total Shareholder Equity
Investors want to avoid companies with too much debt as it raises their risk profile. A D/E ratio of greater than 2:1 suggests risk as the company may be saddled with too much debt.
Capital Structure
Companies finance their assets and operations in varying ways, differentiating their capital structure. This can include a mixture of debt, equity, and other securities such as preferred stock, convertible bonds, warrants or options.
The capital structure includes money borrowed through loans along with money invested in the company by shareholders.
Investors look at a company’s capital structure to determine how risky or financially stable it is. A company with lots of debt could face high interest payments, which can drain its financial resources. Whereas a company with significant equity could be in a stronger position to meet its financial obligations.
The balance sheet can give you insights into a company's capital structure, and here, finance professionals tend to look for a balanced capital structure with a mix of both debt and equity.
Consider Overall Financial Health
In addition to these specific factors, it's also good practice to consider the company's overall financial health. This includes looking at its profitability (as reflected in the income statement) and any trends or changes in key financial metrics over time (such as revenue and expenses). It can also be helpful to compare the company's financials to those of its industry peers to get a sense of how it stacks up.
Overall, the balance sheet is just one piece of the puzzle when evaluating a company as an investment. By considering these factors and looking at the big picture, you can make more informed decisions about whether a particular company is a good investment.
Off-Balance Sheet Items
Off-balance sheet items are assets or liabilities that are not reflected on the balance sheet but may affect its financial stability. These could include leases, pension obligations, and certain types of contracts.
Accounts Receivable
Accounts Receivable is the money customers owe the company. When customers are slow to pay, it can adversely affect cash flow and stability.
Convertibility
Although company assets add value to the business, it’s worth looking at how quickly they can be sold for cash in an emergency. If a company is going through a very tough financial period, it may have to sell assets to survive.
Overall, the balance sheet is just one piece of the puzzle when it comes to evaluating a company as an investment. By considering these factors and looking at the big picture, you can make more informed decisions about whether a particular company is a good investment for you.
We've covered the main things to know and understand about the balance sheet. To dive deeper into this topic, you should read the more advanced 'What Do Finance Professionals Look For In a Balance Sheet?
As always, it's important to consider the company's overall financial health and do your due diligence before making investment decisions.
Why not continue your investing education journey with some of our other informative articles:
How to Find Investment Opportunities
How to Read Financial Statements
How to Read a Cash Flow Statement
How to Read an Income Statement
What Do Financial Professionals Look for in a Balance Sheet?