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A balance sheet is a financial statement produced by a company to report its assets, liabilities, and stockholder’s equity at a specific point in time.
Think of the balance sheet as a snapshot picture of the company’s financial position at the end of an accounting period.
It allows the user of the statement to see what a company owns and what it used to acquire what it owns (debt and equity).
BALANCE SHEET EQUATION
The “balance” in balance sheet refers to the statement’s adherence to the most notable accounting equation:
Assets = Liabilities + Stockholder’s Equity.
The two sides of the equation must balance. The items on the balance sheet for assets must equal the sum of its liabilities and stockholder’s equity.
You can look at it from this angle. The assets that a company owns are owned by either creditors or investors.
Creditors lend you money through loans to purchase your assets and investors invest equity into the company to help you purchase assets.
WHAT IS A BALANCE SHEET USED FOR?
A balance sheet is used to analyze a company’s financial position and health.
Since the balance sheet is only a snapshot at a specific period of time, it takes balance sheets from different periods of time to compare.
Companies use the balance sheet to report its financial position to their stakeholders, including management, government agencies such as the SEC, and the community of investors and creditors.
The balance sheet contains valuable information on it and is used by management, investors, creditors, and lenders for various things.
- Financial ratios can be built from items on the balance sheet for performance, liquidity, solvency, and efficiency
- Creditors will look at a balance sheet to see if a company has the ability to take on more debt and what the risk would be.
- Investors will look at the balance sheet to see if a company would be able to issue a dividend
- A company looking to acquire another company will look at their balance sheet to see how they could structure an acquisition
- Management of companies will analyze their balance sheets to decide whether to raise fund through debt or equity and assess the risk of their balance sheets
- Items on the balance sheet are used to calculate cash flow on the statement of cash flows. For example, changes to items on the balance sheet will change the amount of cash used or received, which will affect the statement of cash flows.
BALANCE SHEET STRUCTURE
The balance sheet is divided into two sections. One section is for listing the assets of the company. The other section is for listing liabilities and stockholders’ equity.
Items the company owns and have an economic value
Examples: Cash, Accounts Receivables, Investments, Inventory, Supplies, Prepaid Items, Land, Property, Pland and Equipment, intangible assets like Goodwill, Copyrights, Patents, Trademarks
What the company owes to creditors
Examples: Notes Payable, Accounts Payable, Salaries Payable, Interest Payable, Wages Payable, Income Taxes Payable, Unearned Revenues
Amount left for shareholders after liabilities have been paid. Amount from sale of shares of the company plus earnings minus distributions
Examples: Contributed Capital, Retained Earnings
For both sections, the line items are listed in order of liquidity, with liquid items at the top and less liquid items towards the bottom.
The Assets section is usually broken down into current assets, non-current assets, intangible assets, and other assets
The Liabilities section of the balance sheet is broken down into short-term and long-term liabilities.
Stockholder’s Equity contains the line items including contributed capital and retained earnings.
WALK-THROUGH OF MAIN BALANCE SHEET LINE ITEMS
- An asset that can be quickly converted into cash or used to pay down liabilities within 12 months.
- Cash, as you know it. It is the most liquid form of an asset.
- Assets of investments made with the expectation to convert it to cash within 12 months
- Examples are money market accounts, Treasury bills, CDs, high-yield savings accounts
- Money owed to the firm by someone else
- All inventory assets the firm owns, including materials, work in process inventory, finished goods, and goods for resale
Other Current Assets
- A catch-all line item for other current assets
- Assets which are not easily and quickly converted into cash
Property, Plant and Equipment
- Assets like land, machinery, vehicles, buildings, etc
- The accumulated amount of depreciation on capital assets that reduce the value of the capital assets on the balance sheet
- Assets that cannot be seen or touched, but still have value
- Examples are trademarks, patents, copyrights and goodwill
- The total of all current, non-current, and other assets the company owns
- The group of liabilities that are due to pay within 12 months
- Money owed to someone else due within 12 months
- Salaries the company is obligated to pay out
- Money received for work that has yet to be performed
Other Current Liabilities
- A catch-all line item for other current liabilities
- Debts owed by a company that are to be paid further than 12 months out of the balance sheet being viewed
- Cash and other assets contributed by investors in exchange for shares in the company
- Cumulative net earnings amount after a company has paid out dividends to shareholders
- Retained Earnings = Prior Period Retained Earnings + Net Income – Dividends
HOW TO ANALYZE A BALANCE SHEET
You can analyze a single balance sheet on its own for a company, but it will probably be more useful to analyze multiple balance sheets from the same company at different points in time.
Then you can make sense of the line items and find out what the historical averages are looking like.
Once you are ready to dig into the numbers, here are some questions you can ask yourself to understand the company’s financial position and health.
- How much does the company have in assets? debt? stockholders’ equity?
- Have those numbers been increasing or declining over the years? Why?
- What are the current vs non-current items telling me?
- Does the company have enough liquid assets to pay off short-term liabilities?
- How much debt does the company have compared to equity? Is the company at risk with its debt levels?
A great way to utilize the balance sheet is to build financial ratios from the line items and the line items from the income statement and statement of cash flows.
There are financial ratios that can help you analyze liquidity, solvency, efficiency, and profitability.
- Quick ratio = (Cash + Cash Equivalents + Short Term Investments + Current Receivables) / Current Liabilities
- Current Ratio = Current Assets / Current Liabilities
- Debt to Equity Ratio = Total Liabilities / Total Equity
- Equity Ratio = Total Equity / Total Assets
- Debt Ratio = Total Liabilities / Total Assets
- Accounts Receivable Turnover Ratio = Net Sales / Average Accounts Receivable
- Asset Turnover Ratio = Net Sales / Average Total Assets
- Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
- Gross Margin Ratio = Gross Margin / Net Sales
- Profit Margin Ratio = Net Income / Net Sales
- Return on Assets Ratio = Net Income / Average Total Assets
- Return on Invested Capital Ratio = Net Operating Profit / Invested Capital
- Return on Equity Ratio = Net Income / Shareholders’ Equity
You can use these ratios compare different companies against each other and also compare a company to itself at a different point in time.
Look for trends that are developing for a company and compare those trends vs the industry average.
Once you start dissecting the ratios, you’ll be able to understand more about the business and the industry to make investment decisions.
Finally, you can read the management commentary and footnotes.
- Management commentary and footnotes can be found in a company’s annual report and quarterly filings.
- In the management commentary section, management will talk about the operations of the business, fresh news and development, and any trends they are seeing.
- In the footnotes, you can learn a lot about the accounting methods used to calculate certain line items and important one-time events can be disclosed in the footnotes.
- Both management commentary and footnotes are insightful to read and can help give you some color around analyzing the balance sheet
WHERE TO FIND THE BALANCE SHEET FOR A COMPANY
There are several places where you can find a company’s balance sheets and other financial statements as well:
- EDGAR stands for Electronic Data Gathering, Analysis, and Retrieval and it is a tool on the SEC website where you can find the filings of companies
- The link is here and you can search a companies name or ticker
Investor Relations Website
- A company will typically have an Investor Relations section on their website with a bunch of information they want their investors to know about, including press releases, financial statement filings.
- Here is a link to Walmart’s Investor Relations page as an example
Sites like Yahoo! Finance
- Financial news websites like Yahoo! Finance will have interactive financial statements for public companies on their site. Simply search the company name or ticker in the search bar.
- As an example, here is a link to Carnival Corporation’s balance sheet
- A Bloomberg Terminal is a computer software program that contains a massive amount of financial data on companies
- It is an extremely expensive subscription to have, but if you have access to one, you can find the SEC filings of a company on it
LIMITATIONS OF BALANCE SHEETS
Limited on its own
- The Balance Sheet is a snapshot at a point in time. On its own, it can be valuable, but for more context, you will need balance sheets from prior accounting periods to compare to. Also, it helps to analyze the Balance Sheet alongside the Income Statement and Statement of Cash Flows
- Some of the values for assets are based on estimates which may lead to an inaccurate picture of the true financial position of a company
- Assets valued on historical cost can have inaccuracies as well and may not show an accurate market value. Value of assets on the balance sheet such as land may be presented much lower than its true market value.
Assets not accounted for by value
- Assets such as employee loyalty and know-how as well as company culture are not reflected on the balance sheet in a monetary value.
- Accounting systems and methods can differ for a company from period to period and can also differ between companies and industries
- It is necessary to go further in your analysis to understand the accounting policies implemented by a company and how that affects the line items
The balance sheet is key in determining the financial position of a company.
The foundation of the balance sheet is that assets must equal liabilities plus stockholders’ equity.
It is best analyzed with balance sheets from the same company from different periods and alongside the income statement and statement of cash flows as well.
By using the three financial statements together, you can analyze using financial ratios to look at liquidity, solvency, efficiency, and profitability.