How to Read a Balance Sheet: The Basics of Wise Investment Decisions
Choosing investments takes a lot of research into a company’s situation, past, present, and future. Periodically, companies make available certain financial statements that convey the firm’s financial position at a certain point in time in the past. The information contained in these statements gives clues to the company’s profitability and ability to compete with other firm’s in the same industry. Luckily, these statements follow certain rules and regulations that allow an investor to understand the corporation at a glance.
The Balance Sheet of a corporation is made up of three main parts. These parts have a relationship with one another which is known as the balance sheet identity. This identity is expressed with the equation:
Assets = Liabilities + Owners’ Equity
However, this identity is often confusing to the beginning investor. With a little math, the balance sheet identity can be rewritten as:
Owners’ Equity = Assets – Liabilities
This rewritten equation makes more sense because it is intuitive that the equity of the owners is made up of what the company is worth (assets) minus what the company owes (liabilities).
Assets are typically broken down into two types. The first type, current assets, is the firm’s assets that are most liquid. An asset is liquid if it can quickly be turned into cash with little loss of value. Cash is considered the most liquid asset and is sometimes synonymous with liquidity. Other liquid assets include accounts receivable, inventory, and those assets that are considered cash equivalents such as shares of stock in another company. An asset is generally considered current if it is expected to be turned into cash within one year from acquisition.
The second type, fixed assets, is the firm’s assets that are least liquid. In the market, they can not be quickly turned into cash without a significant loss of value. Such assets include property, plant, equipment and even intangible assets such as patents and trademarks. An asset is generally considered fixed if it is expected, at the time of acquisition, that it will not be turned into cash within one year. In fact, many fixed assets, such as buildings and land, are expected to stay on the company’s books for the life of the company.
Just like assets, liabilities are broken down into two types. The first type, current liabilities, is the firm’s liabilities that are expected to mature within one year. However, unlike assets, the maturity of a liability represents an outflow of cash rather than an inflow. Current liabilities include accounts payable, notes payable, and accrued expenses which are liabilities for which a good or service has been received but not yet paid for.
The second type, long-term liability, is the firm’s liabilities that have a maturity of more than one year. They include long-term bonds and even deferred taxes. Long-term liabilities often represent a major source of capital and funding for normal operations of a corporation.
Owner’s Equity (sometimes called stockholders’ equity) is the total value of the company’s stockholders and represents the second major source of capital for operations. This part of the balance sheet is comprised of the value of preferred stock, common stock, and retained earnings from operations. It is reasonable to think of owners’ equity as a plug number to make the balance sheet identity hold true. Owners’ equity is whatever is left over after the value of liabilities has been subtracted from the value of assets.
The Balance Sheet in its Entirety
Although the balance sheet can be broken down into the parts described above, the balance sheet as a whole is what’s important to an investor. On the left-hand side, current and fixed assets are combined to be referred to as just assets. This side of the balance sheet represents the decision-making of the firm’s managers. Keep in mind that there is a principal/agent relationship between the company’s owners and its managers. As agents, managers act in the interests of the owners who, because of the nature of the corporation, do not have direct control over their ownership of the firm.
The right-hand side of the balance sheet represents the firm’s capitalization and is made up of debt (liabilities) and equity (owners’ investments). Capitalization is a term used to describe how a company funds its operations. The two major sources of capitalization also represent the decisions of the firm’s managers. Although it is beyond the scope of this article to discuss the intricacies of choosing debt over equity, suffice it to say that the capitalization decisions of the firm’s managers can make or break a company if the wrong decisions were made.
The balance sheet of a corporation represents the cumulative decisions of the firm’s managers. The principal/agent relationship suggests that the managers act in the interests of the owners who do not have direct control over their ownership of the firm.
A multitude of ratios and other calculations are often used to determine certain aspects of a firm’s profitability and stability. For example, working capital is defined as current assets minus current liabilities. Working capital represents the firm’s ability to cover short-term liability. An inability to do so usually spells trouble in the market. The principle of market efficiency suggests that information such as this is reflected in the price of a company’s stock quickly and efficiently. At the first sign of trouble on the balance sheet, the stock price will change in response to the bad news.