April 20, 2024

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Costing Accounting Everyday

How to Read a Balance Sheet for Investing

As you get more advanced in your investment journey, you’ll want to analyze stocks in greater detail (more than just looking at charts and other experts’ recommendations).

One thing you should understand as you become an advanced investor is how to read a balance sheet. So in this article, we’ll break down what precisely the balance sheet is, why it’s essential, and how to read it so you can make better investment decisions.

What Is a Balance Sheet?

A company’s balance sheet is one of the most important financial documents they report on. The balance sheet is a document designed to communicate how much an organization or a company is worth. This is also called the book value.

The balance sheet lists the company’s assets, liabilities and the owners’ equity of a particular date. This date is called the reporting date. Usually, the balance sheet is prepared and delivered to stakeholders on a quarterly or monthly basis, but you’ll also see an annual balance sheet in the company’s annual report, assuming they’re a publicly traded company.

What Is the Purpose of the Balance Sheet?

Along with the income statement and the cash flow statement, the balance sheet makes up what most consider the cornerstone of a company’s financial statements. It summarizes the company at a point in time, and it shows its financial position, which is broken down into assets, liabilities, and equities.

As a manager or an executive within the company, especially someone who is tasked with making important decisions on the company’s future, the balance sheet provides a lot of insight into whether the company succeeds or fails.

If their balance sheet doesn’t look good and looks as if they might be on track to failure, the company can shift their approach to correct some negatives showing on their balance sheet. This might include looking at new investment opportunities or adding additional resources.

On the flip side, if a company’s balance sheet looks good as they’re checking in on it monthly or quarterly, it allows the company to look at what’s working well and enable them to leverage and continue to do those things so they can continue to grow.

The balance sheet provides a nice checkpoint for how well the company is doing. More importantly, from an investor’s perspective, the balance sheet provides a lot of insight into how the company is performing, how they are financed, and whether or not it’s an investment worthwhile for you.

Based on the information you could pull from the balance sheet, you as an investor can determine whether you want to invest in that company. Also, the balance sheet provides information allowing you to calculate things like liquidity, the company’s debt-to-equity ratio, and their short- and long-term profitability.

There’s a lot of information aside from what you see on the balance sheet. You can use this information to calculate even more information to go deeper in your technical analysis of the company. It provides a ton of information for investors.

Finally, external auditors use the company’s balance sheet to ensure that the company is complying with reporting laws they are subject to.

How to Read the Balance Sheet

Now that you have a better understanding of the balance sheet and its purpose let’s get into a little more information on how to read the balance sheet to make better investments.

The Balance Sheet Equation

One of the fundamental things you need to understand about the balance sheet is its information and how it’s organized into these equations. The main equation that you will see is:

Assets = Liabilities + Owners’ Equity

That’s pretty common. However, you can also see the equation written as:

Liabilities = Assets – Owners’ Equity

or

Owners’ Equity = Assets – Liabilities

Either way, those equations equal the same thing, and it’s an equation that balances out the balance sheet.

As the name suggests, the sheet is all about balance. Assets must always equal liabilities plus owners’ equity. And if the balance sheet doesn’t balance, more than likely, the document was prepared incorrectly.

These errors often come from either missing data, incomplete information, incorrectly entered transactions, miscalculations of equity, or mistakes in currency exchange rates or inventory levels.

It could also happen with miscalculated amortization or depreciation, so that’s the first sign of a red flag if you ever see this equation out of balance.

Ninety-nine percent of the time with a publicly traded company, this will always be accurate. Still, sometimes smaller companies or newer companies make mistakes, and it’s best to double-check this information before you make any investment.

A Breakdown of the Balance Sheet Categories

You have a general understanding of the balance sheet and the equation balancing it out. But now, I want to break down the specific categories on the balance sheet, so you have a better understanding of what everything means.

Assets

Assets are anything the company owns. Assets hold what’s considered inherent and quantifiable value meaning the business could convert these assets into cash through liquidation if they needed to. Usually, assets are shown as positives on the balance sheet, and two sub-categories of assets are essential to know about:

  1. Current assets: Current assets are any assets the company expects to be converted into cash within a year. These are short-term, and you can look at these as assets that will no longer be around after this year and could add to the company’s cash balance and be used to do things like pay off debt or reinvest in the business. Some examples of assets are marketable securities, accounts receivable, prepaid expenses, inventory, cash and cash equivalents.
  2. Non-current assets: Think of non-current assets as long-term investments. They’re things that aren’t expected to be converted into cash within that calendar year or even in the short term. Think about patents, trademarks, land, intellectual property, equipment used to produce goods or services, goodwill, and any branding information. Things not easily convertible into cash or the company probably doesn’t want to liquidate because it’s a vital part of their long-term business strategy. A more real example is, say you’re investing in a car manufacturing company. Let’s say a car manufacturing company has just purchased a new factory on a piece of land somewhere in the middle of Kansas. That piece of land, and the building that sits on it, would be considered a non-current asset because it’s a long-term investment. The company isn’t buying the land or the manufacturing plant to liquidate that within a year. Now, in some sporadic cases, this does happen. Suppose the company goes belly up and they have to liquidate immediately. In this case, it might happen but still be considered a non-current asset because it’s not expected to be liquidated within that year.

Liabilities

A liability is considered anything a company owes. It could be a legal obligation or a financial obligation, and these are almost always shown as negatives on the balance sheet. For example, if the company has a loan they took out from another company or a bank, it will show a financial obligation to pay a certain amount back to a debtor.

Another example of a liability is an obligation to provide goods or services. For example, perhaps the company took payment for something that’s going to be delivered later in the year or a subsequent year. This is considered a liability. Like assets, there are two sub-categories of liabilities:

  1. Current liabilities: Much like assets, current liabilities are liabilities due back to the debtor within one year. Good examples of this are debt financing, rent payments, accounts payable, payroll expenses, or other accrued expenses that the company would be expected to pay back within a single year. This can be good or bad as an investor, depending on how you look at it. If a company has a high amount of liabilities, you can look at it one of two ways. You can say they might be paying that back within a year, and those will no longer be liabilities for the company, or maybe it’s a concern that they’re not able to pay for those liabilities within this year.
  2. Non-current liabilities: Again, like non-current assets, non-current liabilities are long-term obligations or debts not typically due within a year. Going back to my example of the car manufacturing company that bought the land and the manufacturing plant on the land, those would be non-current liabilities if they took out financing to pay for those. Things like bonds payable, provisions or pensions, leases or loans with the manufacturing plant, and deferred tax liabilities are examples of non-current liabilities, so this is essentially long-term debt.

Owners’ Equity

Owners’ equity is anything belonging to the shareholders of the business after the liabilities are accounted for, so this is also called shareholders’ equity if you go back to the equation I gave you above.  There are two elements of owners’ equity:

  1. Money: Money is contributed to the business, usually in an investment in exchange for some ownership, and it’s usually represented in shares. If you buy a share of a stock of a company, you have some owners’ equity.
  2. Earnings: Earnings are what the company generates over time, and what it retains will also be included in the owners’ equity. Any money not given back to shareholders in dividends will be included in the owners’ equity.

How to Analyze the Balance Sheet

Okay, so up to this point, we understand the balance sheet and how to read some of the standard terms and understand the balance sheet itself. Now, below are tips on how to better analyze the balance sheet so you can make more informed investments.

Using Ratios

When you’re analyzing information on a balance sheet, the primary strategy is to leverage financial ratios and examine those. You’ll be using formulas to gain better insight into both the company and its operations. The essential formulas that you’ll want to look for are as follows.

A quick note on ratios. Using the ratios like I’ll mention below begins to get into more advanced investing techniques. For this, I would recommend E*TRADE, which has the most advanced features of any online brokerage I’ve seen. This way, you’ll be able to research stocks and analyze the balance sheet the right way the first time.

Liquidity Ratios

Liquidity ratios measure a company’s ability to pay off its short-term debts as they become due. This is done using the company’s current or quick assets.

You may hear about three of the primary liquidity ratios: quick ratio, working capital ratio, and current ratio.

To calculate the liquidity ratio, the formula is as follows:

Quick Ratio = (Cash and Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities

If the ratio is greater than 1, it typically indicates that the company has sufficient cash and cash equivalents to pay its debt obligations and cover all its operations.

But if the ratio is less than 1, it might indicate that the company does not have enough cash to cover its obligations, which might be a warning sign.

Note, though, it’s not always a negative if this ratio is lower than one. This should require you to do a little bit more due diligence.

Maybe this becomes an opportunity for an investment that other people would pass on because of this ratio, for example. You may also hear the liquidity ratio called the acid test.

Solvency Ratios

Solvency ratios are also considered financial leverage ratios. A solvency ratio will compare the company’s debt levels against its assets, equity, and earnings. This is done to evaluate how likely the company is to stay afloat by paying off its long-term debt.

This also includes paying the interest on that debt, so examples of solvency ratios include things like interest coverage ratios, debt-to-equity ratios, which is popular, and debt-to-asset ratios.

Profitability Ratios

A profitability ratio will calculate how well a company can generate profits from its operations. This is an important thing to look at. It includes ratios like the return on equity, the return on assets, profit margin, gross margin ratios, and return on capital employed.

A profitability ratio can be a crucial indicator of how successful a company is likely to be, regardless of its debt or assets. What these ratios can show you is how well they’re operating and how much profit they’re making.

For example, if a company has an increasing profit margin, this is typically a good sign, especially compared to its competitors.

Efficiency Ratios

Efficiency ratios evaluate just how efficiently a company uses its assets and liabilities to generate sales and maximize its profits. Efficiency ratios are also called activity ratios.

Some examples include the inventory turnover ratio, which is how often the inventory balance is sold during an accounting period. This is calculated by taking the cost of goods sold and dividing it by the average inventory for that specific period.

Another example is the turnover ratio, which is how efficiently an organization uses its assets to tender a sale. This is calculated by taking total sales and dividing it by the total assets. And finally, day’s sales in inventory, so how much inventory they have in terms of sales.

Coverage Ratios

A coverage ratio measures an organization’s capability to make interest payments and other obligations associated with the debts it owes. Probably the most prime example of a coverage ratio is the times interest earned ratio.

Another popular one is the debt-to-service coverage ratio. I rarely delve too profoundly into coverage ratios. However, it’s a good checkpoint of information to ensure that the company can make any obligation payments it has.

Market Prospect Ratios

These are probably some of the most common ratios used in fundamental analysis when looking at a stock. They include the dividend yield, the earnings per share, EPS, the price-to-earnings ratio, the P/E ratio, and the dividend payout ratio.

The market prospect ratios are used to help predict the earnings and future performance of an organization.

What I would caution you about is not to over-index on these ratios. You might read articles and see people talk about just using things like PE ratio or EPS to calculate whether a stock is worth investing in.

Remember, this is just a single point of data along with many of the other calculations I’ve talked about, and this is only the balance sheet that we’re talking about, so there are many checkpoints of information you should look at when you’re investing in an individual stock.

Again, this is useful information to know and compare against competitors of the company you’re looking to invest in. However, don’t overcompensate with things like price-to-earnings or earnings-per-share because this information alone can be misleading.

Working Capital

Another helpful ratio is looking at the capital a company has to use in its day-to-day operations, which is considered the working capital. The ratio is simple:

Working Capital = Current Assets – Current Liabilities

Debt-to-Equity Ratio

I mentioned the debt-to-equity ratio above, and this is important to see how much of the company’s financing comes from investors versus creditors. And this can be done using the following calculation:

Debt-to-Equity Ratio = Total Liabilities / Shareholders’ Equity

Now, like other ratios, I wouldn’t overcompensate by just focusing on the debt-to-equity ratio, but it is essential to look at and consider when you’re investing. Typically, companies with higher ratios, meaning they have more financing from debt than investors, are considered riskier investments.

Again, take this with a grain of salt because every situation will be different. Still, if a company has more financing from debt than investors, I would take a second look and do a deeper dive before considering an investment.

This is because the company has to pay that money back, and companies with lower debt-to-equity ratios are typically considered more stable.

Again, a company with a lower debt-to-equity ratio would mean they have more money coming in from investors than they have obligations in debt. You might often see this ratio written as the D/E ratio.

What All This Tells You

The balance sheet does a great job of summarizing the company’s financial performance. This way, you can determine the value of the company. You can look at the company’s assets and liabilities, along with the value of the stock.

This provides an excellent overall picture of how healthy a company is and whether it’s worth investing in. Just remember the balance sheet is only one financial statement to consider. It’s an important one, but it’s just one, so use it with other information.

At a Given Time

Remember the balance sheet you’re looking at is just a snapshot of a company from a specific amount of time, so to understand the company’s overall health, it’s probably best to read balance sheets from several points in time of the company.

If they produce them monthly, I would go back at least six months. If they produce them quarterly, I would go back two to three quarters. Maybe even look at the annual performance of a company.

Reading through some of the old balance sheets to see how the company has grown or declined over time is essential.

And remember the more balance sheets you look at and analyze, the better idea you will have about how well the company has done historically and how it typically operates.

I would never say that past performance is an indicator of future performance. However, it’s hard to ignore if a company has trended upward or downward, at least from a financial perspective.

And as I mentioned, the balance sheet is a good indicator of how their company operates and how efficient they are.

Efficiency

Remember the balance sheet is probably one of the most efficient ways to get a snapshot in time into the company that you’re considering investing in and how it’s doing from a financial perspective.

Before investing in an individual stock, it is pertinent to look at the company’s balance sheet. This should help you determine whether it’s a good investment and whether or not you’re likely to have a good return on that investment.

Additional Resources

Using an online broker like TD Ameritrade will give you not only access to a company’s balance sheet for research, but also additional tools to do in-depth analysis on a company. Check out our TD Ameritrade review to learn more.

Ally Invest is an excellent option when you’re looking for new companies to invest in. They make screening for stocks simple, and they utilize a clean and intuitive interface so you’re not bogged down with complexities. Check out our Ally Invest review for more information.

Final Thoughts

Hopefully, this gave you a good picture of how to look at the balance sheet and why it’s crucial. However, there’s a lot more information to learn as you go deeper into your journey as an advanced investor.

I mentioned ratios throughout this article, so I’d recommend you take some time to review those and determine which are the best for you to make a more informed decision on your investment.

Either way, by thoroughly understanding and reviewing the balance sheet before you make an investment, you’re already a leg up on many other investors who look at the necessary information like recommendations from “experts” or charts online.