READING BALANCE SHEET
A company’s balance sheet, also known as a statement of financial position, shows the firm’s assets, liabilities and owners’ equity. The balance sheet, combined with the income statement and cash flow statement, together constitute for a company’s financial statements. The balance sheet tells what a company owns (Assets), how much does it owe
(liabilities) and equity which is a difference between assets and liabilities. Hence, reading balance sheet becomes important in the fundamental analysis
Investors looking for investing in a company must adhere to the balance sheet and analyse the financial stability of a company before investing as a balance sheet tells a lot about the company’s fundamentals, operations, and performance.
Sample balance sheet
There are two main types of assets: current assets and non-current assets. Current assets are those assets that are either used or converted into cash within one business cycle, normally a period of twelve months. Three major current assets shown on balance sheet are cash, inventories and account receivables.
Since cash provides protection in hard times, investors are often interested in companies that hold sufficient cash on the balance sheets. Growing cash reserves are the sign for the stability of the company, however, diminishing cash stock may indicate problems. If company’s balance sheet constantly shows loads of cash the investors may get doubtful about the soundness of company as occupying a lot of cash may imply that management is not putting cash to desired use and money is sitting idle as they lack investment options.
Inventories are finished products that have not been sold by the company yet. Investors should know the inventory level to analyse if companies have too much money caught up in inventories. Selling the inventory results in the generation of cash. Inventory turnover computed by dividing average inventory by cost of goods sold shows how much time a company takes to sell the merchandise to customers. Hence, by evaluating this an investor can know if inventory grows faster than sales which imply deteriorating fundamentals.
Receivables are uncollected bills of the company. Financial stability and efficiency of a company can be analysed by knowing at what speed a company collects what it is owed. Problems may approach if the company’s collection period becomes longer. As the faster the company receive its payments, the faster it pays other expenses such as salaries, inventory, loans, dividend and hence increase the growth opportunities.
Assets not categorized as current assets are basically non-current assets. These assets include fixed assets such as property, machinery, plant, and equipment etc. Investors should have a careful check on a company’s fixed assets as when companies are unable to sell their fixed assets in the desired amount of time, assets are carried on the balance sheet at cost and not actual value. This way, companies may increase these numbers which may become misleading for investors.
There are two categories in liabilities: current liabilities and non-current liabilities. Current liabilities are obligations the firm has to pay within a year, such as payments to suppliers. Whereas, Non-current liabilities show what the company owes in a year or more time.
Investors are willing to see the achievable amount of debt. Fall in the level of debts is considered as a good sign. Usually, a company with more assets than liabilities is considered reliable. Too much debt in relation to cash flows needed to pay for debt and interest is not considered an ideal situation of a company by investors as a company is likely to go bankrupt facing those scenarios.
Equity is also known as shareholder’s equity, that is, indicates what shareholders apparently own. Equity equals total assets minus total liabilities.
The two major equity items are paid-in-capital and retained earnings. The amount shareholders paid in order to acquire shares when a company first offered the stock to the public is called paid-in-capital. It shows how much money was received by the company from shareholders. On the other hand, retained earnings are the amount company decides to invest in a business and not to pay to shareholders. Hence, investors should always look where companies have put their retained earnings into and what is the return on retained earnings.
Investors should get a thorough understanding of the balance sheet of companies they are willing to invest in. There are some techniques used to examine the balance sheet and its information. One often used technique is financial ratios analysis.
Financial ratios help investors to gain information about companies by using few formulas. Ratios like debt to equity ratio while analysing the balance sheet can provide a broad idea about the financial stability of the company. There are many other ratios that investors can use to be aware of the operations and performance of the companies in order to determine whether a company is financially strong to invest in or not.