The balance sheet highlights the financial condition of a company and is an integral part of the financial statements. It offers a snapshot of a company’s health by showing how much a company owns (its assets), and how much it owes (its liabilities). The difference between what it owns and what it owes is its equity, also known as net assets or shareholders equity.
A lot about a company’s fundamentals i.e., how much debt the company has, how much it needs to collect from customers (and how fast it does so), how much cash and equivalents it possesses and what kinds of funds the company has generated over time can be obtained from the balance sheet.
Assets:
There are two main types of assets: current assets and non-current assets. Current assets are likely to be used up or converted into cash within one business cycle – usually around twelve months. The three important current asset items found on the balance sheet are: cash, inventories, and accounts receivables.
Investors can be attracted to companies with plenty of cash on their balance sheets as it offers some sort of security during economic downturns, and it offers companies more options for future growth. Growing cash reserves often signal strong company performance whilst a dwindling cash reserve could be a sign of trouble. However, if a lot of cash is a permanent feature of the company’s balance sheet, investors may ask questions on why the money is not being put to use. Cash can be a sign of a lack of investment opportunities or a suggestion that the management of a company is too short-sighted to come up with viable investment proposals.
Inventories are finished products that have not yet been sold. Investors want to know if a company has too much money tied up in its inventory. Inventory turnover (cost of goods sold divided by average inventory) measures how quickly the company is moving stock through the warehouse to customers. If inventory grows faster than sales, it is almost always a sign of deteriorating fundamentals.
Receivables are outstanding debts (what is owed to the company). The speed at which a company collects what it is owed can be an indicator of its financial efficiency. A growing collection period is usually not a good sign to investors. The company may be letting customers stretch their credit to recognise greater top-line sales and that can be an indicator of future problems, especially if customers fail to meet their payment obligations. If a company gets its customers to make payments quicker, it can utilise the cash to pay for salaries, equipment, loans, and dividends and capitalise on growth opportunities.
Non-current assets include fixed assets, such as property, plant, and equipment (PP&E). Investors pay less attention to fixed assets since companies are often unable to sell their fixed assets within any reasonable amount of time. They are carried on the balance sheet at cost regardless of their actual value. As a result, it’s possible for companies to grossly inflate this number, leaving investors with questionable and hard-to-compare asset figures.
Liabilities:
Current liabilities are obligations the firm must pay within a year, such as payments owing to suppliers. Non-current liabilities represent, what the company owes but is due in a year or more time. Typically, non-current liabilities represent bank and bondholder debt.
Falling debt levels are a good sign. If a company has more assets than liabilities, then it is in decent condition. By contrast, a company with a large amount of liabilities relative to assets needs to be examined with more diligence. If a company has too much debt relative to cash flows required to pay for interest and debt repayments, then it can easily go bankrupt.
To determine a company’s ability to meet its short-term debt obligations, the quick ratio can be used. This is obtained by subtracting inventory from current assets and then dividing by current liabilities. If the ratio is 1 or higher, the company has enough cash and liquid assets to cover its short-term debt obligations.
Quick Ratio = Current Assets – Inventories/Current Liabilities
Equity:
Equity represents what shareholders own, so it is often called shareholder’s equity. Equity is equal to total assets minus total liabilities.
Equity = Total Assets – Total Liabilities
The two important equity items are paid-in capital and retained earnings. Paid-in capital is the amount of money shareholders paid for their shares when the Initial Public Offering (IPO) was made. Retained earnings are a tally of the money the company has chosen to re-invest in the business rather than pay to shareholders. Investors and analyst look closely at how a company puts retained capital to use and how a company generates a return on it.
Some assets and debt obligations are not disclosed on the balance sheet. Companies often possess hard-to-measure intangible assets. Corporate intellectual property (items such as patents, trademarks, copyrights, and business models), goodwill and brand recognition are all common assets in today’s marketplace. they are not listed on company’s balance sheets but are worth considering when carrying out fundamental analysis.
It is important to look out for off-balance sheet debt and other off-balance sheet risks. This can be in the form of financing in which large capital expenditures are kept off a company’s balance sheet through various classification methods. Companies will often use off-balance-sheet financing to keep the debt levels low.