How Investors Use a Balance Sheet

Monday, October 8, 2018 | MarketBeat Staff
How Investors Use a Balance Sheet

In our personal finances, we use a budget to keep track of our personal expenses. When we go a little deeper, we may do a more comprehensive look at all of our assets and liabilities to determine our personal, or our family’s, net worth.

In business, one of the key tools of fundamental analysis is a company’s balance sheet. The balance sheet is one tool investors use to help determine a company’s net worth. In this article, we’ll review what a balance sheet is, the balance sheet formula, how each part of the balance sheet is defined, and additional analysis investors can arrive at by using the balance sheet.

What is the balance sheet?

The balance sheet is a snapshot of a company’s net worth. It is sometimes referred to as a statement of financial position. In the most simplified terms, a company’s balance sheet gives an accounting of what a company owns (its assets), what it owes (its liabilities), and the amount of capital that the company receives from its shareholders.

A balance sheet is only as accurate as the period of time it is measuring. To that end, investors should be careful to look at several balance sheets over different period of times to look for patterns that can help determine trends or patterns.

The balance sheet formula

The fundamental truth about a balance sheet is that every asset of a company has to be offset by liabilities or shareholder equity. The two sides must balance out. The formula that every balance sheet follows is:

Assets = Liabilities + Shareholders’ Equity

As an example, if a company has $100,000 in assets and has an additional $40,000 in outstanding shares, its basic balance sheet would look like:

$100,000 (Assets) = $60,000 (Liabilities) + $40,000 (Shareholder Equity)

In this case, the $60,000 in liabilities is assumed because the two sides of the balance sheet must be equal so in this case, the following formula can be used:

Assets – Shareholder Equity = Liabilities

Let’s look at a couple of other examples. If a business takes out a bank loan for $10,000, that $10,000 is recorded as both an asset and as a liability. It’s an asset because the company can immediately use that cash to help grow their business, but it will also be a liability because it will have to be paid back.

Now let’s say instead of taking out the loan, that same business issues shares and receives $10,000 from shareholders. In this case, the $10,000 will again appear as an asset on the balance sheet. However, to balance things out, the $10,000 will also be reported as shareholders’ equity.

Understanding each part of the balance sheet

The formula for the balance sheet:

Assets = Liabilities + Shareholders’ Equity is a very simplified overview of a balance sheet. In reality, each component of the balance sheet is made up of subsections that offer a more complete view of where a company’s money is going. Every company and every sector will approach these subsections differently based on the specific nuances of their industry. However, each category shares some broad components that we’ll look at here:

Assets - The assets on a balance sheet are always listed from top to bottom in order of how liquid the asset is, meaning how easily can the asset be converted to cash. For that reason, cash and cash equivalents will always be the top line item under every listing of assets. The last line items on an asset listing may include prepaid expenses such as insurance and anticipated rent which is the value that has already been paid for. You’ll also see a distinction made between a company’s current assets and their long-term assets. The distinction between current and long-term assets is usually the length of time with one year typically being the difference between items being listed as current or long-term assets.

A sample list of current assets might include:

  1. Cash and cash equivalents
  2. Marketable securities – these include securities such as stocks (equity) and bonds (debt) that the company is planning to be converted into cash and for which there is a market to do so.
  3. Accounts receivable – these include money that is owed to the company by its customers.
  4. Inventory – the items that a business has on hand for sale to their customers. When included on the asset sheet, these items are either listed at cost (i.e. what the company pays for them) or at market price, whichever is lower
  5. Prepaid expenses – as mentioned above this is a listing of items with the value that has already been paid for.

A list of long-term assets might include items like:

  1. Long-term investments – these are securities such as stocks and bonds that the company will not or cannot liquidate (convert into cash) in the next year.
  2. Fixed assets – these are usually capital-intensive items such as land, machinery, equipment, and buildings.
  3. Intangible assets – these are the most variable part of the asset portion of the balance sheet. This category includes items such as patents, trademarks and other forms of intellectual property. This can also include the goodwill that arises when one business purchases another at a premium.

Liabilities – The liabilities on a balance sheet are a listing of money that a company owes. Like assets, liabilities are usually broken down into current and long-term liabilities. Liabilities are listed as

A sample list of current liabilities might include:

  1. A portion of long-term debt that must be repaid within one year – For example if a company took out a five-year, $10,000 loan. They might, for example, record $2,000 as a current liability and $8,000 as a future liability.
  2. Money owed to any banks (referred to as bank indebtedness)
  3. Interest payable
  4. Payments for rent, taxes, and/or utilities
  5. Wage expenses
  6. Prepayments to customers
  7. Scheduled dividend payments

A sample list of long-term liabilities might include:

  1. Long-term debt – in our example above, the $8,000 would be listed here. This category also includes interest and principal on bonds issued.
  2. Required payments into a company’s employee retirement accounts.
  3. Accrued taxes that will not be paid for another year (also called deferred tax liability).

There are some additional liabilities, such as operating leases that are considered off-balance sheet because they will not appear on the balance sheet.

Shareholders’ Equity- The shareholders’ equity on a company’s balance sheet is the money that is the result of shareholders (i.e. business owners). This is also known as a company’s net assets.

A sample list of items to be included as shareholders’ equity might include:

  1. Retained earnings - Any revenue the company generates after fulfilling the obligation of their liabilities goes toward shareholder equity. Because that money must also show up on the asset side of the balance sheet, it will show up on the asset sheet under some sub-category (cash, inventory, etc.).
  2. Treasury stock – shares of stock that a company either has never issued or has repurchased.
  3. Preferred stock – shares of stock that have priority over shares of common stock and generally have a higher yield.
  4. Common stock
  5. Capital Surplus – this refers to any equity that investors have paid into a company outside of purchasing shares of common or preferred stock.

Additional analysis that comes from the balance sheet

Because every balance sheet follows a specific formula and, by definition, must balance, investors need some ways to analyze what a balance sheet is really saying. Two ratios that can be determined from the balance sheet are a company’s debt-to-equity ratio and their acid-test ratio.

Debt-to-equity ratio– this is a way to determine the amount of debt a company is using to finance its assets (i.e. how much leverage they are assuming) in relation to the value of their shareholders’ equity. The debt-to-equity ratio formula is:

Debt/Equity Ratio = Total Liabilities/Shareholders’ Equity

If Company X has a total liabilities of 55 billion and total shareholders’ equity of 15 billion, it has a debt-to-equity ratio is 55/15 = 366.67%. Company Y has total liabilities of 27 billion and total equity of 120 billion for a D/E ratio of 22.5%. This tells investors that Company X is taking on more debt than Company Y. By itself, this does not make Company X a poor investment, but if the company reaches a point where they cannot handle their debt, the company may have to go into bankruptcy. If this were to happen, shareholders are hurt because creditors will always be paid first. 

However, a company’s debt/equity ratio needs to be compared to other companies in its sector. This is because different sectors have a different “acceptable standard”. So while, in our example, there is a large discrepancy between Company X and Company Y, the former may be in a capital-intensive sector whereas Company Y may not. The takeaway is to ensure you are comparing apples to apples.

Acid-test ratio– this is also known as the quick ratio and is considered to be a strong metric for investors to use when determining if a company has enough short-term liquid assets to cover its current liabilities. The formula is

Cash + Accounts Receivable + Short-term Investments /Current Liabilities (total)

Notice that for the purposes of the acid-test ratio, the assets to be included are liquid assets. Accounts receivable may or may not be considered liquid assets depending on when the company expects to realize those assets. The purpose of the acid-test is to determine how easily the company can convert assets into cash to cover their expected current liabilities. Although an acid-test ratio of less than 1 is considered to mean the company is very dependent on inventory to cover its current liabilities (remember inventory is not included in the acid-test ratio). However, for some segments, such as retail, this is normal and so there are other ratios that may need to be considered to get a truer sense of the health of those companies. 

The bottom line on balance sheets

Balance sheets provide a snapshot of the health of a company at a particular moment in time. Balance sheets are considered one of the primary tools used in the fundamental analysis of a company and its stock. All balance sheets follow a formula of listing all assets and then balancing those assets with a company's liabilities and shareholders' equity. The formula is: 

Assets = Liabilities + Shareholders’ Equity

Every asset must be offset by either a liability or through shareholders equity. While balance sheets follow a formula, the subsets that make up each category can vary widely depending on the sector a company is in.

Two common ratios that investors can arrive at from the balance sheet include the debt-to-equity ratio that determines how much debt a company is using to finance its assets and the acid-test ratio which measures if the company has sufficient liquid assets to meet its current liabilities. Like the balance sheet itself, these ratios should be looked at with respect to the sector that a company is in to ensure that the ratios are giving an accurate picture of the health of a company relative to others in their sector.

 




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