Introduction to Balance Sheets for Stock Investors
A company’s balance sheet is important for stock investors because it gives you a financial snapshot of what the company looks like in terms of the following equation:
Assets – liabilities = Net worth (or net equity)
Analyze the following items that you find on the balance sheet:
Total assets: Have they increased from the prior year? If not, was it because of the sale of an asset or a write-off (uncollectable accounts receivable, for example)?
Financial assets: In recent years, many companies (especially banks and brokerage firms) had questionable financial assets (such as subprime mortgages and specialized bonds) that went bad, and they had to write them off as unrecoverable losses. Does the company you’re analyzing have a large exposure to financial assets that are low-quality (and hence, risky) debt?
Inventory: Is inventory higher or lower than last year? If sales are flat but inventory is growing, that may be a problem.
Debt: Debt is the biggest weakness on the corporate balance sheet. Make sure that debt isn’t a growing item and that it’s under control. In recent years, debt has become a huge problem.
Derivatives: A derivative is a speculative and complex financial instrument that doesn’t constitute ownership of an asset (such as a stock, bond, or commodity) but is a promise to convey ownership. Some derivatives are quite acceptable because they’re used as protective or hedging vehicles. However, they’re frequently used to generate income and can then carry risks that can increase liabilities.
Standard options and futures are examples of derivatives on a regulated exchange, but the dangerous form of derivatives are a different animal and in an unregulated part of the financial world. They have a book value exceeding $600 trillion and can easily devastate a company, sector, or market (as the credit crisis of 2008 showed).
Find out (from the company’s 10K report) whether it has derivatives and, if so, the total amount. Having derivatives that are valued higher than the company’s net equity may cause tremendous problems. Derivatives problems sank many organizations ranging from stodgy banks to affluent counties to once-respected hedge funds to infamous corporations.
Equity: Equity is the company’s net worth (what’s left in the event that all the assets are used to pay off all the company debts). The stockholders’ equity should be increasing steadily by at least 10 percent per year. If not, find out why.
Assets (What the Company Owns) Amount 1. Cash and inventory $5,000 2. Equipment and other assets $7,000 3. TOTAL ASSETS (Item 1 + Item 2) $12,000 Liabilities (What the Company Owes) 4. Short-term debt $1,500 5. Other debt $2,500 6. TOTAL LIABILITIES (Item 4 + Item 5) $4,000 7. NET EQUITY (Item 3 – Item 6) $8,000
By looking at a company’s balance sheet, you can address the following questions:
What does the company own (assets)? The company can own assets, which can be financial, tangible, and/or intangible. An asset is anything that has value or that can be converted to or sold for cash.
What does the company owe (liabilities)? A liability is anything of value that the company must ultimately pay someone else for. Liabilities can be invoices (accounts payable) or short-term or long-term debt.
What is the company’s net equity (net worth)? After you subtract the liabilities from the assets, the remainder is called net worth, net equity, or net stockholders’ equity. This number is critical when calculating a company’s book value.