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What You Should Know about Balance Sheets for Trading

The balance sheet gives traders a snapshot of the company’s assets and liabilities at a point in time. This differs from the income statement, which gives you operating results of a company during a particular period of time. A balance sheet has three sections, including

  • An assets section that details everything the company owns

  • A liabilities section that details the company’s debt or any other claims on the company’s assets made by debtors

  • A shareholder’s equity section that lists all the claims made by owners or investors

The balance sheet gets its name because the total assets of the company are supposed to equal the total claims against it — total liabilities plus total equity.

Assets and liabilities are listed on the balance sheet according to their liquidity, or how quickly and easily they can be converted into cash. Assets or liabilities that are more liquid appear first on the list, while the ones that are increasingly more difficult to convert to cash appear later.

The asset section is divided into current assets and long-term assets, as is the liabilities section — current liabilities and long-term liabilities.

Current assets include cash and other assets that can quickly and easily be converted into cash — marketable securities, money market mutual funds, accounts receivables, and inventories. Long-term assets include holdings such as buildings, land, and equipment.

Similarly, on the liabilities side, current liabilities include any claims against assets that are due during the next 12 months, such as accounts payable and notes payable. Long-term liabilities are claims due in more than 12 months, such as mortgage or lease payables.

Equity accounts include outstanding preferred and/or common stocks and retained earnings. Retained earnings reflect the profits that are reinvested in the company rather than paid out to owners or shareholders.

How to analyze assets

In analyzing assets, two key ratios to look at are how quickly a company is collecting on its accounts receivable — the accounts receivable turnover — and how quickly inventory is sold — the inventory turnover.

A two-step process is used to find the accounts receivable turnover. First you must find out how quickly a company turns its accounts receivables into cash, using this formula:

Accounts receivable turnover = Sales on account ÷Average accounts receivable balance

Then you need to find out how quickly a company collects on its accounts by dividing the accounts receivable turnover into 365 to find out the average number of days it takes to collect on accounts.

Testing for inventory turnover uses a similar two-step process. First you must find out how quickly inventory turns over during the year, using this formula:

Inventory turnover ratio = Cost of goods sold ÷Average inventory balance

Then you need to divide the inventory turnover ratio into 365 to find out the average number of days it takes a company to turn over its inventory. Comparing these results for the companies you’re considering can help you determine how well each company is handling the collection of its accounts receivable and the sale of its inventory.

Obviously, the faster a company collects on accounts or sells its inventory, the better that company is doing in managing its assets.

Whenever you see accounts receivable rising rapidly, and the number of days to collect on those accounts also is rising, that signals a red flag that indicates cash problems likely lie ahead. Whenever you see inventory numbers rising, a company can be having a hard time selling its product, which also raises a red flag, indicating problems ahead.

Debt

When considering debt, the two primary ratios you want to look at are the current ratio and acid or quick ratio. You can quickly calculate the current ratio, which tests whether a company can make its payments, by looking at the balance sheet and using this formula:

Current ratio = Current assets ÷ Current liabilities

You must compare the ratio of one company to that of other companies in the same industry. A current ratio that’s lower than most other companies in the industry can indicate the company is having a problem paying its short-term debts, which, in turn, is a strong sign that bankruptcy may be just around the corner.

A current ratio that’s significantly higher can be a bad sign too, because it can mean the company isn’t using its assets efficiently. Traders like to see companies with current ratios that are close to the industry average.

Luckily, you won’t have to calculate current ratios, because they’re easily found on any website that includes fundamental statistics. Using Yahoo! Finance, you can find that Home Depot’s current ratio is 1.33 and Lowe’s is 1.15.

The acid test, or quick ratio, is almost the same as the current ratio; however, the key difference is that inventory value amounts are subtracted from current assets before dividing that result by current liabilities. Many financial institutions take this extra step because inventories aren’t as easy to convert to cash. The acid test ratio is calculated by:

Acid test ratio = (Current assets – Inventory) ÷ Current liabilities

The acid test ratio is primarily of interest to financial institutions thinking about making a short-term loan to a company. They look for an acid test ratio of at least 1 to 1 before considering a company a good credit risk.

Even though as a trader you’re not likely to be in the business of making loans, a company that has problems getting short-term debt is likely to have problems meeting its short-term obligations in the near future. As the market recognizes the problem, the company’s share price is likely to drop.

Goodwill

Goodwill is not a tangible asset but rather is usually collected through the years as companies are bought and sold. Goodwill reflects a competitive advantage, such as a strong brand or reputation. When one company buys another and pays more than the tangible assets are worth, the difference is added to the acquirer’s balance sheet as goodwill.

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