The Balance Sheet Explained: Interpreting the Balance Sheet
In the first part of the financial statements I explained what the income statement was and I gave an example of a snapshot of a real income statement to better illustrate and explain the income statement. Just like the income statement, the balance sheet is another very important document to search through and use for analysis of a good company to invest in. The Balance Sheet is a great document to analyze to find the financial strength, weaknesses, assets and liabilities of a company. Keep in mind that the balance sheet is not for current position of a company as the balance sheet is updated every quarter. But nonetheless, it is important to keep track off and watch how the balance sheet changes over time. The balance sheet is basically a snapshot of all assets and liabilities within a company. People can have personal balance sheets as well, as in the picture, you could ask yourself, “how much money do I have versus how much liabilities (like a car or house payment) do i have?”
What Makes UP the Balance Sheet?
A balance sheet is nothing more than a summary of assets and liabilities. One important thing to remember is that the accounting equation is assets equal liabilities plus equity. For example, on the asset side of the balance sheet you could have cash and on the liabilities side you could an I.O.U. if someone lent you the money. Let’s elaborate further, say you had $500 in cash and used it as start up capital. That would be considered owner’s equity and a asset. Now suppose you borrowed $800 from the bank to purchase an asset for the business, however the cost came out to $500 total. You would have $300 left over, the accounting equation would look like such:
Assets($500 Startup Cap in cash)+($500 Asset)+($300 Cash left over)= Liabilities ($800 loan)+Equity ($500 Owner startup Cap)
Assets=$1,300 and liabilities and equity=$1,300
Using the Balance Sheet for Investment Analysis
The balance sheet is a great place to look to find discrepancies and see how the management is using capital. If a company had $50,000,000 in a short term loan and only $2,000,000 in cash then it is a possibility that the company has too much debt and could risk going bankrupt if they are borrowing too much debt. On the flip side, if a company has $100,000,000 in cash and total liabilities, both short term and long term of $25,000,000 then management has utilized its capital wisely and is most likely a financially strong company. Another way to put this into perspective is to say, the company has a 4:1 ratio of assets to liabilities. Therefore the company has plenty of cash to pay off its debt and still have surplus to invest somewhere if need be. A ratio of 1:1 would indicate that the company has only enough assets to pay off debts and have nothing left, which in my opinion is just as bad as having too much debt. Think of it as your income: Say you make $1,000 a month and spend $1,000 a month. You would have no savings! What if you get in a wreck and have to pay to have your car fixed? What if you get hurt and need money for the emergency room? What if your child’s tuition for school is more than you thought it would be? The same principles are involved. A company with no savings is doomed for failure.
I hope this was insightful and that now you have a better understanding of what goes into the balance sheet. It is always a good idea to view the balance sheet to see where a company stands at a given point in time. Always be on the lookout for debt levels and that the company has enough assets to pay off the debt should an unforeseen event occur. Always due your own research and do not go by what others say until you have a complete understanding of how the company makes money and how they spend their money!
For more information view http://www.investopedia.com for insights into the balance sheet and financial information.