If you’re interested in investing, you’ve probably read quite a few articles that say “do your homework” before buying a stock.
Reading and understanding a balance sheet is one of these duties. Together with the income statement and the cash flow statement, the balance sheet gives investors a sense of the value of a business, says Robert Johnson, professor of finance at Creighton University.
âInvestors with a trained eye and attention to detail can take a quick glance at a balance sheet and identify a company’s financial strengths and weaknesses,â he says.
To understand the fundamentals of a balance sheet, as well as the financial position that a balance sheet can convey, investors should ask themselves the following questions:
- What is a balance sheet?
- What’s in a balance sheet?
- What is a balance sheet for?
What is a balance sheet?
Investment experts see the balance sheet as a snapshot of the health of a business at any given time. It is a summary of what a company owns in assets, owes in liabilities and the difference between the two, which is shareholders’ equity.
The balance sheet is so named because all assets must equal or balance with liabilities and equity.
In-house accounting departments usually prepare the balance sheets of large companies, which are then audited by an independent accounting firm. Small businesses may have an external accountant to help them prepare the balance sheet, or the task may fall to an in-house accountant.
What’s in a balance sheet?
While you can explore the accounting definitions as far as you want – it’s a must, after all – here’s a look at what you’ll find in a balance sheet:
Assets: Assets include cash, investments, accounts receivable, inventory, land and buildings which are aggregated from most liquid to least liquid. So the money would come first and the buildings would come last on this list. Intangible assets lack physical substance. The total amount of assets owned by a business is called total assets.
Liabilities: Liabilities, such as accounts payable, short- and long-term debts, capital leases, and pensions or other retirement benefits are listed in order of due date, earliest to latest. Long-term debts are due at any time after one year in the future. The total liabilities of a business are all debts and obligations owed to other parties.
Equity: This is probably where you come in as an investor. Common or preferred stocks are types of equity. You might hear the term “book value” instead of shareholders’ equity, but you will learn more about book value.
What is a balance sheet for?
A balance sheet is often used in conjunction with other documents, such as an income statement, which shows profit or loss, and a cash flow statement that lists how a business has spent and received money. Together, these documents can help you decide whether or not to buy a stock.
âBalance sheets can help investors understand businesses by providing them with some of the basics needed to look at key financial ratios that they can use to assess the overall health of a company and to compare one company to another in the market. same sector, âsays Cassandra Kirby, Private Wealth Advisor at Braun-Bostich & Associates.
Ratios to watch include a company’s debt to equity ratio, which can tell you if a company has incurred too much debt.
“The more debt a company has (…) the more investors worry about the likelihood of a company defaulting,” said Mayra Rodriguez Valladares, senior manager at MRV Associates.
Another key ratio is a measure known as the current ratio, which divides current assets by current liabilities.
âBusinesses with current assets only barely greater than current liabilities typically need to finance their working capital through a line of credit or other debt financing, which puts a strain on the company’s cash flow and can lead to problems such as an inability to buy products or pay. for top talent and in some cases can lead to bankruptcy, âsays Sam Brownell, founder of Stratus Wealth Advisors.
Financial ratios can track progress over a period of time and can be used to compare a company’s balance sheet with industry benchmarks, says Jessica Distel, director of tax and business services at Buckingham Advisors.
Examining a balance sheet can also help investors find good deals.
“Book value is roughly designed to give investors an idea of ââwhat a company would be worth if all of its assets were (…) sold,” Johnson explains. “Some investors look for undervalued companies by looking for where stock prices are below a company’s book value.”
The bottom line
Investors using broad-based index funds probably don’t need to be obsessed with monitoring company balance sheets because their holdings are going to be very diverse, Brownell says.
If you are buying funds with concentrated positions or individual stocks, then you will definitely want to know how to analyze a balance sheet, he says.
âEveryday retail investors probably don’t need to be too wrapped up in balance sheet analysis,â Kirby said. “However, having a general understanding of the variables that go into a balance sheet and how to analyze certain key financial ratios can help a retail investor better understand a potential investment and be able to calculate some of these ratios and compare them to. a possible alternative. “