Understanding a company's financial statements is step 1 in evaluating investment potential. There are 3 primary statements—the balance sheet, income statement, and statement of cash flow—each providing a different perspective on a company's financial well-being. This article looks at the first of these documents: the balance sheet.
A popular definition of the balance sheet is that it's a snapshot, a picture of a company's financial status at one single point in time. This is often expressed by the formula that gives the balance sheet its name: assets = liabilities + shareholder equity. Quite simply, what a company owns must be paid for, i.e., "balanced" by moneys invested or borrowed.
Assets are what the company owns—cash, property, equipment, inventory, etc. Liabilities are what it owes—debt, rent, payroll, bills from its suppliers. Shareholderequity, sometimes called stock equity, would be what's left, the company's net worth.
Beneath those 3 banners are a variety of accounts or line items that provide more detailed information. These vary by industry and by company, but generally speaking, you can expect to see these categories: Current assets comprise anything that could be converted to cash within a year. Long-term assets are those not intended for sale within a year, such as property, plant, and equipment, or PPE; some financial assets; and goodwill. Goodwill expresses the value of a company in excess of its physical assets or actual book value. A superior reputation and a well-known name may not be tangible, but they are valuable assets nonetheless; when a company is sold, the purchaser pays a premium for these assets, which appear on the balance sheet as goodwill.
The breakdown on the other side of the equation is much the same. Current liabilities are those that can be discharged within a year, such as accounts payable. Long-term debt comprises financial obligations that extend beyond 1 year. Shareholder's equity, which may be either common or preferred stock, is the last major category.
Depreciation at a glance
As simple as the balance sheet might appear, there's a lot more to know about how those values are determined. A good example is depreciation. Depreciation is a way of determining the changing value of an asset over its useful life. It tells us what the asset is worth at a given point in time, for, just like one's car, a company's assets decrease in value as they age. This is accounted for on the balance sheet like an expense. Assets can be depreciated over different lengths of time, depending on their anticipated life, and there are different methods of depreciation depending on the type of asset, legal requirements, and other factors. For instance, one could depreciate an asset by a fixed percentage each year, or one could depreciate it using a method called mark to market.
Why is this important? Because it's what ultimately defines what a company is worth; this is expressed as net worth, book value, or shareholder equity. If a company uses a fixed percentage basis for depreciation, one needs to recognize that the book value of its assets as they appear on the balance sheet may not be what someone will actually pay for them, called the assets' net realizable value.
Marking to market (also called fair value accounting) is a method of depreciation that does recognize this. It computes depreciated value based on what assets are worth on the open market. This means the depreciated value can go up or down over time. Originally developed to reflect changing values of futures contracts on a daily basis, marking to market aims to show the real-world value of a company's assets and liabilities.
Read the fine print
Even this very brief foray into balance sheet definitions and explanations illustrates that there's a lot of complexity and nuance beneath the line items of the balance sheet. That's why discussions of the balance sheet emphasize the importance of reading the footnotes. There's a wealth of information there, some simply offering more detail than the line items of the balance sheet can provide—like accounting methods—or correcting errors in previous statements.
Some footnotes, however, reveal information that, frankly, the company does not want to draw attention to, for instance, debt that has been transferred to a joint venture or other entity so that it will not appear as a liability on the balance sheet. Obviously, something like that can significantly alter one's assessment of the company's risk and/or its investment potential. Because there are few standards or requirements for footnotes, they can be filled with hard-to-understand legal or technical jargon, purposeful obfuscation, and general confusion. Or they may dismiss a serious issue with just a brief paragraph. In short, read carefully!
Balance sheets vs. income statements and statements of cash flow
As stated above, the balance sheet is a picture of a company’s net worth (assets, liabilities, and equity) at one point in time. By comparison, the income statement tells how profitable the company is (revenues minus expenditures) over a specified time period. A statement of cash flow, as the name implies, looks specifically at inflows and outflows of cash over a specified time period, recognizing that the day a sale is made or equipment is purchased may well not be the day revenue for the sale is received or the bill for the new equipment is paid.
Who analyzes balance sheets and why?
The balance sheet is a go-to document for anyone wishing to understand a company’s financial condition. Investors use it to assess a company’s potential. Loan officers want to understand the company’s current debt profile and whether it is a good loan candidate. Suppliers look to see if this is a company that will pay its bills. Government agencies could scrutinize the balance sheet for tax or compliance purposes, for instance.
The balance sheet is an essential tool for understanding a company's financial position and a treasure trove of information…if you know how to read it.