Welcome to part 2 of my three-part financial statement posts. In this post, we’ll dive into the balance sheet. If you missed part 1 of the series, click here. Since there is more on the subject of what I look for in the balance sheet, I’ve divided the topic of the balance sheet into two.
Unlike the income statement, which covers a period of time, the balance sheet is a snapshot of a company’s assets and liabilities in a particular point in time.
Assets
Assets are what the company owns, that can produce income or reduce expenses. They typically include the following: Equipment, machinery, vehicles, buildings, land etc. These are two categories of these: current assets and non-current assets. The reason for this breakdown is liquidity (how quickly the company can convert the asset into cash).
Current assets can typically be converted into cash within a year and usually include the following: cash & short-term investments, accounts receivable, inventories and prepaid expenses. The reason I say “typically converted” is because things such as inventory is not always as liquid as companies want.
Non-current assets (also referred to as long-term assets) are a company’s long-term investments for which the full value will not be realized within the accounting year. Examples of non-current assets include investments in other companies, intellectual property (e.g. patents), and property, plant and equipment. Non-current assets are capitalized, not expensed. This means that the company allocates the cost of the asset over the number of years for which the asset is used instead of allocating the entire cost to the accounting year in which the asset was purchased. The asset is depreciated, amortized, or depleted depending on its type.
Liabilities
This is what the company owes. Liabilities are defined as a company’s legal financial debts or obligations that arise during the course of business operations. Debt liability is a vital aspect of a company because it is used to finance operations and pay for large expansions. Just as with assets, liabilities are broken down into long-term and short-term,based on the time frame they need to be paid. Current liabilities are debts due within one year, while long-term liabilities are debts payable over a longer period.
Shareholders Equity
Subtract the total liabilities from the total assets, and you end up with shareholders’ equity. Also known as book value. Think of this number as the company’s “net worth”. Just as you would evaluate someone’s personal net worth by taking what they own and subtracting what they owe. Shareholder equity represents the amount of money that would be returned to shareholders if all assets were liquidated and all of the company’s deb paid.
Retained earnings is part of shareholder equity and is the percentage of net earnings that were not paid to shareholders as dividends. Think of retained earnings as savings since it represents a cumulative total of profits that have been saved and put aside or retained for future use. Shareholders’ equity can be either negative or positive. When positive, the company has enough assets to cover its liabilities. If negative, the company’s liabilities exceed its assets; if prolonged, this will lead to insolvency.
Below is an example of Apple’s balance sheet from 2017.
Conclusion
Preferably, you want a strong balance sheet. Simply put, this means more assets than liabilities. Generally the lower the debt, the better.
The debt (aka. leverage) part needs to be explained a bit more. Some industries are heavy on leverage. Some companies are in a position where they can take on massive leverage and be able to pay due to the positioning of a product (e.g. Coca Cola). Though there are exceptions, debt is a double edged sword. Yes, it may boost a company’s earnings when things go well. But say if a recession hits, that debt can be a real danger. Investors tolerance for debt differ, but it’s very hard to go bankrupt without debt.
I’ll end this post with another video from one of my favorite investors, Phil Town. Phil explains very simply the balance sheet and adds a few things he looks for when analyzing it. The next part will be part 2 where I explain further on what I personally look at in the balance sheet when evaluating a business.
Now that we know our way around the basics of the balance sheet, I wan’t to draw your attention to some of the things you should pay attention to in this financial statement. Up next, what to look for in the balance sheet.
-IGTSKasimir
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