What a Balance Sheet Does and Doesn't Show About a Firm
A company's balance sheet presents a snapshot of its assets, liabilities, and owners' equity.
When deciding whether to invest in the stock of a company, examining the information in a balance sheet can help you get a sense of its prospects and pitfalls. But it's important to understand what a balance sheet does—and doesn't—show about a company so that you can put the data it into context alongside figures from other financial documents and make smarter investment decisions.
Parts of a Balance Sheet
The typical balance sheet has a two-column layout, with the assets on the left and the liabilities and owners' equity on the right. Each of these components reveals a different aspect of the company's fundamentals:
- Assets: These are things that the company owns, such as buildings, furniture, machinery, inventory, and cash in the bank. On a balance sheet, assets are usually listed in order of liquidity—that is, how quickly they can be converted to cash. Assets in excess of liabilities is generally a good sign in a company because it indicates growth.
- Liabilities: This represents what a firm owes, including outstanding loans, accrued wages owed, and bills payable to suppliers and other vendors. Liabilities are generally ordered by their due date on the balance sheet. Liabilities in excess of assets give cause to more closely examine a firm's capacity to repay its debts.
- Owners' equity: This represents the amount of equity the owner or owners have in the company, which amounts to the net worth of a firm after it sells off its assets and pays all its liabilities. It's often labeled as shareholders' or stockholders' equity. In general, a leveraged or aggressive firm that requires substantial investment by the owners would benefit from more owners' equity to buffer against losses. A conservative firm that doesn't require much, if any, investment, can get by with less owners' equity.
As the name suggests, the overarching goal is for a balance sheet to balance, which means that the company's assets should equal its liabilities plus owners' equity. This also means that owners' equity is the difference between assets and liabilities.
What a Balance Sheet Shows About a Company
Beyond assets, liabilities, and owners' equity, the balance sheet also tells you the answers to important questions about the business, the risks inherent in that business, and, in some regards, the talent and ability of its management.
The balance sheet can tell you about the capital structure of the firm, which is the mix of debt and equity a firm holds and can reveal the extent to which a firm relies on outside sources for financing. It's usually expressed as a debt-to-equity ratio, which you can calculate if you divide the liabilities on the balance sheet by the owners' equity. While debt isn't in and of itself a bad thing since it can be used to fuel growth and increase profitability (through a higher return on equity), too much debt can increase the risk of bankruptcy. A debt-to-equity ratio of between one and two is ideal.
Understanding a firm's capital structure can help you identify the risks and advantages of using that capital structure and how it differs from companies in the same industry or sector.
For example, given the steady revenues guaranteed by rate-setting boards, public utilities frequently employ large amounts of debt alongside equity. But if an electric utility has a lot of debt coming up for refinancing and interest rates are much higher than they are on the old debt, costs could rise, and profits could fall. This could lead to a high price-to-earnings ratio, which might mean that the stock price is overvalued relative to its earnings.
Conversely, some software companies enjoy such high levels of profitability that debt is fairly unnecessary during the expansion phase. If, say, a young software company is saddled with debt, that could be a red flag.
A company that shows a large amount of cash and other assets on its balance sheet that can readily be converted to cash is generally in good financial health. It will have an ample financial cushion during business slowdowns and can spend money to facilitate growth.
In contrast, poor liquidity may signal that a company is having or will have trouble repaying its debts. For example, if the banks closed tomorrow and the capital markets seized, a lack of cash might render a firm incapable of paying its bills. Before the global financial crisis of 2008, a lot of businesses found themselves in this position because they had become overly reliant on short-term financing such as commercial paper. That's risky because commercial paper is not as liquid as cash and short-term treasury bills. In a recession, you want to be cash-rich.
If a company continues to show a large amount of cash on the balance sheet over time, it could also mean that management has no clear strategy and is only hoarding cash because it doesn't know how to put its money to work efficiently.
You can also glean the quality of the enterprise—and hence, its long-term profitability—from the balance sheet. Profitable businesses tend to have the ability to generate high, sustainable owner earnings relative to the tangible book value (the book value excluding intangible assets on the balance sheet). They also have shareholder-friendly management that prioritizes existing long-term owners over business growth purely for the sake of growth.
When you look at the owners' equity section of the balance sheet, you'll see a snapshot of the company or partnership's history. If the business is currently profitable, but you notice enormous book value (asset value) deficits, that warrants further examination. However, if it's the result of substantial share buybacks, it may actually be a good thing, provided that they put no strain on liquidity.
But if retained earnings (money accumulated for investment) is a negative value, it means that there were huge losses at some point in the past, which the firm could sustain again. It might also mean that there is a tax-loss carryforward being used to artificially increases profitability by reducing the amount the government takes. Once that tax-loss asset is depleted or has expired, ordinary tax rates will apply, again, and could cause net income to drop.
What the Balance Sheet Doesn't Show You
It's important not to become overly reliant on the balance sheet alone—it's not an all-encompassing metric that can replace staying in touch with other financial statements and actual operating execution. Notably, it omits some critical information about a firm, including:
- Profits and losses: The balance sheet doesn't contain information on the company's profits or losses; you'll have to rely on an income statement to determine whether the firm is actually making money.
- Cash flows: The document doesn't provide information on cash flows into and out of accounts. You can't tell how much cash the company has actually spent (and in which areas) without looking at the cash flow statement.
- Market value: Despite showing the book value of the firm (its total assets), the balance sheet doesn't show you its market value according to the stock market.
- Claims against assets: A firm might appear to have amassed substantial assets, but the balance sheet won't tell you if creditors have claims against the assets because they have yet to be paid.
When companies put too much focus on attempting to improve business by over-managing balance-sheet metrics, they can unwittingly set events in motion that cost the company in terms of profit.
For example, company management in a retail firm might get taken over by people who are immersed in financial performance indicators but have little to no operating experience, and who may not understand, intrinsically, the customer experience and psychology of buyers. Instead, they become obsessed with improving the company strictly based on financial ratios derived from the balance sheet and income statement (inventory turnover, for example).
They may press for systems like "just-in-time inventory," with the result being that customers must return to the store over and over because the shelves are never stocked, or variety will been substantially reduced. Far from improving the business, these measures can cause customers to stop frequenting the store and move on to better-stocked competitors.
Pay attention to a company's actions as well as figures in the balance sheet when assessing its value as an investment. Some companies may prioritize the management of metrics over the management of the company, to the detriment of the company's bottom line.
Putting the Balance Sheet Into Context
When analyzing a balance sheet, it's as important to understand what it does show you as what it doesn't so that you can understand its value and limitations.
Remember: The balance sheet is merely one piece of a much bigger puzzle. If you were going to buy a private company like the local grocery store or corner gas station, it would be imprudent to make an offer based solely on the balance sheet. Also take into consideration other factors shown on the company's income statement, such as the profit the business generated, the future prospects for the business, and the local competition.
The same is true when you inspect a publicly traded company—make a decision as if you were purchasing a private business. This would involve the use of the income statement, the cash flow statement, and even certain sector and industry resources that help you better understand the economic forces that determine sales, costs, and earnings.
Having the complete financial picture of a firm sets you up to make an informed investment decision.
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