What the Balance Sheet Can and Can't Do
When analyzing a balance sheet, be careful to understand its limitations. It 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, you would almost never want to make an offer based solely on the balance sheet.
Instead, you would 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, the local competition, and a host of other factors.
The same is true whenever you look at a publicly traded company—you must 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 can help you better understand the economic forces at work that determine sales, costs, and earnings.
Components of the Balance Sheet
A company's balance sheet presents a snapshot of its business. Simply put, it shows what the company owns (assets), such as buildings, furniture, machinery, inventory, and cash in the bank. It also shows what it owes (liabilities), including outstanding loans, accrued wages owed, bills payable to suppliers and other vendors. The difference between these two figures is the amount of equity the owner or owners have in the company. This is often labeled as stockholders' equity.
More Than Just Assets and Liabilities
The balance sheet reveals a company's fundamentals, but also holds answers to questions that can help you understand the business, some of the risks inherent in that business, and, in some regards, the talent and ability of management.
Here are some areas to consider:
What can the balance sheet tell me about the capital structure of the firm? What are the risks and advantages of using this capital structure? How does this differ from other 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. Conversely, many software companies enjoy such high levels of profitability, debt is fairly unnecessary during the expansion phase. If a young software company is saddled with liabilities, that could be a red flag.
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 are going to rise, profits are going to fall, and the existing p/e ratio is going to end up being more expensive than it appears.
What can the balance sheet tell you about the liquidity picture? If the banks closed tomorrow and the capital markets went into seizures, could the firm continue to pay its bills? Back before the credit crisis in 2008-2009, a lot of perfectly fine businesses had become overly reliant upon short-term financing such as commercial paper.
That's bad because despite behaving similarly in good times, commercial paper is not the same as cash and short-term treasury bills. In a recession, you want to be cash rich.
What can the balance sheet tell you about the quality of the enterprise? Profitable businesses—the kind that can make your children and grandchildren rich—tend to have a few things in common.
Prime among these is an ability to generate high, sustainable owner earnings relative to the tangible book value (stripping out the intangible assets on the balance sheet discussed in this lesson) and shareholder-friendly management that prioritizes existing long-term owners over business growth for the sake of growth.
What can the balance sheet tell you about the history of the firm? When you look at shareholder 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 deficits, that warrants further examination.
If it's the result of substantial share buybacks, it may actually be a good thing, provided they put no strain on liquidity. On the other hand, if retained earnings show a negative value, it means there were huge losses at some point in the past. Could they return? It might also mean there is a tax-loss carryforward being used that artificially (but in a very real and beneficial way) increases profitability by reducing the amount the government takes. Once that tax-loss asset is depleted or expired, ordinary tax rates will apply, again, and could cause net income to drop.
What the Balance Sheet Doesn't Tell
It's important not to become overly reliant upon the balance sheet alone, looking for a theoretically perfect metric that can replace staying in touch with other financial statements and actual operating execution.
The balance sheet does not contain information to calculate a company's profit or loss, and it also doesn't contain enough information to see how much actual cash the company has spent and in which areas, among other metrics.
When companies put too much focus on attempting to improve business by over-managing balance sheet metrics, it can set some scenarios in motion that ultimately cost the company in terms of profit.
For example, this appears from time to time in retail companies. In some situations, company management gets taken over by people who are immersed in balance sheet-derived key 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 from the balance sheet and income statement by relying on ratios such as inventory turnover.
They may press for systems like "just-in-time inventory" when it doesn't make sense, with the result that customers must return to the store over and over because the shelves are never stocked, or variety has been substantially reduced. Far from improving the business, it simply means that customers will stop patronizing the store and move on to better-stocked competitors.
In the banking industry, there are millions of wealthy Americans that happily pay a higher price to a bank with a firm that has hidden branches, mahogany-paneled walls, and private bankers you can reach nearly all hours of the day. The balance sheet doesn't tell anything about customer preference, and judging business performance based on balance sheet efficiency ratios alone is another way to damage profit potential. Reducing balance sheet assets to increase efficiency could negatively impact the customer experience, and very well counterintuitively lead to declines in revenue that make the assets less efficient in the end.