How to Analyze a Balance Sheet
The Basics of Balance Sheet Analysis
When flipping to the back of a company's annual report or 10-K, you may have found yourself blankly staring at dozens, or even hundreds, of pages of numbers and tables. You know those figures are important to your investment decision, but you're not sure what they mean. This information is likely a company's balance sheet, which is a financial statement a company releases to report on the condition of its financial health.
What Is a Balance Sheet?
A balance sheet provides a picture of a company's assets and liabilities, as well as the amount owned by shareholders. A balance sheet can help you determine what a business is really worth. When reviewed with other accounting records and disclosures, it can warn of many potential problems and help you to make sound investment decisions.
The Role of the Balance Sheet in Financial Statements
For every business, there are three important financial statements you should examine:
- The Balance Sheet tells investors how much money a company or institution has (assets), how much it owes (liabilities), and what is left when you net the two together (net worth, book value, or shareholder equity).
- The Income Statement is a record of the company's profitability. It tells you how much money a corporation made or lost.
- The Cash Flow Statement is a record of the actual changes in cash compared to the income statement. It shows you where the cash was brought in and where the cash was disbursed.
How to Read a Balance Sheet
A balance sheet is composed of rows and columns that list a company's assets and liabilities, and money owned by shareholders. One column lists the category of assets and liabilities, and one lists the total amount for each of those categories. It may even have two years' worth of information. Oftentimes, assets are listed in order of how quickly they will be converted into cash and liabilities are listed in order of their due dates. Sometimes shareholders' equity follows the assets and liabilities on the sheet. You may want to look at a company's balance sheet to determine its financial health. Ideally, a company's assets should be equal to its liabilities and shareholder equity.
By knowing how to analyze a company's financial information, you can determine:
- How much debt the business has relative to its equity
- How quickly customers are paying their bills
- Whether short-term cash is declining or increasing
- The percentage of assets that are tangible (e.g., factories, plants, and machinery) and how much comes from accounting transactions
- Whether products are being returned at higher-than-average historical rates
- How many days it takes, on average, to sell the inventory the business keeps on hand
- Whether the research and development budget is producing good results
- Whether the interest coverage ratio on the bonds is declining
- The average interest rate a company is paying on its debt
- Where profits are being spent or reinvested
To make sound investment decisions, it is important to know how to read a balance sheet. Study some sample balance sheets to become comfortable with what the numbers mean and how to use them to your advantage.