Looking at Company Financial Statements and Ratios: The Balance Sheet

When you are looking to invest in individual stocks, it makes sense to look at the company’s financial statements (or at least the company profiles on Yahoo! Finance and Morningstar). This series “Looking at Company Financial Statements and Ratios” tries to break down some of the things you should look at to help understand how the company is doing and whether it is priced fairly. Last week, we looked at the accountant’s report. This week, we’re going to look at the basics of the Balance Sheet.

The Balance Sheet

The Balance Sheet, or Statement of Financial Position, gives the company’s assets, liabilities and equity on the last day of the financial period you are looking at. It’s a snapshot of the company at a fixed point in time, usually presented right beside the balance sheet for the last day of the previous period for comparison. A balance sheet is called a balance sheet because the total assets must equal the total liabilities plus the total equity. This makes more sense if you look at it the other way: The assets (all of the company’s resources) minus the liabilities (all of what it owes to others) equals the equity (the value of the company remaining for investors once all liabilities are accounted for).

Balance sheet assets and liabilities are presented with the most liquid assets and liabilities first. Assets and liabilities are divided into current and noncurrent. Current assets are those that will be used within one year: cash, accounts receivable, current investments and inventory. Even though a company will probably have inventory listed every year, the components of that inventory will (mostly) completely turn over. Current liabilities are the money that a company owes that will be paid over the next year: accounts payable, accrued expenses like salaries and interest, short term debt and the current portion of long term debt.

Long term assets are the resources that will endure over more than a year. This would include plant, property and equipment, long term investments and intangible assets like copyrights and goodwill.  Again, the company may purchase some new equipment each year, but that equipment will be used for longer than just one year. Long term liabilities are debts that are due in more than one year. The primary long term liabilities are long term debt and long term pension obligations.

Finally, the equity section shows the amount of value that the shareholders have left in the company after all liabilities have been accounted for. If liabilities are larger than assets, this can be a negative amount. Equities are usually split into stock, paid in capital (the amount of money paid for stock over par value), treasury stock (what the company has paid to repurchase stock) and retained earnings.

The company’s income statement feeds into the balance sheet through retained earnings. Retained earnings is the cumulative effect of a company’s earnings or losses, minus any dividends paid to stockholders or other adjustments. So, if your company had a loss of $20 Million, retained earnings should drop by $20 Million from the previous period’s balance sheet. If your company had a gain of $20 Million, retained earnings should rise by $20 Million from the previous period’s balance sheet. If your company declares dividends, the amount declared will be subtracted from the retained earnings, and either the cash will be off the balance sheet for the dividends or there will be an additional liability listed as Dividends Payable.

Common-Size Analysis

One of the most basic ways to look at a balance sheet is with common-size analysis. To do this, you compare the amount of each component of the balance sheet to the total assets. Let’s look at the balance sheet for Mobileye.

Download (Mobileye-Balance-Sheet.xls, 36KB)

Mobileye shows total assets in 2014 of $436 Million, and total liabilities of $42 Million. Using common-size analysis, we see that liabilities were 10% of the total assets, which means that equity was 90% of the assets. Mobileye got most of their capital from their investors, not from borrowing money. But it’s from investment in the company, not from earnings, because paid in capital is 120% of total assets. Retained earnings are negative. And, when I look at the asset size, I see they are holding a lot of cash. Almost 80% of their assets are cash. That’s a big jump from the previous year, when cash was only 43%.

This is not a normal balance sheet. What’s going on?  Mobileye went public in July of 2014, getting a large influx of cash for its IPO. The end of 2014 showed this large influx of cash from investors. That’s why the amounts, and ratios diverge so strongly between 2013 and 2014. This makes it very useful when looking at  a company over time. Are they diverging from a pattern? Is this good divergence or problematic change?

Common-Size analysis also makes it easier to compare balance sheets of companies of different size, or to compare a company to industry averages or benchmarks. A company that shows debt as 20% of total assets may be carrying a lot of debt, or it may be carrying less debt than its competitors. With common-size balance sheets, it’s easier to see these trends.

Restrictions of the Balance Sheet

As we stated at the beginning, the balance sheet is a snapshot of the company at one time, the last day of the accounting period. As you can see from our Mobileye example, you need more information to put balance sheet numbers in perspective. But as with the Mobileye example, the balance sheet is good for pointing you toward questions to ask.

Another restriction is that accounting conventions may cause the balance sheet to inaccurately show the company’s value. The most common example of this is that asset values are shown at their acquisition cost. If the company holds lots of fixed assets for a long time, the cost the company paid for the assets may not reflect their actual market value. The company may be worth much more than what is being shown as the equity. Similarly, internally developed assets, like proprietary software and  may not be properly reflected on the balance sheet.

It is often necessary to dig into the supporting statements to really understand the information presented in the balance sheets. The supporting statements contain lots of information on the company’s accounting procedures, recent history, debt structure, and other matters of importance.

Why You Should Care about the Balance Sheet

The balance sheet gives you a company’s basic structure. It answers three basic questions: What are the company’s resources? What does it owe? What is its value? Also, the balance sheet is the basis for many ratios that are used to evaluate companies. In order to understand those ratios, you need to understand how the balance sheet works.

This article is for information purposes only. Mobileye was used as an example of a balance sheet, but this was not intended for any other purpose. Investors should proceeed with caution and do lots of research before putting their money in any investment. 

Resources and Additional Reading:

The Balance Sheet and Common Size Balance Sheet-From Accouting Tools

Balance Sheet (Explanation) and What are the Limitations of the Balance Sheet-From My Accounting Coach

Reading The Balance Sheet-from Investopedia

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