Understanding balance sheets
So far, your analysis of an individual company has enabled you to build up a general picture of the business, the way it's run and its state of health. The final step is to carry out a detailed review of the company's finances.
This may take a bit of time and effort, but it's worth doing. Financial statements can yield all sorts of interesting quantitative data from which you can deduce the strength of the company, the effectiveness of its strategy and its prospects for the future.
So what should you look for in financial statements and how do you interpret the figures you see? In this lesson and the two that follow, we'll run through some key areas you should include in your analysis and explain what they mean.
What is a balance sheet?
A balance sheet is a statement of the company's assets, liabilities and capital at the end of a particular reporting period. It typically includes:
- Cash: the most liquid assets, which also include any government debt being held
- Marketable securities: equity and debt securities that can be traded on a liquid market
- Long-term securities: securities which can't be liquidated immediately
- Inventory: goods available for sale, typically valued at their cost or market price, whichever is lower
- Accounts receivable: money owed to the company by its customers, factoring in any expectation of money unlikely to be paid
- Fixed assets: these include land, equipment and machinery
- Intangible assets: non-physical assets such as intellectual property
- Long-term debt: the interest and principle on corporate bonds that the company has issued
- Tax payable: taxes that will have to be paid off, although not immediately
- Pension funds: money set aside to provide for employee pensions
- Shares: the equal parts into which the company's capital is divided, with their owners being entitled to a proportion of the profits made by the business
- Retained earnings: earnings that are subsequently reinvested in the business or used to pay off existing company debt
- Treasury shares: shares which are set aside to be used at a later date if the company needs to raise funds. This can also refer to shares that the company has bought back
The best way to interpret a balance sheet is to compare it with previous releases, looking to see which way the figures have been changing over time. You might also want to review it alongside balance sheets for other, similar companies within the industry to get a sense of what's the norm.
From a balance sheet you can derive a number of useful ratios, such as the popular debt/equity ratio. This measures a company's financial leverage. To find it, you divide the company's liabilities by its shareholder equity.
IncorrectDivide the company's total liabilities by its total shareholder equity to get the debt-to-equity ratio. A debt-to-equity ratio of around 20% would be considered low, whereas a figure over 100% is high. So Oil Company B has a considerable amount of debt.
IncorrectA high ratio could indicate that the company is financing ambitious growth plans. If these come to fruition, shareholders could reap the rewards. However, in the meantime the company will be liable for greater interest expenses and exposed to higher risk, potentially even making it likely to fail and go out of business.
- A balance sheet is a statement of a company's assets, liabilities and capital at the end of a particular reporting period
- From the balance sheet you can derive useful ratios, such as the debt/equity ratio, which measures financial leverage
- You can calculate the debt/equity ratio by dividing the company's liabilities by its shareholder equity
- A high debt/equity ratio implies an aggressive strategy with potentially high risk
What is fundamental analysis4 min
How does fundamental analysis work7 min
Analysing an individual company4 min
Evaluating a company's management6 min
Understanding balance sheets8 min
Analysing cash flow statements4 min
Understanding the income statement7 min
The pros and cons of fundamental analysis5 min