How to Read a Balance Sheet
Companies and news releases go hand-in-hand, communicating a stream of important appointments, recently signed contracts, new products and newsworthy information.
But often overlooked in the avalanche of releases is a treasure trove of important information. The source of some of the most useful information to you as an individual investor has the decidedly un-sexy title of the annual report. The annual report holds two important financial statements – the balance sheet and the income statement.
In this section, you’ll…
- Learn how to read an annual report and get to the information that matters
- Learn how to interpret a balance sheet
- Get useful tips on how to use balance sheets to choose your stock investment
The source of some of the most useful information to you as an individual investor has the decidedly un-sexy title of the annual report. Virtually all annual reports are available online for free.
Give Yourself the Advantage with Annual Reports
Every year, publicly traded companies have to file specific documents with the regulatory authorities. The annual report is probably one of the most critical documents for investors like you who are willing to put in a little legwork to assess their investments.
Annual reports are available free to the public. You don’t even have to be a shareholder. Many newspapers regularly offer annual report mailing services.
But now you don’t have to turn over your spare bedroom to house these stuffy reports…you can find them all on-line.
The Annual Report: Just What’s Inside?
An annual report typically has a lot of words aimed at giving you a warm, fuzzy feeling. Some companies make a real point of telling you they weren’t at fault for last year’s woes, and that you better wear shades because the future’s so bright.
But a major part of the annual report is devoted to numbers, not words, and accounting firms audit these numbers. Of course, numbers can still be massaged and packaged to make things look better than they really are.
That said, it’s still worth your while to go over two main highlights of an annual report: the balance sheet and the income statement.
In the next section, we’re going to show you how to break down a balance sheet. We’ll also take a look at what makes up an income statement and how to use it to judge a company.
What is a Balance Sheet?
A balance sheet is a snapshot of a company’s financial situation at a certain point in time. If you’ve ever done any financial planning for yourself, you may have considered preparing a net worth statement.
Your personal net worth statement would typically have two big categories. The first would be your assets – your home, car, savings accounts, and so forth. The second category would be your debts – any outstanding money you owe on your mortgage, credit card balances, student loans, and so forth.
A company’s balance sheet is very similar. In the business world, what a company owns are called assets. Its debts go by a different name, referred to as liabilities.
An annual report typically has a lot of words aimed at putting a positive light on past performance and the future. A balance sheet is a snapshot of a company’s financial situation at a certain point in time.
The best way to understand a balance sheet is to take a look at one; let’s look at the balance sheet for BOEING.
How To Approach Balance Sheets
While balance sheets can at first seem overwhelming, they actually aren’t all that complicated. Just remember to think of them as a corporate version of your own financial life.
Balance sheets are usually displayed on-line as a long document with one section following the next. But they are easier to understand if you think of them as a two-page leaflet.
On the left-hand side go the assets. On the right-hand side go two major categories – the first is a company’s liabilities; the second is shareholders equity.
Let’s zoom in closer and look at what’s on the “left hand side” of Boeing’s balance sheet, starting with its assets.
Think of balance sheets as a corporate version of your own financial life. Just like you’ve got your personal assets (house, bank accounts, jewelry, etc.), companies also
The First Part Of The Balance Sheet: ASSETS
The first thing to notice is that balance sheets typically deal in millions of dollars. You’ll find that point made right under Boeing’s name at the top of the chart (on page 10 of this lesson).
The first major category here is assets or things of value. Just like you’ve got your personal assets (house, bank accounts, jewelry, etc.), companies also have assets.
The most common asset is Cash. Just like you, companies usually have some cash on hand. Forget the movies. It’s not stacked in big piles in a vault behind the president’s desk. Corporate cash is generally invested in short-term securities to earn income while it’s not being used.
Notes and Accounts Receivable: This is money that is owed to the company. Say Boeing sold $100 million of equipment to a customer, but hadn’t yet collected the money. That money owing would show up on the balance sheet as an asset. Receivables will typically grow as a company does more business. However, one potential red flag is if the accounts receivable grows faster than sales. This can mean that customers aren’t happy with what they’ve bought, and are dragging their heels on paying for merchandise. It can also mean that the company is selling to customers that may not be able to pay up all the money they owe.
Inventories: This is where you’ll find the value of the company’s products that it has on hand but hasn’t sold yet. Sometimes Inventories are broken down into two categories – Finished Goods, and Work in Process and Raw Materials. As the words suggest, “finished goods” are products that are ready to go out the door. “Work in process and raw materials” are the total value of all the various materials the company uses to make its products, but that haven’t yet been fully fashioned into the “finished Goods” listed above.
Total Current Assets: This is a total of the company’s assets that can be turned into cash within 12 months (hence the term current). This includes cash, accounts receivable, inventory, short-term securities, and so on. Another common type of current asset is “Prepaid Expenses”. You likely pay for some of your ongoing living expenses ahead of time -say your transit pass or your property taxes. On the first day of the month, your transit pass is worth a lot more than at the end of the month. Similarly, companies pay for a variety of expenses upfront. The reason they qualify as assets is because they are paid for, but not yet used up.
Current assets are a company’s assets that can be turned into cash within 12 months. If inventory increases faster than revenues, it can mean demand is shrinking, the company has overproduced, or that the product may not have long-term appeal.
Net Property and Equipment: All companies need all sorts of buildings, machines, and computers to produce their products and sell their services. Net Property and Equipment isn’t included in current assets because it typically can’t be sold quickly. In addition, unlike current assets, the value of a company’s plant and equipment decreases over time as it depreciates. This depreciation is a cost of doing business, and shows up as an expense.
Investments and Advances: Beyond parking their spare cash, companies often invest in bonds and the stock of other companies, just like an investor would, to obtain a return on their investment.
Intangibles: These are rights and other non-physical (and often non-tradable) resources the company owns. This category can include copyrights, patents, and goodwill.
Total Assets: This is simply the sum total of all the above categories. This number must equal the total number on the other side of the balance sheet, which is made up of two major categories: liabilities and shareholder’s equity.
Now that we’ve tackled the left side of the balance sheet, let’s tackle the right side and its two major categories – liabilities and shareholders equity.
The Lower Side Of The Balance Sheet: LIABILITIES
Let’s zoom in closer and look at the first major category of the ‘right hand side’ of Boeing’s balance sheet – liabilities.
Notes and Accounts Payable: When companies make purchases, they usually have a set number of days or even weeks before they actually have to pay for the goods. As companies grow and require more supplies to operate, their accounts payable will also grow in size.
Current Portion Long Term Debt: This is money that the company has to pay back within the next twelve months.
Current liabilities are obligations the company has to pay back within the next 12 months.
Current Portion Capital Leases: This is what the company will have to pay out in the next twelve months on its leases.
Accrued Expenses: Accruals are usually obligations to pay money out to employees at some point in the future. For example, if a company has a pension plan, it has an obligation to set money aside in order to meet its future promised pension payments to retiring workers.
Income Taxes Payable: Just like you, companies have to pay the tax department taxes on the money they make, after deducting allowable expenses. This line sets out the amount of money the company has set aside to meet its expected tax bill.
Total Current Liabilities: This is the total of all the company’s obligations to pay out over the next 12 months.
Deferred Income Taxes: This is tax that the company has managed to push off into the future. Companies can do this because often they can claim larger deductions when calculating their tax bill than when arriving at their net income for their financial statements.
Long-Term Debt: These are debts the company has that don’t have to be paid within the next twelve months. This differs from Current Liabilities, which have to be paid within 12 months.
Total Liabilities: As you’ve likely guessed, this is just a total of all the company’s liabilities.
Accruals are usually obligations to pay money out to employees at some point in the future. If a company is doing well its assets should more than equal its liabilities, resulting in a positive shareholders’ equity.
Why Balance Sheets Balance
One good thing is that unlike a lot of financial jargon, the term balance sheet actually makes sense. The reason why balance sheets have such a nifty name is that they are required to do just that…balance.
As we talked about earlier, if you take a snapshot of your own financial situation, you total up your assets, and then your debt. This is the personal side of a corporation’s assets and liabilities.
If you’re doing well, your assets should more than equal your liabilities. The degree to which they do so gives you your net worth.
Similarly with a company, when you take away the liabilities from the assets, you should end up with a positive number. In a corporation, this number is known as shareholders’ equity. In essence, think of it as the shareholders’ stake in the company. Shareholders’ equity is the item that always makes a balance sheet do what its name suggests – namely balance.
The Right Side Of The Balance Sheet: SHAREHOLDERS’ EQUITY
The second major category of the balance sheet’s right side is shareholders’ equity. Shareholders’ equity is the amount by which total assets exceed total liabilities. It’s what would be left over for shareholders if the company were sold and its debt retired.#
Shareholders’ equity is the amount which would be left over for shareholders if the company were sold and its debt retired.
This category is commonly made up of the following components:
Preferred And Common Stock: The shareholders’ equity is completely different from a company’s market value. The stock prices used here are the par, or face value of the shares.
Retained Earnings: This is the money that a company earns in profits but doesn’t pay out in the form of dividends to shareholders.
Total Shareholder’s Equity: This is simply a total of the stock values listed above, along with the retained earnings.
Total Liabilities and Shareholder’s Equity: This is the total value of everything on the ‘right-hand side’ of the balance sheet. This number always matches what’s on the ‘left-hand side’ – the company’s assets.
Viewing this mathematically, the formula would look like this:
ASSETS = LIABILITIES + SHAREHOLDERS’ EQUITY
Can a company be worth less than its book value? Absolutely! It’s goodwill may be overstated for instance, or its real estate may have declined in value.
Key Learning Points
- For individual investors, one of the most important sources of relatively unbiased information is the annual report.
- Two key areas to read in any annual report are the balance sheet and the income statement.
- A balance sheet is a snapshot of a company’s financial situation at a certain point in time. It’s similar to a personal net worth statement, taking into account the company’ assets (things it owns) and its liabilities (debt owed and other financial obligations).
- All balance sheets must balance so that ASSETS = LIABILITES + SHAREHOLDERS’ EQUITY. Think of a balance sheet as a two-paged leaflet – on the left-hand side go the company’s assets; on the right-hand side are its liabilities and its shareholders equity.
Shareholders equity is the amount by which total assets exceed total liabilities. It is what would be left over for shareholders if the company were sold and its debt retired.