As most investors should know, there are three financial statements - the income statement, the statement of cash flows and the balance sheet. A lot of media attention tends to focus on the income statement - after all, earnings are typically the most widely reported figures every quarter. Nonetheless, investors should always analyze all three statements together. Today, we will look at a few tips for deciphering the balance sheet.
What is it?
First things first: What is a balance sheet? A balance sheet is a ledger that lists a business' assets (the things that a company owns) on one side and its liabilities (the company's debt) and equity on the other side. The two sides must balance, so the equity is whatever is left over when you subtract liabilities from assets. As an example, let's say you open a lemonade stand. You finance it with $300 of your own money, and take out a $200 loan from the bank. The total assets are $500, the liabilities are $200 and the equity is $300.
Companies, however, are more complex than lemonade stands. Examples of assets include cash and cash equivalents, inventories and capital assets (equipment, property and other long-term assets). Examples of liabilities include money owed to banks, bondholders, suppliers and other parties. Unlike the income and cash flow statements, which cover certain periods (typically a quarter or a year), the balance sheet is a snapshot in time - it shows a company's financial position at a specific moment.
Lessons for investors
So what can investors learn from a balance sheet? One of the most basic things is the relationship between debt and equity. Not all debt is bad - borrowing money can help a business grow and earn money more efficiently - but generally speaking, the less debt a company has, the better. Less debt means more equity left over for shareholders. Conversely, a company with high levels of debt owes a lot of money to people who are not shareholders.
Additionally, high debt levels are often synonymous with higher risk. Borrowed money can magnify returns, but if a company runs into some sort of financial trouble, the interest that it will owe on its debt may overwhelm its ability to generate cash. It's important to note that financial trouble doesn't just come from within a business - more often than not the worst shocks come from the wider economy. For this reason, taking on large amounts of debt is almost always a risky strategy, as it is - by definition - impossible to forecast surprise economic shocks.
Another important aspect of balance sheet analysis is working capital, which is calculated by taking the ratio between current assets (cash, accounts receivable and other assets that are easy to convert into money) and current liabilities (short-term debts like accounts payable and bank loans that are due within the course of a year). This simple calculation can give you a sense for a business' liquidity. A working capital ratio of more than 1 indicates the company may be better positioned to survive the aforementioned financial shocks.
Of course, financial analysis is a lot more complex than looking at these simple ratios, but they do give you a good starting point.
Read more here:
- Howard Marks: Here's When You Need to Get Out of the Market
- Seth Klarman Explains Why Investors Should Retain Cash
- Jim Chanos Believes Markets Have Gotten Too Speculative
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