Although investors often overlook the balance sheet, it is an integral part of the financial statements. The balance sheet offers a snapshot of a company’s health, revealing how much a company owns (its assets) and how much it owes (its liabilities). The difference between what it owns assets and liabilities is known as equity, also called “net assets” or “shareholders equity”.
The balance sheet tells investors a lot about a company’s fundamentals such as the level of debt, how needs to be collected from customers (and how fast the company does so), and how much cash and equivalents it possesses.
There are two main types of assets: current assets and non-current assets. Current assets are likely to be used or converted into cash within one business cycle – usually treated as a one year period. The three most important current asset items found on the balance sheet are: cash, inventories and accounts receivables.
Companies with plenty of cash on their balance sheets are attractive to investors since a cash pile offers protection against tough times and provides more options for future growth. Growing cash reserves often signal strong company performance while dwindling reserves could be a sign of trouble. However, if loads of cash seem to be a permanent feature of a company’s balance sheet, investors need to question if management has run out of investment opportunities or don’t know what to do with the money.
Inventories are finished products that haven’t been sold yet. To generate revenue to pay bills and return a profit, companies must sell their merchandise. Inventory turnover measures how quickly the company is moving merchandise through the warehouse to customers. There should be concern if inventory grows faster than sales, since it is almost always a sign of deteriorating fundamentals.
Receivables are uncollected bills. Observing how quickly a company collects what it’s owed can speak volumes about its financial efficiency. For instance, if a company’s collection period is growing longer, it could mean that the company is letting customers stretch their credit in order to recognize greater top-line sales. But, this can lead to trouble later on, especially if those customers face a hard time and aren’t able to pay for the goods or services. The quicker a company gets paid, the sooner it can pay salaries, merchandise, equipment, loans, and best of all, invest in growth opportunities.
Non-current assets include items that are fixed assets, such as property, plant and equipment (PP&E). Unless the company is forced to liquidate assets because of financial hardship, investors don’t need to pay too much attention to fixed assets. It’s also important to note that companies often value their fixed assets at cost regardless of their present value. Consequently, companies can grossly inflate this number, leaving investors with questionable figures.
There are two types of liabilities: current liabilities and non-current liabilities. Current liabilities must be paid within a year, such as payments owed to suppliers. Non-current liabilities represent what the company owes in a year or more time. Typically, these liabilities embody bank and bondholder debt.
When analyzing a company’s liabilities, an investor normally wants to see a manageable amount of debt. It’s a good sign when debt levels are falling. Generally, if a company has more assets than liabilities, it is in decent condition. Conversely, a company with more liabilities than assets should to be examined with more care. Too much debt relative to cash flows required to pay for interest and debt repayments can bankrupt a company.