Invest Wisdom

I’m out of the country on vacation all this week (To Spain, thanks for asking!). But rather than leave you with nothing, I’m going to take this blog back to basics again, with an introduction to company balance sheets. Even if you’re a seasoned investor, it helps to be reminded of the earnings statement’s less-favored brother. I hope you pick up a few new things along the way.

A few weeks ago, I gave a basic intro to value investing and tackled the price-to-earnings ratio (P/E), one of the most used measures pulled from a company’s income statement.

For the next several days, I’m going to address the balance sheet, which is just as important. A company could earn $100 million per year in revenues but still go bankrupt if it carries too much debt. The balance sheet can also reveal the value a company carries even if it faces depressed earnings.

Here’s the lineup: Today I’ll introduce the balance sheet and talk about current assets.

On Wednesday, I’ll talk about the rest of the asset side of the balance sheet.

On Friday, it’s on to a company’s debts.

And a week from today, I’ll sum it all up and show some of the other ways it can expose problems or advantages that a company has.
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A primer and a few definitions

Unlike the income statement, which records gains and losses throughout a year or quarter, the balance sheet is a snapshot in time. The balance sheet is a window into what assets and liabilities the company carries at the exact moment that the company drew it up.

You can divide the balance sheet into two parts: a company’s assets, which include cash, receivables, inventory and equipment; and a company’s liabilities and shareholder equity.

Within the liabilities category is “Current Liabilities”, which is debt due within a year, and “Long-Term Liabilities,” which is not.

The shareholder equity of a company, which is the same as net worth, is the total amount of liabilities minus the total debt.

Analyzing the company’s assets

When you begin to look at a balance sheet, it’s good to tackle the assets in two main segments: current assets, and everything else.

Current assets are a company’s most liquid assets and include cash, accounts receivable (i.e. money soon to be paid to the company), and inventory. It helps to think of the current assets line-up as a chain: inventory becomes accounts receivable, accounts receivable becomes cash.

Cash: More is better (duh). But it’s also important to remember that companies with huge piles of cash didn’t always accumulate them from ongoing business. Cash hoards can appear after the sale of a business segment or the issuance of bonds.

If you’re not sure how the company earned the cash it has, you can always look at the last few years of cash balances to see if it accumulated gradually or suddenly. The debt portion of a company’s balance sheet, which we’ll look at on Wednesday, will also reveal if it has issued bonds.

Companies can use cash in several ways. It can be reinvested into the business, used to pay down debt, to give back to investors in the form of stock buybacks or dividends, or to acquire other businesses. Some companies simply like to carry a lot of cash as a kind of emergency fund in case of a rainy day.

Net receivables: Many companies don’t collect payment immediately after selling a product. Instead, the customer will have a certain number of months to pay. Until the customer does, the money is considered a receivable. Of course, some customers will renege on their payment, and for balance sheet purposes, the company estimates how much will never be collected and deducts it from the receivables figure.

Inventory: Inventory is all the goods that a company has already manufactured for sale but that haven’t been sold yet. By itself, it doesn’t tell you much, but look at how the inventory has changed over time, and you can learn how a company is faring.

If earnings are consistently increasing and inventory correspondingly goes up, it means the company is expecting increased demand for its products and has increased manufacturing to keep up. If earnings went up but the inventory went down, it could mean that the company is expecting a drop in business, which could either be because of its own problems or simply because its industry is cyclical. For some companies, like those in the tech business, carrying a lot of inventory is dangerous, because the product could become obsolete.

Other current assets: In most cases, these don’t tell you a ton about a company’s ongoing business but they’re useful to know. They could include prepaid expenses or deferred income tax refunds.

Add all of those components up, and you should get the “Total Current Assets” figure that a company puts on its balance sheet.

On Wednesday, come back to learn about the other assets that a company could have and how you should consider them.

— Joe Light