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Decoding the Balance Sheet    Bookmark and Share

The balance sheet is one of the major financial documents that a public company is required to publish. It provides a snapshot of a company's current financial position. By doing their own balance sheet analysis, investors can determine if a company manages its finances well. In a difficult economic environment, knowing the difference between which companies are doing a good job of managing their finances and which ones aren't can make the difference between investing success and failure.

The company balance sheet is comprised of three major sections. The first major section of the balance sheet is the assets section. Assets can be described as items of monetary value that a company possesses. This includes things like inventory, accounts receivable, cash, equipment, and real estate. The value or estimated value of these assets is recorded on the balance sheet.

The liabilities section is the next major section of the balance sheet. A liability is essentially a debt that a company owes. There are many types of liabilities, including fixed, long-term, and current liabilities. For example, if you go to buy a car, but need to borrow money from the bank in order to pay for it, the amount of the loan that you owe to the bank can be considered a liability to you. You will held liable to pay the money back to the bank. In the same way, companies borrow money to pay for the things that they need to keep their businesses running, and record the associated debt as liabilities on their balance sheets.

The stockholders' equity section is the third and final major section of the balance sheet. It is basically a measure of how much shareholders will end up with after the company pays its debtors and gets rid of its liabilities. It is also commonly referred to as the book value of the company. Stockholders' equity equals the company's total assets minus the company's total liabilities. This is the basic formula of the balance sheet.

So, now that you know the basics, how do you make sense of all the information?

Many people use ratios to analyze the balance sheet. This is because there are a lot of numbers to analyze, and it is difficult for most people to make sense of a balance just looking at the numbers by themselves. Let's outline a few of the most common balance sheet ratios.
  • Current Ratio = Current Assets ÷ Current Liabilities. The current ratio is a measure of solvency. A company with a low current ratio will generally have more difficulty meeting its short-term debt obligations than a company with a high current ratio.
  • Quick Ratio = (Cash + Accounts Receivable) ÷ Current Liabilities. This ratio is a measure of liquidity, or how readily can a company pay for its current liabilities with its most liquid assets.
  • Debt To Equity Ratio = Total Liabilities ÷ Shareholders' Equity. This ratio is a measure of financial risk. A higher debt to equity ratio typically means more risk to shareholders.
Additionally, it is a good idea not only to analyze the current balance sheet, but also past balance sheets. This helps to put the company's current financial position into perspective. If you notice gradual improvement in the balance sheet over time, it is generally an indicator that the company is moving in the right direction.

In conclusion, it may seem somewhat tedious at first, but if you can learn to analyze the balance sheet effectively, you will be well on your way to becoming a successful investor.

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