Investment – What is, and how do you read the Balance Sheet or Financial Position?
As previously explained in our post about Company Reports, the Balance Sheet (or Financial Position) is one of three reports or statements that a company or business produces which shows how the business has performed. The other two reports are Profit and Loss (or Income Statement) and Cash Flow Statement.
The balance sheet (also known as the statement of financial position, is a snapshot of a company’s health at a particular period or point of time, such as end of month or end of year. By reading it, we can learn how much a company owns (assets), and how much it owes (liabilities). The difference between what it owns and what it owes is called equity, or “net assets” or “shareholders equity”.
Another way to explain, the balance sheet tells a lot about a company’s fundamentals: how much debt the company has, how much it needs to collect from customers, how much cash and equivalents it possesses and what kinds of funds the company has generated over a period.
Assets, liability and equity are the three main sections of the balance sheet. They can tell investors a lot about a company’s fundamentals especially when ratios are performed on certain parts.
Here is a simple diagram of the Balance Sheet –
ASSETS
There are two main types/groups of assets: current assets and non-current assets or long-term assets.
Current assets are likely to be used up or converted into cash within twelve months. Three important current asset items are: cash, inventories and accounts receivables.
Cash – Investors normally are attracted to companies with plenty of cash on their balance sheets. After all, cash offers protection against tough times, and it also gives companies more options for future growth. Growing cash, if watched from year to year, can signal strong company performance. A reducing cash pile could be a sign of trouble. So, if loads of cash are more or less a permanent feature of the company’s balance sheet, investors will ask why the money is not being put to use.
Inventory – Inventories are the finished product that hasn’t been yet sold. Investors want to know if a company has too much money tied up in its inventory. Companies have limited funds available to invest in inventory. To generate the cash to pay bills and return a profit, they must sell the product they have manufactured or purchased from suppliers.
Accounts Receivable – Are outstanding invoices owed by customers. The speed at which a company collects what it’s owed can tell a lot about its financial efficiency. If a company’s collection period is growing longer, it can indicate problems. The company may be letting customers stretch their credit in order to recognize greater top-line sales and that can bring trouble later on, especially if customers face a cash crunch. Getting paid sooner is preferable to waiting for it – since some of what is owed may never get paid. The quicker a company gets its customers to make payments, the sooner it has cash to pay for salaries, merchandise, equipment, loans, and most importantly, dividends and growth opportunities.
Non-Current assets – Non-current assets are all the rest that are not classified as a current asset. This includes items that are fixed assets, such as property, plant and equipment . Unless the company is in financial distress and is liquidating assets, investors need not pay too much attention to fixed assets. Since companies are often unable to sell their fixed assets within any reasonable amount of time they are carried on the balance sheet at cost regardless of their actual value. As a result, it is possible for a company to inflate this number.
LIABILITIES
There are current liabilities and non-current liabilities.
Current liabilities are obligations the firm must pay within a year, such as payments owing to suppliers, payroll taxes, superannuation, credit cards and other short-term loans.
Non-current liabilities, are what the company owes in a year or more time. Typically, non-current liabilities represent bank and bondholder debt.
We usually want to see a manageable amount of debt. When debt levels are falling, that’s a good sign. Generally speaking, if a company has more assets than liabilities, then it is in decent condition. By contrast, a company with a large amount of liabilities relative to assets ought to be examined with more diligence. Having too much debt is one way a company can go bankrupt.
EQUITY
Equity represents what shareholders own, so it is often called shareholder’s equity. As described above, equity is equal to total assets minus total liabilities. The two important equity items are shareholders’ funds or paid-in capital and retained earnings.
Shareholder Funds are the amount of money shareholders paid for their shares when the stock was first offered to the public. It represents how much money the firm received when it sold its shares.
Retained Earnings are profit or loss after tax accumulated over the years – it is money the company has chosen to reinvest in the business rather than pay to shareholders. Investors look closely at how a company puts retained earnings and borrowings/debt (together are called Capital) to use and how a company generates a return on it.
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