Breaking down the balance sheet

The balance sheet is arguably the most important financial information on a company. The balance sheet shows you what the company owns, and what it owes; assets and liabilities. They are public information, therefore easily accessible via the company’s ‘Investor Relations’ site, or via the Securities and Exchange Commission site. You will find balance sheets in 10K’s or 8K’s.

A balance sheet does exactly what it says, it balances. The calculation is simple: Assets = Liabilities + equity. For every dollar of assets, there needs to be a dollar of:

  1. Liability or
  2. Equity

If I took out a $1 million loan to purchase a building, then on the asset side I would show $1 million under property and equipment, and on the liability side I would show a liability of $1 million for the debt. $1 million building = $1 million liability, it balances. Assets = Liabilities + Equity. In the example I just gave, there is no equity. Therefor, nothing is entered under equity.

Let’s say I started my business with $1 million of my own money (lol, ya right). For the balance sheet, I would enter $1 million under assets, and $1 million under equity since the money I invested was mine. So, $1 million cash = $1 million equity, it balances. No liability in this case, so that would just be zero. Assets = Liabilities + Equity.

A balance sheet simply shows the company’s assets, liabilities, and owners equity. That’s it. But it is hugely important for investors to see.

For this tutorial on balance sheets, I chose Facebook. Let’s take a look at what important information can be found in one.

First, the assets.

Balance Sheet August 31

Assets are what a company owns. Current assets are assets that can easily be liquidated into cash: marketable securities and cold hard cash are what make up current assets. Marketable securities are investment vehicles like bonds or stocks. Then, of course, there are assets that are not easily liquidated into cash: property, equipment, etc., cannot be easily converted into cash.

What do assets tell us? They can tell an investor how financially sound a company is. Does the company have a lot of cash on hand? Would the company be able to easily pay off their debt should something happen? Does the company have plenty of cash to reinvest in itself for research and development? These are just a few questions that the assets portion of a balance sheet can answer. I look for companies with large amounts of cash and cash equivalents. I compare how much current assets they have to their industry peers.

liabilities

Now the liabilities portion of a balance sheet. There are – just like assets – current liabilities. Current liabilities are debts due within one year. They are short-term debts. On the flip side, long-term debts are liabilities that are expected to take longer than one year to pay off.

Short-term debts are things like lines of credit, or interest payments. Long-term debts are things like buildings and land.

Liabilities also tell a story. Is the company taking on more debt than it can pay off? What is the debt for? Are they buying buildings because they are expanding? Are they buying equipment because they are trying to become more efficient? Or, are they simply spending money because they do not know what they are doing?

I always want the assets to be more than the liabilities. Makes sense right? I don’t want the company having more debt than it can pay off. Technically, we as people should live our every day lives with the same philosophy. But, unfortunately, as soon as we purchase a house, that thought goes out of the window for the majority of us. Unless you are a multi-millionaire who can pay cash for that house.

Anyways, if you take the total assets, and subtract the total liabilities, you get equity.

equity

Equity can also be called ‘Owners Equity.’ It is what is left over for investors. In theory, it is also what the company is worth (very very much so in theory). Obviously, there is a lot more that goes into deciding what a company is worth. But, that’s basically the definition of equity.

I do look at equity, but not as much as I look at the assets and liabilities. I want to know where they are spending money, and what are they doing with their debt. More importantly, I want to know how much debt they have compared to their business as a whole. Too much debt is bad, too little debt can also be bad. There’s a fine line in there.

There is no such thing as too much cash in my opinion, however, I would question why they aren’t buying back shares, or investing more back into their business, investing more to expand, or paying a dividend; things like that. But for the most part, there is no such thing as too much cash. There can, however, be too little cash.

The only thing I use equity for, is to roughly gauge if they are under or over-valued compared to what they are selling for in the market. VERY roughly guage! As I said, determining a company’s true value goes much deeper than their equity.

This was a basic run-down of the balance sheet. This sheet is very important for value investors. If the balance sheet is weak, I won’t look any further into the company. The balance sheet must be strong.

 

 

 



Categories: Investing

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