Now that you have a good idea of how profits are recorded on the income statement, let's adjust those green eyeshades, insert that pocket protector, and move on to the balance sheet. As we’ve mentioned before, the balance sheet tells investors how much a company owns (its assets), how much it owes (its liabilities), and the difference between the two (its equity) at a specific point in time. Thus, you can think of the balance sheet as a snapshot of what a company is worth--according to accounting rules--on a given day.
Although we're going to keep it fairly simple, this lesson will provide more details on the key sections of a company's balance sheet and may get a little technical at times. However, we think it will be well worth the time and effort needed to plough through it. So take a deep breath and let's dig in.
Assets, liabilities, and equity--it all equals out
One of the most important things to understand about the balance sheet
is that it must always balance. Total assets will always equal total
liabilities plus total equity. Thus, if a company's assets increase from
one period to the next, you know for sure that the company's liabilities
and equity increased by the same amount.
Let's now take a deeper look at the various sections of the balance sheet. Although there are potentially many more specific line items that we could cover, we're going to stick with the most common and, in our opinion, the most important sections that investors should be aware of.
Current assets
Assets are generally defined as things a company owns, which are
expected to provide future benefits. There are two main types of assets:
current assets and noncurrent assets. Within these two categories, there
are numerous subcategories, or line items.
Current assets are things a business owns that are likely to be used up or converted into cash within one business cycle--usually defined as one year. The most common line items in this category are cash and cash equivalents, short-term investments, accounts receivable, inventories, and other various current assets.
Cash and cash equivalents: This line item doesn't necessarily refer to actual bills sitting in a cash register or vault. Generally, cash is held in low-risk, highly liquid investments such as money market funds. These holdings can be liquidated quickly with little or no price risk. This is considered money that can be used for any purpose the company wants.
Short-term investments: This represents money invested in bonds or other securities that have less than one year to maturity and earn a higher rate of return than cash. These investments may take a little more effort to sell, but in most cases investors can lump them with cash to figure out how much money a firm has on hand to meet its immediate needs.
Accounts receivable: Think of receivables as bills that a company sends its customers for goods or services it has provided but for which the customer has not yet paid but is expected to pay within the next year. In other words, these are sales (recorded on the income statement) that haven't been paid for yet with cash. Generally, accounts receivable are shown as a net amount of what a company expects to ultimately collect, because some customers are likely not to pay. The amount of receivables a company thinks it won't collect is typically known as an allowance for doubtful accounts (i.e. bad debt). Not only do additions to the allowance for doubtful accounts decrease the amount of accounts receivable, but they also increase a company's expenses--known as bad debt expense.
Keep an eye on accounts receivable in relation to a company's sales. If accounts receivable are growing much faster than sales, it generally means a company isn't doing an ideal job collecting the money it is owed. This could potentially be a sign of trouble because the company may be offering looser credit terms to increase its sales, but it may have difficulty ultimately collecting the cash it's owed. Conversely, if accounts receivable are growing much slower than sales, the firm's credit terms may be too stringent, at the expense of sales.
Inventories: There are many different types of inventories, including raw materials, partially finished products, and finished products that are waiting to be sold. This line item is especially important to watch in manufacturing and retail firms, which are saddled with large amounts of physical inventory.
The value of inventories shown on a company's balance sheet should be taken with a grain of salt because of the way inventories are accounted for. Similar to accounts receivable, changes in inventories are generally related to a company's sales or, more specifically, the gross profit (sales price minus the cost of the inventory sold) it makes from each sale. If inventory levels are growing much faster than a company's sales, it may be making or buying more goods than it can sell. That may force the company to lower its prices, which results in lower profits for each item sold and lower profitability for the company. In some cases, it may have to reduce prices to levels below the value of the inventory itself, resulting in losses.
Additionally, inventories tie up capital. The cash that was used to create inventory can't be used for anything else until it's sold. Thus, another important thing for investors to monitor is how fast a company is able to sell its inventory.
Other current assets: While there are too many to list here, this category includes any other assets the firm may have that are expected to turn into cash within the next year. However, some current assets will not turn into cash, the most common of which are known as prepaid expenses (yes, even though it's called prepaid expenses, it's actually an asset). For example, say Volkswagen buys and pays up-front for an insurance policy for the coming year. Accounting rules say the company should record the entire payment as a prepaid expense (asset) as opposed to a normal expense on the income statement because it represents something of future worth to the company--a full year's worth of insurance coverage. As the year goes on, the value of the asset will decrease--less time remaining on the policy--and the amount of the decrease is recorded as an expense, a process known as amortisation. Keep in mind that a company's prepaid expenses--which belong to a broader category known as capitalised costs--represent cash that was paid up-front and will turn into expenses instead of cash within the next year.
Noncurrent or fixed assets
Noncurrent assets, otherwise known as fixed assets, are cleverly defined
as anything not classified as a current asset. The main line items in
this section are long-term investments; property, plant, and equipment
(PP&E); and goodwill and other intangible assets.
Long-term investments: This is money invested in either bonds with longer terms than one year or the stock of other companies. These aren't as liquid as cash and short-term investments, and prices may fluctuate, so it's possible that the value shown on the balance sheet may be too high or too low. If it's a big enough balance, you may want to dig into the details to make sure you're comfortable with the kinds of risks the firm is taking with shareholders' money.
Property, plant, and equipment (PP&E): These assets represent the bricks and mortar of a company: land, buildings, factories, furniture, equipment, and so forth. The PP&E amount on the balance sheet is typically reported net of accumulated depreciation--the total amount of depreciation recorded against the assets over their life. Eventually, PP&E has to be replaced, and depreciation is a company's best estimate of these "replacement" costs from wear and tear. Keep in mind that PP&E is usually not a very accurate measure of what a firm's bricks and mortar are really worth. Many times, buildings worth millions of pounds are reported at next to nothing in PP&E because of accumulated depreciation. Likewise, the actual value of a company's land--which is recorded in PP&E at its acquisition price--may be worth exponentially more than what is recorded.
Goodwill and other intangible assets: Intangibles are, just as the name describes, assets that can't be touched and are generally not going to turn into cash. The most common form of intangible assets is goodwill. Goodwill is formed when one company buys another and pays more than the target company is worth (as defined by the net worth, or equity on the target's balance sheet).
You should view this line item with high levels of scepticism because most companies tend to pay too much when making acquisitions. Therefore, the value of goodwill that shows up on the balance sheet is often higher than what the intangible assets are really worth. Accounting rules require companies to value goodwill every year, and if a company lowers the value of the goodwill it records--a phenomenon known as impairment--it's a tacit admission that the company paid too much for an acquisition it made in the past.
Current liabilities
Now that we're more familiar with what a company owns, let's move to the
other side of the balance sheet: what it owes. Similar to assets, there
are two main categories of liabilities: current liabilities and
noncurrent liabilities.
Obligations the firm must pay within a year are known as current liabilities. The main line items you should be concerned with in this category are short-term debt and accounts payable.
Short-term debt: This refers to money the company has borrowed for a term of less than one year. It's often in the form of a line of credit that may be drawn down at the company's discretion. Typically, the proceeds are used for short-term needs. Often, the amount of long-term debt that must be paid back within one year is also lumped into this line item. The amount of short-term borrowings is an important figure, especially if a company is in financial distress or pays a high dividend, because the entire amount must be paid back relatively quickly, leaving little wriggle room.
Accounts payable: Accounts payable represents bills the company owes for goods or services it hasn't paid for yet. It is the opposite of accounts receivable and, generally speaking, investors like to see the opposite trends for the two line items. For example, with receivables, we'd prefer a company to collect what it's owed as soon as possible. However, if a company can postpone paying what it owes for a longer period of time--without getting in trouble--it will hold on to its cash for a longer period of time, a plus for cash flow.
Noncurrent liabilities
Noncurrent liabilities are the flip side of noncurrent assets. These
liabilities represent money the company owes one year or more in the
future. Although you'll see a variety of line items in this category,
the most important one by far is long-term debt.
Long-term debt: This represents money the company has borrowed, typically by issuing bonds, that doesn't need to be paid back for several years. Too much long-term debt is generally risky for a company, because the interest on debt must be repaid no matter how the business is doing. Determining how much debt is too much is very firm-specific and depends on many things including the interest rate a company pays on its debt, and the stability of the firm's earnings and cash flows. One good way to determine if a company can afford the interest payments on its debt is to see how many times the firm's operating income--otherwise known as income before interest and taxes (EBIT)--will cover its interest expenses (interest coverage ratio).
Equity
As we mentioned earlier in this lesson, equity is equal to total assets
minus total liabilities. It represents the part of the company that is
owned by shareholders; thus, it's commonly referred to as shareholders'
equity. It is also referred to as net assets, or net worth. Although
there are several line items within equity, the two main categories
investors should focus on are retained earnings and treasury stock.
Retained earnings: This line item represents the total profits the company has earned since it began, minus whatever has been paid to shareholders as dividends. Because this is a cumulative number, if a company has lost money over time, retained earnings can be negative and would be renamed "accumulated deficit."
Treasury stock: This line item shows how much of its own stock a company has repurchased. Because repurchasing stock is analogous to paying dividends to investors--and in some cases can be even more desirable--investors should take note of changes in this account to see how much stock a company is repurchasing from one period to the next.
The bottom line
You can now exhale: you've made it through our tour of the balance
sheet! Although we've admittedly left out plenty of specifics, you
should know enough now about the income statement and balance sheet to
be dangerous.
In the next lesson we'll move forward to what's arguably the most important financial statement of all--the statement of cash flows.
Check out our Learning Centre for more investment lessons on bonds, funds, stocks and portfolio management.
