When analyzing a stock you plan to invest in, it is crucial to look at its balance sheet to see its current financial health. A balance sheet shows a snapshot of a company's assets and liabilities at the particular date shown on the balance sheet. It is also referred to as the statement of financial position. To beginners, balance sheets may seem complicated if you don't know what to look for. That's why we are breaking it all down in this post.
What is a Balance Sheet - The Basics
As mentioned above, a balance sheet shows what a company's assets and liabilities were at the date specified by the company. An asset is what the company owns. A liability is what the company owes. When you subtract liabilities from assets, you get owners' equity, also known as shareholders' equity or stakeholders' equity. This formula is known as assets - liabilities = owners' equity.
Think of owners' equity as a company's net worth. If you personally had 1 million in assets and 300k in debt, your equity or net worth, would be 700k. The same goes for a company's balance sheet.
On a balance sheet you will see current assets and current liabilities. For assets, this means that they are quickly (1 year or less) convertible into cash. Examples of current assets are cash, cash equivalents, accounts receivables, and inventory. Current liabilities are liabilities that the company is expected to pay off within 1 year or less. Examples of current liabilities are accounts payable and current debt (debt maturing in 1 year or less).
The only difference between current and non-current is the time horizon. Non-current assets or liabilities have lifespans of over 1 year. These are also known as long-term assets/liabilities. An example of a long-term asset is property, plant & equipment (PP&E) because companies generally hold PP&E for many years and it can be illiquid to sell as well. An example of a long-term liability would be long term debt (debt maturing in over 1 year).
Important Things to Look For in a Balance Sheet
Compare Assets to Liabilities:
Does the company have more assets than liabilities? If so, is it by a large margin? Important ratios to know that deal with this specific question are the current ratio, quick ratio, debt to asset ratio, and debt to equity ratio.
Current ratio = Current assets divided by current liabilities. A ratio greater than 1 is considered good because it means the company has more assets than liabilities. The higher this number, the better.
Quick ratio = (Current assets - inventory - prepaid expenses) divided by current liabilities. This is a more stringent version of the current ratio. Again, over 1 is good. The higher the better.
The images above are the current asset/liabilities section of Microsoft's balance sheet. To calculate the current ratio, you would take 181,915,000 divided by 72,310,000 to get 2.52. For the quick ratio, you would remove receivables and inventory from the current assets to get 148,009,000 divided by 72,310,000 which will give you 2.05 as your answer. Both these ratios are well over 1.00, indicating that Microsoft is in a healthy situation when it comes to their short-term obligations.
Keep in mind, the numbers on balance sheets are usually in thousands, meaning that total current assets are actually 181,915,000,000 (three extra 0's for everything). Financial statements will usually state somewhere if they are in thousands or not, but most of the time, you can just assume that they are.
Debt to asset ratio = Total debt divided by total assets (total meaning both current and non-current). A ratio of 1.00 indicates that the company has the same amount of debt as total assets. Ideally, you want the number to be less than 1.00. The lower the better.
The debt to asset ratio for Microsoft would be 63,327,000 divided by 301,311,000 = 0.21. This is well under 1.00, indicating that MSFT is not over leveraged and is in good shape.
Debt to Equity Ratio = (Short-term debt + long-term debt + other fixed payments) divided by shareholders' equity. Generally, the lower this number, the less risky the company is.
Other Questions to Ask Yourself:
Do the company's short term assets cover their total liabilities? If yes, extra checkmarks.
Is total debt increasing much faster than total assets are? If a company's debt load is increasing by $1B every year, but their assets are increasing by only $100M, that may be a cause for concern. This is especially true if assets are actually shrinking.
How much of the company's assets are actually made of tangible assets? An asset such as "goodwill" is not physical, it may be difficult to value or convert to cash. Other "intangible assets" include trademarks, brand names, patents, licenses, etc. A company may seem to have many more assets than liabilities, but if these assets are mostly goodwill, it is difficult to determine whether the value stated is accurate.
Is the shareholders' equity increasing every year? Since equity is the company's net worth, you want this to be getting higher every year, not shrinking. But again, monitor if equity increases are mainly because of goodwill if you want to be extra cautious.
Goodwill is the premium the company has paid to acquire another company (or several companies over the years). If Microsoft wants to buy ABC company and ABC is worth $1B, Microsoft may have to pay $1.25B to acquire them. This is because usually acquiring companies pay a premium over the company's total assets value to acquire it. The extra $0.25B that Microsoft paid gets added to the balance sheet as "goodwill". If the value of goodwill increases after the acquisition, the amount stays unchanged and doesn't get ammortized. However, if the value decreases, it gets charged to the income statement as an impairment charge. These changes in value are determined by management's judgement and require a great deal of discretion.
Analyzing a Company Doesn't Just Stop at the Balance Sheet
As one would suspect, less debt for a company generally equals less risk. Why do we say "generally" though. Isn't it always the case that less debt equals less risk? Well, not always. It really just depends on the type of company/industry you are dealing with. Let's put two hypothetical company's side by side. ABC stock: a start-up furniture company with no debt but also not cash flow positive; and XYZ stock: an established, utility company with a 60% debt to equity ratio that generates enough cash flow to keep its debt under control. It is clear here that the utility stock is less risky even though it has some debt because of the nature of the business and the fact that it generates cash flow. Utilities are in constant demand, whereas furniture demand may be influenced by macroeconomic conditions.
Looking at a balance sheet is a great first step to determining a company's financial health, but it doesn't stop there. The other financial statements such as the income statement and cash flow statement should be looked at as well, and common sense should also be used when judging a company.