Fundamental analysts, when valuing a company or considering an investment opportunity, normally start by examining the balance sheet. This is because the balance sheet is a snapshot of a company's assets and liabilities at a single point in time, not spread over the course of a year such as with the income statement.
The balance sheet contains a lot of important information, some of which are more important to focus on to get a general understanding of the solvency and business dealings of a company.
Key Takeaways
- A company's balance sheet is a snapshot of assets and liabilities at a single point in time.
- Fundamental analysts focus on the balance sheet when considering an investment opportunity or evaluating a company.
- The primary reasons balance sheets are important to analyze are for mergers, asset liquidations, a potential investment in the company, or whether a company is stable enough to expand or pay down debt.
- Many experts believe that the most important areas on a balance sheet are cash, accounts receivable, short-term investments, property, plant, equipment, and other major liabilities.
Why Balance Sheets Are Important to Analysis
They say that "the numbers don't lie," and that is true more for financial analysis than anything else. Balance sheets are important for many reasons, but the most common ones are: when a merger is being considered, when a company needs to consider asset liquidation to prop up debt, when an investor is considering a position in a company, and when a company looks inward to determine if they are in a stable enough financial situation to expand or begin paying back debts.
Many experts consider the top line, or cash, the most important item on a company's balance sheet. Other critical items include accounts receivable, short-term investments, property, plant, and equipment, and major liability items. The big three categories on any balance sheet are assets, liabilities, and equity.
Important Assets
All assets should be divided into current and noncurrent assets. An asset is considered current if it can reasonably be converted into cash within one year. Cash, inventories, and net receivables are all important current assets because they offer flexibility and solvency.
Cash is the headliner. Companies that generate a lot of cash are often doing a good job satisfying customers and getting paid. While too much cash can be worrisome, too little can raise a lot of red flags. However, some companies require little to no cash to operate, choosing instead to invest that cash back into the business to enhance their future profit potential.
Important Liabilities
Like assets, liabilities are either current or noncurrent. Current liabilities are obligations due within a year. Fundamental investors look for companies with fewer liabilities than assets, particularly when compared against cash flow. Companies that owe more money than they bring in are usually in trouble.
Items on the balance sheet are used to calculate important financial ratios, such as the quick ratio, the working capital ratio, and the debt-to-equity ratio.
Common liabilities include accounts payable, deferred income, long-term debt, and customer deposits if the business is large enough. Although assets are usually tangible and immediate, liabilities are usually considered equally as important, as debts and other types of liabilities must be settled before booking a profit.
Important Equity
Equity is equal to assets minus liabilities, and it represents how much the company's shareholders actually have a claim to. Investors should pay particular attention to retained earnings and paid-in capital under the equity section.
Paid-in capital represents the initial investment amount paid by shareholders for their ownership interest. Compare this to additional paid-in capital to show the equity premium investors paid above par value. Equity considerations, for these reasons, are among the top concerns when institutional investors and private funding groups consider a business purchase or merger.
Retained earnings show the amount of profit the firm reinvested or used to pay down debt, rather than distributed to shareholders as dividends.
The Bottom Line
A company's balance sheet provides a tremendous amount of insight into its solvency and business dealings. A balance sheet consists of three primary sections: assets, liabilities, and equity. There are several useful metrics or calculations that can help you demystify the information it contains.
Depending on what an analyst or investor is trying to glean, different parts of a balance sheet will provide a different insight. That being said, some of the most important areas to pay attention to are cash, accounts receivables, marketable securities, and short-term and long-term debt obligations.
