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A company's financial statements - balance sheet, income statement and cash
flow statement - are a key source of data for analyzing the investment value of
its stock. Stock investors, both the do-it-yourselfers and those who follow the
guidance of an investment professional, don't need to be analytical experts to
perform financial statement analysis. Today, there are numerous sources of
independent stock research, online and in print, which can do the "number
crunching" for you. However, if you're going to become a serious stock
investor, a basic understanding of the fundamentals of financial statement
usage is a must. In this article, we help you to become more familiar with the
overall structure of the balance sheet.
The Structure of a Balance Sheet
A company's balance sheet is comprised of assets, liabilities and equity.
Assets represent things of value that a company owns and has in its possession
or something that will be received and can be measured objectively. Liabilities
are what a company owes to others - creditors, suppliers, tax authorities,
employees etc. They are obligations that must be paid under certain conditions
and time frames. A company's equity represents retained earnings and funds
contributed by its shareholders, who accept the uncertainty that comes with
ownership risk in exchange for what they hope will be a good return on their
investment.
The relationship of these items is expressed in the fundamental balance sheet
equation:
Assets = Liabilities + Equity
The meaning of this equation is important. Generally sales growth, whether
rapid or slow, dictates a larger asset base - higher levels of inventory,
receivables and fixed assets (plant, property and equipment). As a company's
assets grow, its liabilities and/or equity also tends to grow in order for its
financial position to stay in balance.
How assets are supported, or financed, by a corresponding growth in payables,
debt liabilities and equity reveals a lot about a company's financial health.
For now, suffice it to say that depending on a company's line of business and
industry characteristics, possessing a reasonable mix of liabilities and equity
is a sign of a financially healthy company. While it may be an overly
simplistic view of the fundamental accounting equation, investors should view a
much bigger equity value compared to liabilities as a measure of positive
investment quality, because possessing high levels of debt can increase the
likelihood that a business will face financial troubles.
Balance Sheet Formats
Standard accounting conventions present the balance sheet in one of two
formats: the account form (horizontal presentation) and the report form
(vertical presentation). Most companies favor the vertical report form, which
doesn't conform to the typical explanation in investment literature of the
balance sheet as having "two sides" that balance out. (For more information on
how to decipher balance sheets, see Reading The Balance Sheet.)
Whether the format is up-down or side-by-side, all balance sheets conform to a
presentation that positions the various account entries into five sections:
Assets = Liabilities + Equity
Current assets (short-term): items that are convertible into cash within one
year
Non-current assets (long-term): items of a more permanent nature
As total assets these =
Current liabilities (short-term): obligations due within one year
Non-current liabilities (long-term): obligations due beyond one year
These total liabilities +
Shareholders' equity (permanent): shareholders' investment and retained
earnings
Account Presentation
In the asset sections mentioned above, the accounts are listed in the
descending order of their liquidity (how quickly and easily they can be
converted to cash). Similarly, liabilities are listed in the order of their
priority for payment. In financial reporting, the terms current and non-current
are synonymous with the terms short-term and long-term, respectively, and are
used interchangeably. (For related reading, see The Working Capital Position.)
It should not be surprising that the diversity of activities included among
publicly-traded companies is reflected in balance sheet account presentations.
The balance sheets of utilities, banks, insurance companies, brokerage and
investment banking firms and other specialized businesses are significantly
different in account presentation from those generally discussed in investment
literature. In these instances, the investor will have to make allowances and/
or defer to the experts.
Lastly, there is little standardization of account nomenclature. For example,
even the balance sheet has such alternative names as a "statement of financial
position" and "statement of condition". Balance sheet accounts suffer from this
same phenomenon. Fortunately, investors have easy access to extensive
dictionaries of financial terminology to clarify an unfamiliar account entry.
(To search a financial term, see our dictionary.)
The Importance of Dates
A balance sheet represents a company's financial position for one day at its
fiscal year end, for example, the last day of its accounting period, which can
differ from our more familiar calendar year. Companies typically select an
ending period that corresponds to a time when their business activities have
reached the lowest point in their annual cycle, which is referred to as their
natural business year.
In contrast, the income and cash flow statements reflect a company's operations
for its whole fiscal year - 365 days. Given this difference in "time", when
using data from the balance sheet (akin to a photographic snapshot) and the
income/cash flow statements (akin to a movie) it is more accurate, and is the
practice of analysts, to use an average number for the balance sheet amount.
This practice is referred to as "averaging", and involves taking the year-end
(2004 and 2005) figures - let's say for total assets - and adding them
together, and dividing the total by two. This exercise gives us a rough but
useful approximation of a balance sheet amount for the whole year 2005, which
is what the income statement number, let's say net income, represents. In our
example, the number for total assets at year-end 2005 would overstate the
amount and distort the return on assets ratio (net income/total assets).
Since a company's financial statements are the basis of analyzing the
investment value of a stock, this discussion we have completed should provide
investors with the "big picture" for developing an understanding of balance
sheet basics.
To learn more about financial statements, read What You Need To Know About
Financial Statements, Understanding The Income Statement and The Essentials Of
Cash Flow.
by Richard Loth
Richard Loth has more than three decades of international experience in banking
(Citibank, Industrial National Bank, and Bank of Montreal), corporate financial
consulting, and non-profit development assistance programs. During the past 12
years, he has been a registered investment adviser and a published author of
books and publications on investing. Currently, he devotes his professional
activities to educational endeavors, writing and lecturing, aimed at helping
individual investors improve their investing know-how (see http://
www.lothinvest.com )