Interpretation of Financial Statements: Balance Sheet

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Chapter 22 — Interpretation of Financial Statements: Balance Sheet
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Interpretation of Financial Statements: Balance Sheet

The quantitative factors are the numbers you use to measure business performance. While qualitative factors allow you to look forward and evaluate the company’s potential forward progress, quantitative factors give you a historical perspective. They are the numbers you use to gauge how successful the company has been in the past.

 

It is useful to have numbers as a starting point, but every financial report will say that past performance is not a predictor of future performance. It also is important to keep in mind that a company can be a good investment even if it does not meet every standard for financial strength and profitability. A company that appears financially strong can also be a poor investment if it does not have a strong competitive position, or if the price is too high. A comprehensive company analysis requires a balance of both types of evaluation.

 

Interpretation of Financial Statements

 

At this point, you should already know what type of information each financial statement contains. The purpose of this section is to explain how to use these statements to evaluate a company’s financial health and future growth potential. The ratios that come from financial statements are better evaluation tools, but financial statements should not be overlooked.

 

When evaluating financial statements, it is important to consider the accounting rules that the company is using. For example, some accounting rules allow companies to count their profits before ever making any actual sales. Having that type of insight will help you make a better prediction about the company’s future.

 

It is also important to keep in mind that some financial statements are simply unreliable. If a statement says “unaudited,” that means that the numbers have not been double-checked. This is common for the 4th quarter reports, but you should be concerned if you see too many unaudited financial statements.

 

An even more unreliable type of financial statement is the “pro forma” type. If you see a pro forma statement, you should ignore it completely. It is a way of reporting the company’s finances that ignores everything important about the business’ operations. Pro forma is often described as “what we wish would have happened.” It often has no connection to reality.

 

When you look at the legitimate financial statements, there are still some important pieces of information that can be buried inside footnotes or hidden near the end of the report. To make sure that you don’t overlook key information, skilled investors recommend that you read financial statements from the bottom up, and always read every footnote. If the information in the footnotes doesn’t make any sense, you should probably pass, because that is usually a sign that the management is trying to hide something.

 

Balance Sheet

 

The balance sheet is the financial statement that you will use to determine the company’s financial health. In general, a “strong” balance sheet, is one that has low levels of debt and high levels of current (liquid) assets. But this does not tell the whole story, because the accepted numbers depend on the size of the company and the industry that it operates.

 

In general, the overall numbers that you find on the balance sheet are not as important as the flexibility they represent. For example, current assets can be used quickly, and long-term liabilities give the company a long time to repay debt. Both items give the company a better chance for survival in the short term.

 

The best way to evaluate a balance sheet is to take several balance sheets over a period of time and track the company’s changes. When you use this method, you can see if the company is becoming stronger or weaker over time.

 

i. Assets

 

The amount of assets that a company has is one crude way to measure its size, but size is always relative to the industry. For example, the average bank, railroad, utility, or manufacturing firm will all have a higher level of assets than the average retailer. If you use assets as a measurement to compare different companies, make sure that those companies are in the same industry.

 

a. Current Assets

 

When reviewing current assets, it is important to examine the composition of those assets. For example, cash is always worth its listed value, but the real value of inventory is always slowly declining until it is sold, and is not always guaranteed. Similarly, the value of accounts receivable is not always guaranteed.

 

In general, the more cash a company holds, the healthier its financial position will be. A large build-up of cash can be created from either borrowing money or from business performance, so it doesn’t always give a complete picture. However, a large build-up of inventory or accounts receivable may indicate problems with generating sales or collecting on those sales.

 

It is important to pay attention to how these assets are being used to generate profits and also how they balance out against liabilities. It is also important to make sure that you have checked the footnotes for receivables that may not be included in the actual balance sheet.

 

b. Non-Current Assets

 

The non-current assets are split into tangible assets and intangible assets. To properly evaluate a company, you should look at both. In general, firms that require lots of physical machinery, such as manufacturers and utilities, will have higher levels of tangible assets. Service-oriented firms and firms with low levels of physical assets, such as software firms, will have higher levels of intangible assets. Both types of non-current assets can be easily overstated.

 

Tangible assets are never worth their stated value, but this is not a major issue unless the company is facing bankruptcy. At best, you can assume that the numbers for items such as equipment will represent future costs.

 

Intangible assets are extremely fuzzy. Some, such as patents, can have relatively reliable numbers. But others can have a very wide range of possible values. When you review the value of intangible assets, it is helpful to pay attention to the assumptions the company uses to determine their value because sometimes these assumptions are too optimistic. The real value of intangible assets comes from the earnings that you can expect them to produce in the future.

 

ii. Liabilities

 

 

The amount and type of liabilities that a company carries depend on its industry. For example, financial firms typically have very high levels of both short-term and long-term liabilities, and technology companies often have little or no long-term debt. Retailers usually have high amounts of short-term liabilities.

 

a. Current Liabilities (Short-Term)

 

The amount of debt taken during the course of normal business (current liabilities) is not a concern by itself. What matters for the short term is the company’s ability to pay off those short-term debts. To evaluate current liabilities properly, you should compare them to current assets. If the current assets are enough to cover current liabilities, then the firm is unlikely to see any short-term financial trouble.

 

To get a concrete number on the company’s short-term financial health, subtract current liabilities from current assets. What you find is the company’s working capital.

 

 

Current Assets – Current Liabilities = Working Capital

 

Working capital represents the company’s ability to do business without having to borrow extra money or become constrained by financial emergencies. Low amounts of working capital can result in business shutdowns or lower future credit ratings.

 

The amount of working capital depends on the type of business. Industries that require lots of machinery and have long manufacturing times, such as the automobile industry, will need a high level of working capital. Industries where sales occur more quickly, such as retail, don’t need as much working capital. You will want to compare the company’s use of its working capital to its competitors and to the amount of long-term debt that it carries. In general, more working capital is better.

 

b. Non-Current Liabilities (Long-Term)

 

Just like short-term liabilities, long-term liabilities are not good or bad by themselves. A proper evaluation requires you to look at the number of liabilities and the type of liabilities, and compare them to assets.

 

A high level of debt can be bad in any of the following situations: when the company pays high-interest rates (meaning it has a low credit rating), when the debts are “off balance sheet” (meaning you must read the footnotes to find them), or when there is not enough assets or earnings power to cover liabilities. Financial firms and utilities usually have higher levels of long-term debt.

 

Since debt also provides leverage, a low level of debt can sometimes be bad. If the company is capable of borrowing money very cheaply (at low-interest rates), it might take on debt that the management knows it can easily repay.

 

In general, most healthy companies will be paying off their long-term liabilities without adding more long-term debt. If you are seeing a decline in non-current liabilities, it is usually a good sign.

 

iii. Equity

 

Not all equity is the same. Some equity comes from people investing in the business (Paid-In Capital), and some equity comes from the earnings of the business (Retained Earnings).

 

There is one case where the distinction is important. If Paid-In Capital is a large portion of the total equity, then you may want to review why the company has a small amount of retained earnings. Younger companies and smaller companies will usually have more Paid-In Capital than older, larger companies.

 

Tracking the amount of retained earnings over time can help you get a feel for how well the company is performing and what it is doing with its money. If retained earnings are not growing, this is not always bad. It can be caused by the company either not performing well or paying out most of its profits through dividends. You will want to check the income statement to get more information about the nature of the retained earnings.

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