What is a business worth? To get the answer, you’ll have to look at his track record. A balance sheet is a statement showing the financial position of an entity by reporting assets, liabilities and equity as of a specific date (usually the end of an accounting period). It shows what a company owns and owes, as well as shareholder ownership.
A balance sheet is one of the key financial statements that every public company must publish on a regular basis. It’s something every investor should know and understand, as it provides important context for a company’s financial health and value. Here’s everything you need to know about a balance sheet.
What is recorded on a balance sheet?
Public enterprise balance sheets have three final sections: assets, liabilities and equity. “Balance” comes from examining what is owned versus what is owed:
Assets = Liabilities + Equity
- Assets are what the business owns and include both fixed and fixed assets.
- Passives are the company’s debts, including borrowings.
- Equity represents the amount of equity offered by shareholders.
Within each of these sections is a more complete breakdown that takes into account the sum total of each column of the balance sheet. For example, under assets you will find cash and cash equivalents, accounts receivable, inventory, fixed assets, intangible assets and more. Similarly, under liabilities, you can find loans, accounts payable, deferred tax liabilities and more. Finally, the equity section would include line items for reinvested earnings and common stock.
The reviews require a well-organized attribution to ensure that readers can identify the main contributors to each section. Specific headings for each type of asset, liability and equity bring clarity to the report as a whole.
How it works?
The balance sheet tells the story of how a business operates: it acquires assets by borrowing money or issuing stock. While a company’s balance sheet is much more nuanced, the core business remains the same.
The balance sheet must live up to its name by remaining in balance. To do this, companies rely on double-entry accounting practices. Each balance sheet entry requires a netting entry elsewhere. Here are some examples :
- When a business obtains a loan, the liabilities and cash flow increase by the amount of the loan.
- As the business repays this loan, it similarly reduces cash assets and cash liabilities.
- The business buys a machine, which reduces cash but adds new capital.
- The company issues stock, which increases equity and liquidity in tandem.
As long as the balance sheet remains balanced, the company’s financial situation makes sense. An overweight balance sheet either side indicates an accounting issue that requires an audit to address. The balance sheet must live up to its nickname.
What is this for?
Balance sheets are an excellent window into the overall financial health of a business. Executives and investors can see, at a glance, what the company owns and owes, along with a generalized breakdown of those numbers. Ultimately, the balance sheet shows the net worth of a business.
A balance sheet can also indicate a company’s short-term financial capabilities. For example, does he have enough cash to pay his future debts? Is it paying an appropriate dividend based on the balance sheet or is it in jeopardy? What is the company’s debt ratio? These questions all provide context for investors when evaluating the prospects of investing in a company.
What can’t a balance sheet tell you?
Although balance sheets provide an excellent overview of a company’s financial health, they are not indicative of trends. There is no cash flow outlook, for example. An otherwise healthy balance sheet could mask the fact that the business has erratic cash flow and issues managing accounts receivable and accounts payable.
Balance sheets are also relatively easy to manipulate thanks to creative (but legal) accounting practices. For example, some companies will write down inventory to improve their balance sheet without actually posting better sales numbers.
The balance sheet is best reviewed in tandem with the income and cash flow statements. These other financial reports provide important context for the assets, liabilities and equity recorded on the balance sheet.
Where to find a company’s balance sheet
The Securities and Exchange Commission (SEC) requires public companies to regularly file balance sheets. Investors can find this information in the company’s 10-K and 10-Q documents. These filings will also include other financial documents, such as tax returns.
The use of information from a company’s 10-K or 10-Q balance sheet comes with an assurance of financial accuracy. A third-party external auditor verifies their accuracy and veracity. This means you can expect GAAP compliance and independently certified financial data. Investors can usually take these numbers at face value, pending an unqualified (or qualified) audit opinion.
Familiarize yourself with the balance sheet
Balance sheets are one of the fundamental financial reports that every investor should be familiar with. Fortunately, they are easy to read and understand with a little practice. And what’s more, you can use these reports to determine if the company is a good investment for you. For more stock advice, sign up for Trade of the day e-letter below. This daily newsletter provides stock tips, trends and picks from Wall Street experts with decades of experience.
Being comfortable with a balance sheet means being able to draw conclusions about a company’s financial health and its prospects for future wealth. This, in turn, helps investors identify investment opportunities and avoid pitfalls. Check a company’s balance sheet as often as it publishes one to identify changes that show positive trends in net worth or negative trends in debt and equity.