The following is a helpful article on understanding balance sheet basics for FINRA Broker exams, including the Series 7 Exam.
A company's balance sheet is a record of its assets and liabilities. Basically, if we look at how much the assets are worth and deduct the total value of the liabilities, we will arrive at the net worth of the company. Net worth or the book value of the company is also known as shareholders' equity.
Under assets, first, we see Current Assets. Current Assets are cash and other assets which can be converted into cash within a very short time. Usually, they are listed in the balance sheet in order of liquidity with cash being the first item as it is the most liquid. Secondly, we have Non-current Assets. These are assets which cannot be converted into cash within a very short time.
One thing that value investors look out for is how much cash and cash equivalents a company has. Having a lot of cash is usually a sign of strength. The company will have the ability to seize business opportunities and will be able to go over rough patches in the business cycle relatively intact.
Next on the list is inventory or the goods which are in the company's warehouse which it sells to customers. In business, we say that we cannot do business with an empty wagon. Our wagon has to be stocked and that's our inventory. However, we do not want our wagon to be overstocked as well. Goods also run the risk of becoming obsolete in many cases.
Accounts Receivables is next. When the company sells goods to its customers, very often, the customers are given credit terms. In businesses which have a strong retail bias, this might be a very small amount if it exists at all since they collect cash for all their sales. We want to keep an eye on this because if most of a company's Current Assets are in Accounts Receivables, we have to question the financial health of its customers and how long does it usually take before payments are made.
Prepaid Expenses or payment in advance is next. I like this because it shows that customers are willing to pay in advance before they receive the goods. It shows that the company's products are in demand and, probably, cannot be replicated or very difficult to replicate by its competitors. The company has a competitive advantage.
Next, we move on to Non-current Assets. Companies might own properties, vehicles and production equipment. Vehicles and production equipment will depreciate in time and the value we see in this line is the total value at the time the balance sheet was prepared minus depreciation.
Then, we have goodwill. This is something which has been discussed in the case of Healthway Medical. This number appears when a company buys over another company at a price above the latter's book value. The value above the book value ends up as goodwill in the former's balance sheet.
This is followed by other intangible assets which cover copyrights, patents, trademarks and so on. Only intangible assets bought from another company can be reflected in a company's balance sheet.
Both goodwill and other intangible assets must be amortized over time if they have a finite life. If they are not depreciating in value over time, then, they need not be amortized.
Long Term Investments are next. This shows any investments a company might have made which have durations of longer than a year. We will have to dwell on this a bit more to see what kind of investments have been made here as and when it occurs. It will differ from case to case but generally, we want to see that these are investments which generate higher returns for the company.
An important ratio we use in fundamental analysis is Return on Assets (ROA). This is a measure of the level of efficiency in which a company utilises its total assets. If we take net earnings and divide this by total assets, we get a figure in percentage terms. The higher the better.
We move on to Liabilities and just like Assets, there are Current and Non-current forms. First off under Current Liabilities, we have Accounts Payable which is money owed to suppliers for goods and services provided.
Then, we have Short Term Debt or Debt which is due. If a company has a lot of Short Term Debt, this could be dangerous in times when credit is suddenly difficult to come by.
To calculate the financial health of a company, analysts employ the Current Ratio which divides the total Current Assets by the total Current Liabilities. So, you can imagine that if you have more of the former and less of the latter, it's a good thing. A more stringent ratio is the Quick Ratio and it measures a company's ability to meet its short term obligations using its Current Assets minus Inventory. Any ratio value of more than 1 is good.
Under Non-current Liabilities, we have Long Term Debts and so on. I guess the important thing to say here is that very strong and long established companies which generate healthy cash flow usually have very little debt.
I think it is common sense that we want to see as little debt as possible in a company's balance sheet but debt is sometimes a necessary evil. So, we have to evaluate debt on a case by case basis.
I hope this quick introduction to what is a Balance Sheet and how to use certain ratios to determine the health of a company is useful.
I'm just another person trying for a secure financial future in an uncertain world. Creating a stream of reliable passive income is a primary objective for me.
By Alvin Koh
http://singaporeanstocksinvestor.blogspot.com/
http://singaporeanstocksinvestor.blogspot.com/2010/02/fundamental-analysis-balance-sheet.html
