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If your learning to invest in businesses then you need to be able to understand the fundamentals of those companies. One of the fundamental pieces of a business is the balance sheet.

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In today’s post I will be discussing what a balance sheet is, how it works and why it is important for investors to know about them.

What Is a Balance Sheet?

A balance sheet is a financial accounting document that lists all of an organization’s assets and liabilities. It’s used to determine whether the organization is solvent — that is, able to pay off its debts.

The balance sheet includes three sections: assets, liabilities, and equity. Assets represent the value of something an organization owns; liabilities show how much money it owes; and equity represents the difference between the total amount of debt and the total amount of assets.

You can imagine the reason a balance sheet is named as it is due to the sheet representing the balance between the companies assets and liabilities. This can help give some indication of a companies current strengths and risks.

How Does a Balance Sheet Work?

Assets are things you own. They might be cash, property, equipment, inventory, intellectual property, patents, trademarks, etc. For a business these assets are similar in nature. A companies properties, equipment, investments etc. are all part of the business’ assets.

Liabilities are what you owe. These could be bills coming due, loans you took out, taxes you still owe, etc. Similarly for a business, the liabilities may be stuff such as debt that the company has.

Shareholders equity is the difference between assets and liabilities. This is essentially the net worth of the company (not to be confused with the market capitalization). The shareholders equity is calculated by subtracting the total liabilities from the total assets.

Short-Term Assets

Current assets include items such as cash, inventory, accounts receivable, prepaid expenses, and marketable securities. Short-term assets are those that can turn into cash within one year. They are used to pay bills and fund operations.

Cash is an important component of current assets because it allows you to use money today to buy things that you need tomorrow. For example, if you sell products and make $100, you can put the money in the bank and earn interest. You could spend the money on something else, like buying a car. Or you could save the money for a rainy day.

Accounts receivable represent short-term debt owed to the firm by customers. If a customer buys a product, he pays for it with a check or credit card. When the bill arrives, the company sends him an invoice. He pays the amount due with his next payment. This type of transaction creates accounts receivable.

Prepaid expenses are amounts that businesses set aside to cover future costs. For example, if a business plans to hire employees in the fall, it might prepay payroll taxes now rather than wait until the end of the year. Prepaid expenses help companies avoid unexpected tax payments.

Marketable securities are investments that generate income over time. Companies often invest in bonds, stocks, and mutual funds. These types of investments usually provide regular dividends or capital gains.

Long-Term Assets

Goodwill is an intangible asset, meaning it cannot be sold like other assets. This makes goodwill very different from tangible assets such as buildings, vehicles, land, and machinery. Intangible assets are difficult to value because there is no way to physically measure how much good will you have earned over time. For example, if you sell a building today, you know exactly what you paid for it and what you received in return. But if you sell goodwill, you don’t know how much money you’ve lost or gained over time.

Intangibles are often used to describe the “good will” associated with a business. In fact, many companies use the term “intangible assets” interchangeably with goodwill. However, goodwill is just one type of intangible asset. Other types include customer relationships, employee training programs, patents, trademarks, copyrights, and licenses.

The difference between long-term assets and short-term assets is important to understand when valuing businesses. Short-term assets are those that can be converted quickly into cash. Examples include inventory, accounts receivable, and current assets. Long-term assets are those whose values won’t change for several years. They’re usually considered part of a firm’s fixed assets, including buildings, furniture, fixtures, and equipment. Some examples of long-term assets include land, leasehold improvements, and intangibles.

Short-Term Liabilities

Current liabilities include short term debts such as accounts payable (AP). A current liability represents money owed now, while a current asset represents money owned now. For example, you might owe $1,500 for rent next month. You could pay off the rent bill by writing a check today for $1,500. This payment would reduce your cash balance and increase your accounts payable account. Your landlord would record this transaction as a reduction of his/her accounts payable.

Longerterm debt is included under longer-term liabilities. Longer-term assets represent money that must be paid out over several months or even years. These types of assets include investments, real estate, and equipment. An investment in stock shares, for instance, is considered a longer-term asset because it takes some time to sell the stocks and receive the profits.

A loan is a type of financial instrument used to raise capital. When you borrow money, you agree to repay the lender plus interest. If you don’t make payments on time, your creditor can take legal action against you. Loans come in many forms including personal loans, mortgages, car loans, student loans, and credit card balances.

Long-Term Liabilities

Current liabilities are what a company owes within one year. They include short-term debts such as accounts payable and long-term debts such as bank loans. Short-term debts must be paid off within one year. Long-term debts are those that don’t need to be repaid until much later. Companies use current liabilities to calculate how well they’re doing financially. A company with high current liabilities might be struggling because it doesn’t have enough money coming in to cover expenses.

Shareholders’ Equity

The total value of a company is determined by multiplying shareholders’ equity by the number of shares outstanding. This gives you the total amount of money investors put into the company. If there are 2 million shares outstanding, and $1 billion worth of shareholders’ equity, the market capitalization is $2 billion.

Net Income

A company’s net income is the difference between revenue and costs. Revenue is how much money a company makes selling products or providing services. Costs include things like salaries, rent, utilities, advertising, etc. A company’s net income tells us whether it’s making money or losing money.

Retained Earnings

Retained earnings is simply profits left over after paying off debt. When a company pays down debt, it reduces retained earnings. Debt includes loans, bonds, and mortgages.

What Can You Tell From Looking at a Company’s Balance Sheet?

A balance sheet provides information about a company’s financial health. It includes key metrics such as total assets, current liabilities, long term debts, short term debts, and equity. These numbers tell you how much money a company has, what it owes, how much it’s worth, and whether it has enough cash to pay off its creditors.

The most important ratio is the debt/equity ratio. This tells us if a company is highly leveraged. If a company has high leverage, it borrows money to fund its operations. In turn, this increases the risk of bankruptcy. Companies that are heavily indebted tend to have lower growth rates and greater volatility.

Another important metric is return on equity. Return on equity measures how well a company uses its resources to generate profits. It is calculated by dividing net income by shareholders’ equity. For example, if a company earns $1 million in profit while having $50 million in shareholders’ equity, its ROE is 20%.

Return on investment (ROI), another important metric, compares the amount of revenue generated over the life of an asset to the cost of acquiring and operating the asset. For example, if you spend $10,000 to acquire a car and sell it for $20,000, your ROI is 50%.

Finally, we look at the book value per share. Book value represents the market value of a company’s shares, adjusted for its retained earnings. Retained earnings are the difference between a company’s annual revenues and expenses.

Summary

Balance sheets provide useful information about a company’s finances. The most important ratios are the debt/equity and return on equity ratios. These two metrics can help you determine if a company is highly levered.

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