Part 1: Analyzing Financial Statements - Balance Sheet
A short overview of the three main financial statements for beginner knowledge.
This is a three-part series where I will go over each of the three main financial statements at a high-level. For those investing in individual stocks, you should be knowledgeable in all of these statements to understand the financial health and performance of a company.
The Balance Sheet
Also known as the statement of financial position, the balance sheet is exactly that. It illustrates a company’s financial position at a specific point in time. The three sections within the balance sheet are as follows: Assets, Liabilities, and Equity. And the uniqueness of this statement is in its name - balance. Yes, put your mathematics cap on because it follows a simple yet powerful equation:
Assets = Liabilities + Equity
Let’s break down each section to understand why this matters and how investors can analyze it effectively.
Note: All the financial excerpts are of Apple’s ($AAPL) 2023 earnings report. Keep in mind that not all statements have the same sub-categories under these three sections.
Assets: What a Company Owns
Asset: A resource controlled by an organization as a result of past events and from which future economic benefits are expected to flow to an organization.
These can range from many things, such as cash, receivables, inventories, tangible and intangible assets, etc.
You will notice that this section is split into two: current and non-current assets. They can also be noted as ‘short-term’ and ‘long-term’ assets (less than a year versus more than a year, respectively). Moreover, they are organized by liquidity. Those items that can be converted to cash more quickly will appear first.
Current assets: These include cash, receivables, and inventories—items that can be converted into cash within a year.
Non-current assets: Also known as long-term assets, these include property, equipment, and intangible assets like patents.
I will touch on some of the main sub-components:
Cash and/or cash equivalents - The preference is for a company to have a strong cash position in order to meet its short-term obligations. At the same time, you don’t want a pile of cash to just be idling for a long period of time. You would want it to be used to create greater shareholder value, either through investments, buybacks, debt reduction, etc.
Receivables - the money that is owed by customers/clients. Collectability may become an issue if the receivable remains for a long period of time.
Inventories - This may not matter for some companies, but for those in the retail, materials, consumer staples/discretionary industries, these are important. Holding inventories may enable an organization to meet demand; however, too much of it may put it at risk to obsolescence and expiration. Too little of it may subside revenues and hurt growth prospects. There needs to be a good balance.
Tangible Capital Assets - otherwise known as Property, Plant, and Equipment, this is useful for capital intensive industries. These lead to higher capital costs, high levels of depreciation or amortization, and likely greater levels of debt.
Liabilities: What a Company Owes
Liability. A present obligation of an organization arising from past events, the settlement of which is expected to result in an outflow from an organization of resources embodying economic benefits.
These can range from many things, such as payables, deferred revenue, debt, lease liabilities, etc.
You will notice a similar presentation to that of the assets section: current and non-current liabilities. They can also be noted as ‘short-term’ and ‘long-term’ liabilities as well (less than a year versus more than a year, respectively). Moreover, they tend to be listed in order of conversion. Those items that can be settled by cash more quickly will appear first.
Current liabilities: Short-term debts and obligations due within a year, such as payables and deferred revenue.
Non-current liabilities: Long-term debts and financial commitments extending beyond a year.
I will touch on some of the main sub-components:
Payables - The money that is owed to suppliers/clients. Any outstanding payables remaining unpaid over a long period of time can indicate a cash crunch. In other words, a liquidity issue.
Deferred Revenue - These tend to represent advance payments that an organization receives for products/services that are to still be delivered/performed in the future. As per accounting rules, it cannot be recognized as revenue just yet until that obligation is met. It technically is a ‘good’ liability.
Debt - The most important of them all. What type of borrowings does the organization hold? How much? What is the percentage between fixed-rate and variable-rate debt? A story can be told just from this. Leverage can certainly expand an organization’s growth opportunities. However, this doesn’t come without risk. High levels of debt are more of a concern during economic downturns and changes to market factors such as interest rates.
Equity: The Shareholder’s Stake
Equity. The residual interest in the assets of an organization after deducting all its liabilities.
It reflects a company's financial strength and how much value shareholders own. The two primary components include:
Shareholder Capital – Also referred to as common stock, this represents funds and/or capital contributed by investors.
Retained Earnings – Often, it is the accumulated profits that the company has earned over time that are not distributed as dividends. This can also be negative if accumulated deficits are consistent.
It is important to point out that some companies that present negative equity positions may be a result of an item called treasury stock, rather than cumulative deficits. When a company buys back its own shares from the market, those shares become treasury stock.
If the buyback price significantly exceeds the original issuance price, it can lead to negative equity. This is subtracted from total equity because it represents shares the company no longer considers outstanding. Think of companies like Home Depot (HD - extract above) and McDonald’s (MCD). Therefore, a negative equity balance is not always a bad sign - it may simply reflect aggressive share buybacks.
Final Thoughts
The balance sheet is a fundamental tool for assessing financial stability. Investors should examine each component carefully to determine a company’s ability to meet obligations, grow its assets, and generate shareholder value.
Stay tuned for Part 2: The Income Statement, where we explore how businesses measure profitability over time! Please give a like and subscribe to be first in line to receive all of DiviStock Chronicles’ posts as soon as they are published. Thank you!
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