“Never invest in a company without understanding its finances. The biggest losses in stocks come from companies with poor balance sheets.”
The ability to read a company’s financials, such as the income statement, balance sheets, and cash flow statement, is a key source of data for investors, both do-it-yourselfers or institutional investors.
As an investor, you don’t need to be an expert at deciphering financial statements and modeling, but at least being fluent in the language of accounting will go a long way toward your success as an investor.
In our continuing series on understanding accounting and financial statements, we are going to unlock the secrets within the balance sheets.
The next focus is on the balance sheet and the components of the balance sheet. Every company, as a public entity, has to file a balance sheet, and the structure of the balance sheet helps inform investors about the financial strength of any company.
Aside from financials such as banks and insurance companies, reading the balance sheet from companies is fairly straightforward.
With the recent Covid-19 crisis, the analysis of the balance sheet has returned to prominence as investors study the liquidity of businesses. Companies such as Visa, Google, Apple don’t have to worry much about liquidity in today’s world, but many others such as those businesses in the retail world, for example, are under siege from the switch from physical stores to online purchasing. And that siege has only been accelerated with the stay-at-home orders.
Analysis of the balance can uncover clues to the liquidity of a company and its ability to survive challenges such as businesses face today.
In today’s post, we will learn:
- Breaking Down the Balance Sheet Structure
- Asset Side of the Equation
- Liability Side of the Equation
- Equity Side of the Equation
Ok, let’s dive in and uncover more about the balance sheet structure.
Breaking Down the Balance Sheet Structure
The balance sheet is one of the big three financial statements that all public companies are required to file. The others being the income statement and statements of cash flows.
The objective of the balance sheet (or statement of financial position, as it is often called) is to provide, at a specific point in time, any information concerning the assets owned by a company, as well as the equity interests.
Assets represent items of value that the company owns and has in its possession. Or others that will be received and can be measured objectively.
Liabilities are what companies owe creditors, such as employees, suppliers, tax authorities, and creditors. The liabilities are obligations that have schedules, conditions, and time frames that govern when, how much, and how often those liabilities are paid back.
Equity or shareholders’ equity consist of retained earnings and monies contributed by shareholders in exchange for ownership.
The balance sheet can best be expressed as a formula. The formula is:
Assets = Liabilities + Equity
The formula is important and can be thought of in this way. As sales grow, the asset base will grow as well. All of which dictates higher levels of inventories, receivables, and fixed assets, like plant, property, and equipment. As the companies assets grow, the liabilities and equity grow in lockstep as the financial positions have to stay in balance concerning the equation.
How the assets are supported, either by financing, by the corresponding growth in payables, debt, and equity, tells us a lot about the company’s financial health.
When considering the financial health of any company, we must consider that having a reasonable mix of liabilities and equity that supports the assets is a sign of a company that is financially healthy.
A simple view of this equation is having assets equal to a smaller portion of liabilities that support those assets while having a larger portion of equity than liabilities that support those assets. Keeping in mind that equity creating revenues is cheaper than debt creating revenues.
The reason we want to consider that equation is debt financing at higher levels lends more risk to your investment, as a company that struggles the possibility of defaulting on that debt rises and the risk of bankruptcy also increases.
The balance sheet is a snapshot in time of the financial condition of any public company. Every quarterly or annual report will contain a balance sheet, and we need to think of those results as frozen in time and to depend on the day.
Standard accounting practices allow for presenting the balance sheet in two formats.
- Horizontal presentation
- Vertical presentation
Most companies use the vertical presentation; in fact, I have never seen the horizontal presentation in a public company. The vertical presentation doesn’t allow for the “balancing” of the sheet as you don’t see the two sides balancing out like you would in accounting class.
Regardless of whether it is horizontal or vertical presentation, all balance sheets conform to the presentation that presents the positions of account entries into five sections:
- Current assets
- Non-current assets
- Current liabilities
- Non-current liabilities
- Shareholders’ equity
Such that Assets equals:
- Current Assets
- Non-current assets
Liabilities: current liabilities + non-current liabilities + shareholders’ equity
More on each of these components in the upcoming sections.
As I mentioned above, the balance sheets for utilities, banks, insurance companies, brokerages, and investment banks are different, significantly, and require different analysis and understanding of the terminology used for those businesses.
Another note about balance sheets, there is little normalization of the nomenclature or naming of said sheets. For example, one company may refer to its balance sheet as a “statement of financial condition” or “financial condition.” Unfortunately, this malady also applies to the accounts of balance sheets, so there is no uniformity to the labeling of accounts for the balance sheet.
Ok, let’s uncover each section of the balance sheet and define the different components of each.
Asset Side of the Equation
As we work through our balance sheet, we will use Microsoft’s (MSFT) as our example.
A quick note on assets for our analysis, assets are the economic resources of a company. The company must have acquired the rights of said assets, and they are likely to contribute to the future net cash flows of Microsoft.
Items such as cash are unquestionably an asset because it has purchasing power that represents a future economic benefit to Microsoft.
Let’s start to look at each component of the asset side of the equation of the balance sheet structure.
A note about the order we find the assets listed in the asset section. The accounts are listed in the order of liquidity, or how quickly those assets can be converted to cash. So accounts receivable is more liquid than inventories, for example. The above point is important to remember when you are analyzing the ability of the company to meets its liabilities obligation.
The asset section of the balance sheet is broken up into two components, and we will break them down by line items.
- Current assets
- Non-current assets
Current assets are the most liquid of assets owned by the business and are the accounts, or line items are listed in order of liquidity.
Current assets can be thought of as assets that a company can liquidate within one calendar year. Think of inventory as something that is used up within one calendar year, for example.
The importance of current assets is they represent the funds that a business can use to fund day-to-day operations for the next calendar year. They are also thought of as the liquid assets of the business.
Let’s next look at the accounts associated with current assets.
Cash and Cash equivalents
These are the most liquid of all assets as they appear on the first line of the assets section. Cash equivalents are also included in this line item. Cash equivalents contain securities, among other items, that are extremely short-term, such as three months.
Think of these securities as short-term bonds, money market accounts, or treasuries. The company uses this account to generate a small amount of income from monies that are not using for the immediate future and want to create some income.
More information regarding the cash equivalents is found on the notes section of the financials, typically listed as the marketable section or investment section.
Microsoft lists $13,576 million in cash and cash equivalents. The company also lists out the short-term investments separately, which we can see a total of $122,951 million. Keep in mind that these securities are very short-term in nature, and the ability of quick liquidity is paramount.
The accounts receivable accounts for all amounts owed to the company by customers that the company has not yet collected. Typically, the bad debt accounts or customers that are unlikely to pay are subtracted from this account.
As Microsoft collects from its customers, this account decreases, and cash will increase by the same amount as collected.
Microsoft lists accounts receivable as $32,011 million.
The inventory line item contains things such as raw materials, work-in-progress goods, and finished goods. Think of inventories as goods waiting to be sold by the company, whether they be cars, computers, or phones.
In many companies, inventory might be the largest line item listed in the current asset section.
The costs associated with the production or acquisition of inventory is listed in the costs of goods sold line item of the income statement.
Microsoft lists inventories of $1,895 million under the current assets section.
Other current assets
Other current assets are typically smaller items that are listed under this catch-all section.
Items such as advances paid to an employee, piece of property being readied for a sale, or restricted cash or investments.
Microsoft is listing $11,482 million of other current assets on its balance sheet.
These assets are items that the company uses for longer life, such as property, plant, and equipment or intangible assets.
The non-current assets have a longer life, typically longer than at least a year, and include goodwill, among others.
Plant, Property, and Equipment (PP&E)
The PP&E line item represents the fixed assets of the company. The line item doesn’t include depreciation, and some companies will list their PP&E on different line items, such as plants as a separate line item.
The PP&E account will vary from company to company, and for many companies, this will easily be the biggest line item under non-current assets.
Microsoft is listing the plant, property, and equipment of $44,151 million on the balance sheet.
Goodwill is probably one of the more controversial items listed on the balance sheet as it contains information that is not always the most transparent and takes some sleuthing to determine what it consists of.
Typically, goodwill expresses the intangible amounts from an excess purchase of another company. Items contained in goodwill can be proprietory or intellectual property or branding.
Goodwill is calculated by subtracting the market value of the assets and liabilities from the purchase price of the assets. Businesses are required to review the value of goodwill annually and record any impairments to the fair value of the asset.
The goodwill for Microsoft is $43,351 million for 2019.
The intangible asset line items include the company’s intangible fixed assets. Some of these items may or may not be identifiable, such as patents, licenses, or a secret sauce or formula.
Microsoft lists intangible assets of $7,038 million on its balance sheet.
That concludes the asset section of Microsoft’s balance sheet, remember the other side of the equation must balance the assets.
Let’s move on to the liability section of the balance sheet.
Liabilities Side of the Equation
Liabilities are the monies that the company owes to help support the assets of the company. Think of them as accounts that support the purchases of inventory to sell the items the company sells.
Or it could be the financing of those purchases for inventories, for example.
Remember that the accounting equation for the balance sheet means that the liabilities and shareholders’ equity must equal the assets for the financial statement to balance.
Let’s walk through some of the line items most commonly seen in the liability section of the balance sheet.
Current liabilities are the short-term obligations that are due within the calendar year, or operating cycle. Current liabilities are usually settled by using current assets to settle them, thus the use of ratios such as the current ratio, or quick ratio to determine the liquidity of companies.
Examples of current liabilities include items such as:
- Accounts payable
- Short-term debt
- Notes payable
- Income taxes owed
Ok, let’s look at some of the more common current liabilities.
Accounts payable is the amount the company owes its suppliers for the goods or services they have purchased on credit from its suppliers. Accounts payable are expected to settle within the year of purchase and are considered the most liquid of all current liabilities.
Microsoft has an account payable of $12,530 listed on its balance sheet.
Current Portion of Long-term Debt
The above line item refers to the short-term portion of long-term debt the company is due within the calendar or operating year. For example, if a company takes out a 10-year bank loan, the current portion of that loan is listed under this account.
The short-term debt of any bonds will be listed under this account for many companies; for example, any debt that is coming due for the current year is listed on this line item.
It may also be referred to as short-term debt as well; again, there is no uniformity in the labeling of accounts, which can lead to some confusion.
Microsoft lists the current portion of long-term debt as $3,749 million.
On Microsoft’s balance sheet, the company lists this item as short-term unearned revenue.
Think of it as revenue that the company has earned but not recognized as the sale has not finalized according to accounting rules.
Microsoft lists short-term unearned revenue as $36,000 million on its balance sheet.
The non-current liabilities are longer term liabilities that have longer maturities, over a year. Any long-term debt is listed under this line item and is a major source of investigation for investors.
This account includes any long-term debt in total, except for the current portion that is due if it is listed under the current liabilities. The long-term debt is paid on a debt schedule, which outlines all of the debt of the company and indicates the schedule of payments, along with the interest expense, total debt due, and the schedule of the principal payments.
All information regarding the long-term debt is listed under the notes section of the financial reports. Here you will find everything you wish to know about the long-term debt for the company.
Of particular note in the notes section is the schedule for debt repayment, this item can go a long way to helping you determine how much debt the company owes and when it is due on a cash flow basis.
Microsoft lists long-term debt of $59,578 on the balance sheet.
Long-term income taxes
This account lists the unpaid or carrying amount of income taxes that are due for longer than one year. Also known as income taxes payable.
Microsoft is listing this item as $29,342 million on its balance sheet.
With that, we will wrap up our summary of the liabilities section of the balance sheet.
To make sure our balance sheet balances, we need the shareholders’ equity section to equal the difference between the assets and liabilities.
So far, Microsoft has:
- Total Assets – $301,311 million
- Total Liabilities – $183,007
Equity Side of Equation
Also referred to as shareholders’ equity or stockholders’ equity is the owners claims on any assets after the debts are paid. Think of it as the percentage of ownership of any assets left over after the debt owed on those assets is paid.
Equity is equal to the firm’s assets minus the liabilities.
Shareholders’ equity can be a positive or negative number, depending on whether the company has more or fewer assets than the liabilities.
If the company owes more liabilities than assets, then the equity in the company will be negative. Many investors, including yours truly, look at negative equity as a risky proprostion because it means the company owes more money than the assets are creating for the company.
The share capital line item indicates the amount of money shareholders have invested in the company. Typically, this is the initial contribution that owners contributed when the company was first created.
They are also known as shareholders’ capital, or equity capital, or common stock.
Microsoft lists this line item as $80,552 million on its balance sheet.
Retained earnings are the total amount of earnings that the company decides to keep after paying share repurchases, dividends, or paying down debt.
Every quarter, the company has decisions to make about what to do with the earnings of the company, whether it wants to return money to shareholders, pay down debt, or reinvest in projects to grow the company.
Any amount is used to pay dividends, for example, deducts from the retained earnings, and any money left over is added to retained earnings.
Keep in mind this is not an actual account in the bank, rather an accounting ledger that indicates how much it has to use for dividend payments, for example. The actual paying of monies for dividends comes from the statement of cash flows, which is the checking account of the business.
More information concerning the retained earnings can be found in the stockholders’ equity statements, which also contains all of the information regarding all items related to shareholders’ equity. That statement can give you more details on the dividend payments for the company, for example.
The retained earnings for Microsoft was $34,566 million for 2019.
That wraps up our summary of the shareholders’ equity section of the balance sheet.
To balance our statement, then, the shareholders’ equity section equals $118,304.
All of the sections then equal the following amounts:
- Total Assets – $301,311
- Liabilities – $183,007
- Shareholders’ Equity – $118,304
Liabilites ($183,007) + Equity ($118,304) = $301,311
Analyzing the balance sheet can give you great insight into the financial health of any company. Many investors focus on the balance sheets of businesses they buy because the balance sheet can tell you how strong the company is, in the event of a downturn in the market.
Given the current condition of the stock market, studying balance sheets is paramount to determining the liquidity of the businesses. Think of the balance sheet as the financial statement that will tell you how much money it has on hand to create more assets, how much those assets will cost, and how much equity the company is worth.
Many metrics are associated with the balance sheet to help determine the strength and health of the company. Among them are:
- Return on Assets
- Return on Equity
- Return on Invested Capital
- Important Debt Ratios
- Short Term Debt Ratios
By learning the balance sheet structure and language of the line items and studying the balance sheet utilizing the above-referenced metrics and ratios, you can learn a lot about the financial strength of any company.
That is going to wrap up our discussion on the balance sheet structure. Here’s links to the other two financial statements if you are interested:
- Simple Income Statement Structure Breakdown (by Each Component)
- Basic Cash Flow Statement Breakdown (by Each Component)
I also highly recommend learning about putting all of this valuable information together, by mastering your ability to analyze the entire annual report (10-k).
As always, thank you for taking the time to read this post, and I hope you find something of value on your investing journey.
If I can be of any further assistance, please don’t hesitate to reach out.
Until next time, take care and be safe out there,
Updated 11/8/20 — Dave Ahern and Andrew Sather