Understanding the Balance Sheet

The balance sheet is a snapshot of everything a company owns and owes at a specific moment. It reveals financial strength and potential vulnerability. [DEFINITION] Balance Sheet: A financial statement showing a company's assets, liabilities, and shareholders' equity at a specific point in time. ### The Fundamental Equation Every balance sheet follows one unbreakable rule: [FORMULA] Assets = Liabilities + Shareholders' Equity This MUST balance—hence the name "balance sheet." [EXAMPLE] Simple Balance Sheet: | Assets | Amount | Liabilities + Equity | Amount | |--------|--------|---------------------|--------| | Cash | $100 | Debt | $150 | | Inventory | $50 | Accounts Payable | $50 | | Equipment | $200 | Shareholders' Equity | $150 | | **Total** | **$350** | **Total** | **$350** | ### Assets: What the Company Owns **Current Assets (convertible to cash within 1 year):** - Cash and cash equivalents - Accounts receivable (money owed by customers) - Inventory (products to sell) - Prepaid expenses **Non-Current Assets (long-term):** - Property, plant, and equipment (PP&E) - Intangible assets (patents, trademarks) - Goodwill (premium paid in acquisitions) - Long-term investments [TIP] Cash is king. A company with lots of cash can weather storms, invest in growth, and return money to shareholders. ### Liabilities: What the Company Owes **Current Liabilities (due within 1 year):** - Accounts payable (money owed to suppliers) - Short-term debt - Accrued expenses (wages, taxes owed) - Deferred revenue (paid but not yet earned) **Non-Current Liabilities (long-term):** - Long-term debt (bonds, loans) - Pension obligations - Lease obligations ### Shareholders' Equity: What's Left for Owners After subtracting all liabilities from assets, what remains belongs to shareholders: - **Common stock:** Initial investment by shareholders - **Retained earnings:** Accumulated profits not paid as dividends - **Additional paid-in capital:** Amounts paid above par value [KEY] Shareholders' equity is the book value of the company—what owners would theoretically receive if all assets were sold and all debts paid. ### Key Balance Sheet Ratios **Current Ratio** = Current Assets ÷ Current Liabilities - Measures short-term liquidity - Above 1.0 = can cover short-term debts - Above 2.0 = strong liquidity [EXAMPLE] Company has $500M current assets, $250M current liabilities. Current Ratio = $500M ÷ $250M = 2.0 (healthy) **Debt-to-Equity Ratio** = Total Debt ÷ Shareholders' Equity - Measures leverage - Below 1.0 = more equity than debt (conservative) - Above 2.0 = heavily leveraged (risky) **Quick Ratio (Acid Test)** = (Current Assets - Inventory) ÷ Current Liabilities - Stricter liquidity test - Excludes inventory (harder to sell quickly) ### Reading Between the Lines [WARNING] Watch for these balance sheet red flags: - Current ratio below 1.0 (can't pay short-term bills) - Rapidly increasing debt levels - Declining cash balances over time - Goodwill that's a large portion of assets (acquisition risk) - Inventory growing faster than sales [EXAMPLE] Comparing two companies: | Metric | Company A | Company B | |--------|-----------|-----------| | Cash | $10B | $2B | | Debt | $5B | $15B | | Debt/Equity | 0.3x | 2.5x | Company A has a fortress balance sheet. Company B is heavily leveraged—fine in good times, dangerous in recessions. ### Balance Sheet Trends A single balance sheet is just a snapshot. Compare over time: - Is cash position improving? - Is debt being paid down or increasing? - Is equity growing (retained earnings increasing)? - Are assets being used efficiently? [EXERCISE] A company has Total Assets of $1 billion, Total Liabilities of $600 million. What is Shareholders' Equity? If they have 50 million shares outstanding, what's the book value per share? |ANSWER| Shareholders' Equity = $1B - $600M = $400M. Book value per share = $400M ÷ 50M = $8 per share. If the stock trades at $12, it's at 1.5x book value. [SCENARIO] You're analyzing a retailer. Their inventory has grown 40% year-over-year, but sales only grew 5%. This is a warning sign—they may have products that aren't selling, which could lead to write-downs or discounting that hurts profits. Always compare balance sheet changes to income statement trends.