Investors and analysts might spend hours crawling through a company’s quarterly and annual statements searching for clues about how well the firm is doing. This lesson explains several commonly reported items on most firms’ balance sheets and helps the viewer understand the relative importance of such concepts to investors.
In order to gauge the current financial health of a company, investors may decide to look at its balance sheet statements. Balance sheet data details a financial summary of a company at any given point in time. These numbers represent an end-of-period snapshot of financial accounting components reflecting all transactions that occurred during the period.
The balance sheet represents the company’s assets, liabilities and owners’ equity, and as the name alludes, the values must balance. That is, the value of a firm’s assets must equal the value of its liabilities plus the equity attributable to shareholders.
Assets are things a firm owns that have value and may be involved in the production of its output. Liabilities and equity are claims against the value of those assets. One can think of liabilities as a debt or as something the company may owe to other parties. Shareholder equity is the owner’s interest in the firm or equity that is left over after claims against its assets are satisfied.
If you look at balance sheets of companies in different industries, you will notice that several may look the same, but you will also find that some sectors require distinct classification. Regardless of whether balance sheets are standardized or more complex, the method of reporting is largely the same. More liquid and short-term assets are current liabilities which are listed first, while less liquid and longer-term claims are listed lower down the balance sheet.
Next, we will describe some of the items commonly listed under the assets side of a balance sheet.
Cash is used to pay bills and other obligations and is, of course, the most liquid of all assets. Companies may put excess cash balances to work in interest-bearing accounts or in marketable securities. Analysts and investors will want to know that the level of available cash is sufficient to pay near-term needs, but feel assured that a stack of cash renders its operations inefficient. The company should be able to put excess cash to use in order to achieve a return above the rate available on idle cash balances.
Accounts receivable represents what is owed to the company at the end of the period by customers for goods sold, but where payment has not yet been collected. Investors may wish to know that the company is in control of its accounts payable. A high level could mean that it has extended too much credit or that it is inefficient in collecting its debts. A low level may indicate that sales are suffering due to tight credit standards and worsening economic conditions. The company may hold a reserve account aimed at settling customer debts that could not be collected, which inevitably damages its numbers. Note that accounts receivable will likely vary between industries, and investors should compare like-for-like companies when trying to assess the impact of accounts receivable information contained within the balance sheet.
Inventory explains a stockpile of finished or semi-finished goods available for sale. Appropriate levels vary between industries, and, should also be compared to final sales. If stock levels are too high, it could be a warning that sales are beginning to slow or that competitors are becoming more successful in selling the same type of goods. Although, some companies may purposely increase inventory in the run up to a known period of high demand, such as retailing holidays, when sales typically surge. Low levels of inventory leave the company vulnerable to strengthening sales and perhaps unable to meet rising demand patterns, especially if the production cycle is longer. Remember, customers might not be willing to wait for 30, 60 or even 90-days for a specific product especially when a competing company has a comparable model immediately available. When sales and inventory patterns deviate, it may raise a red flag for analysts.
Property, plant and equipment (or PPE)
Property, plant and equipment (or PPE) represent the assets a company uses over time to create production. Property is the only fixed asset here that does not depreciate, while machinery and equipment do. Companies allow for depreciation over each period and report a net property, plant and equipment value to reflect such erosion. Such losses are accounted for in the accumulated depreciation account. Of course, PPE is more important for those companies that employ a lot of machinery, such as a manufacturing plant, and less so at service-based companies.
Many companies achieve growth through acquiring other companies simply because they own a well-known brand or a patent. Ownership of a brand can create goodwill with customers and retain sales. For that honor, a company may pay beyond the book or accounting value for the firm it is buying. Items such as goodwill or patents are known as intangible assets since there is no tangible asset at the time of purchase to measure its value to. Companies are obliged to measure goodwill according to its reported value and, if necessary, record an impairment loss over time. Such losses do not affect cash flow, but do create non-cash charges that impact earnings directly.
A company’s liabilities are what it owes its suppliers, creditors and employees. Accountants break down liabilities into those debts with a maturity of less than a year, known as current liabilities, while those obligations payable more than a year out are termed long term liabilities.
Current liabilities generally fall under the section on the balance sheet known as accounts payable. Many current liabilities are in the form of short-term credit extended by a supplying company, where liabilities will be paid once existing inventory is sold and the cash proceeds are collected.
Accrued expenses are costs incurred but not yet paid and can include rent on property, interest on machinery and salaries due to employees.
Income taxes payable
Income taxes payable is the amount set aside to pay for taxes at appropriate known rates on sales. The company also lists notes payable, which is a form of short-term borrowing that has to be repaid within the year to a financial institution. The current liability of the balance sheet also includes an item for the current portion of long-term debt that is due within a year. Remember, investors need to know that the company’s short-term financial position is adequate to fulfill its short-term obligations.
Long-term liabilities are those due beyond one year and can include accounts such as bonds, deferred taxes and employees’ pension obligations. Typically, companies issue long-term bonds, which represent the most common long-term form of liabilities.
Stockholder’s Equity represents an ownership interest in the firm comprised of a common stock account and a retained earnings account. A common stock account is listed on the balance sheet when common stock is sold. The common stock has a stated par value, although it is meaningless to shareholders. The account thus reflects the par value of the stock sold. A paid-in capital account reflects the initial amount received from the sale of common stock over and above its par value. The retained earnings account is the value of accumulated earnings posted by the firm after all expenses and dividends due have been dispersed.
The net worth of a firm is stockholders’ equity or what is left once liabilities are subtracted from assets. Another term associated with this is book value. However, investors must understand that accounting is entirely about ensuring that assets equal liabilities. As such, the balance sheet represents an accounting value and has nothing to do with the implied market value of a firm. For example, a company may report on its balance sheet a book value for property it owns that is far below the actual market value. Many service-oriented firms employ key individuals without whom, the firm would fail. Yet the proper value of these intangible assets might never be reflected on the balance sheet. Some investors do go hunting for hidden asset values on companies’ balance sheets. Yet far more are interested in understanding forward earnings and cash flow potential of assets that the firm currently holds.
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