If you just start out as an investor, the first thing you need to do is to master “reading financial statements”. Reading financial statements is a skill which every investor needs to be thorough at. And there are only four, most important financial statements you can start off with –
- Balance Sheets
- Income Statements
- Cash Flow Statements &
- Shareholders’ Equity Statements
Why focus on these four first? Because these four will help you decide whether a company is meritorious enough to invest into or not. So, you need to learn to read each statement line by line.
In this article, we will talk about the balance sheet in length –
- What do we mean by Balance Sheet?
- Balance Sheet Format
- How to read Balance Sheet?
- Colgate Balance Sheet Example
- Colgate’s Balance Sheet Example – Vertical Analysis
- In the final analysis
What do we mean by Balance Sheet?
Balance Sheet is the “Snapshot” of a company’s financial position at a given moment
Balance Sheet reports the amount of a company’s
- Assets – Current assets/Long-term assets
- Liabilities – Current Liabilities/Long term liabilities
- Stockholders’ (or owner’s) equity – Common stock / Retained earnings
Let’s get started.
- Unlike Income Statement, Balance Sheets are much less complicated (however, there are many items you need to include under few heads). And Balance Sheets portray the overall picture of a company’s financial affair altogether.
- Balance Sheets can’t be formed without first setting up the income statement. Because we need to know the retained earnings from the income statement. Through Income Statement, we can ascertain the net profit. The portion of net profit that is not distributed among the shareholders is called “retained earnings”.
Remember the most important equation while forming the Balance Sheet –
Assets = Liabilities + Shareholders’ Equity
Balance Sheet Format
Assets are arranged on the left-hand side and the liabilities and shareholders’ equity would be on the right-hand side. However, in most of the cases, companies put the assets first and then they set up liabilities and at the bottom shareholders’ equity. The total assets should be equal to the total liabilities and total shareholders’ equity.
Balance Sheet Format is as follows –
- Current Assets
- Current Liabilities
- Long Term Assets
- Long Term Liabilities
- Shareholder’s Equity
#1 – Current Assets
Current assets are expected to be consumed, sold, or converted into cash either in one year or in the operating cycle, whichever is longer. An operating cycle is an average time it takes to convert an investment in inventory back into cash. Current assets are presented in order of liquidity
Assets are arranged on the basis of how quickly they can be converted into cash (means how liquid they are). That means, in the balance sheet, the first things we will put in are current assets. Under current assets, these are the items you can consider –
- Cash & Cash Equivalents – Cash could also include an amount required to be held for deposit to satisfy the terms of a lending agreement. Cash equivalents are securities (e.g. US Treasury bills) that have term of less than or equal to 90 days. Also, have a look at this detailed article on Cash and Cash Equivalents
- Short-term investments – Short Term Marketable Securities primarily includes Bond Investments and Capital Stock Investments. Short-Term Marketable Securities are not as ready as money in your account, but they provided added cushion if some immediate need were to arise
- Inventories – Inventory consists of merchandise a business owns but has not sold. Classified as current assets because investor assumes that inventory can be sold in the near future, turning it into cash. Also, have a look at Types of Inventories
- Trade & Other Receivables – Money that is owed to the company by the customers
- Prepayments & Accrued Income – Sometimes a business will have to pay for goods or services before they actually receive the product. Expenses that have been paid in the current fiscal period but that will not be subtracted from revenue until a subsequent fiscal period
Other current assets also include Derivative Assets, Current Income Tax Assets, Assets Held for Sale etc.
Current Assets will look like following –
|X (in US $)||Y (in US $)|
|Total Current Assets||12500||14500|
#2 – Current Liabilities
Current Liabilities are probable future payments of assets or services that a firm is obligated to make as a result of previous operations. These obligations are expected to require the use of existing current assets or the creation of other current liabilities.
“Current Liabilities” generally include the following –
- Accounts Payable – Amounts owed to suppliers for goods and services that have been purchased on credit. Accounts payable are debts that must be paid off within a given period of time in order to avoid default.
- Short Term Debt – Short Term Debt is also referred to as Notes Payable. Sometimes when the demand is high, a company may raise short-term loans to stock up the inventory (Utilizing leverage)
- Current Maturities of Long-Term Debt – Any portion of long-term debt that is to be repaid within a year of the balance sheet date is reclassified from the noncurrent liability section to the current liability section of the title, current maturities of long-term debt
- Unearned Revenues – Unearned revenue is created when customers pay for services or products before delivery
- Other Accrued Liabilities – This could include Money owed to employees as salary and bonus that the company has not yet paid
Other than that, current liabilities also include accounts payable, sales taxes payable, income taxes payable, interest payable, bank overdrafts, payroll taxes payable, customer deposits in advance, accrued expenses, short-term loans, current maturities of long-term debt etc.
Current Liabilities will look like following –
|X (in US $)||Y (in US $)|
|Current Taxes Payable||5000||6000|
|Current Long-term Liabilities||11000||9000|
|Total Current Liabilities||20000||18000|
#3 – Long Term Assets
Long term assets are typically physical assets that the company own and are employed in the production process of the firm and have a useful life greater than one year. Long term assets are not for sale to the firm’s customers (they are not inventory!)
Long-term assets can be classified into three main categories
- Tangible Assets: These assets have physical existence. Assets like Real Estate, Buildings, Offices, Machinery, Furniture, Telephone belong to this category. The process of allocating the cost of tangible assets over the useful life is called “depreciation” (we will discuss this later)
- Natural Resources: These assets have an economic value derived from Earth and used up over time. Examples include Oil fields, mines etc
- Intangible Assets: These assets have no physical existence and they cannot be felt or touched or seen. Examples include trademarks, copyrights, patents, franchise, and goodwill. The cost of intangible assets is allocated to periods over which it provides benefits through a process called amortization (have a look at this detailed article on Goodwill)
Long term assets are generally reported at their carrying value or book value. If the asset has lost its revenue generating ability, it may be written down (asset impairment, amount of written down is recorded as loss)
#4 – Long Term Liabilities
Long-Term Liabilities are obligations that are not expected to require the use of current assets or not expected to create current liabilities within one year or the normal operating cycle (whichever is longer)
- In most cases, it contains long-term debt. Long-term debt is subject to various covenants or restrictions. Long-term debt can be obtained from many sources and may differ in the structure of interest and principal payments and the claims creditors have on the assets of the firm.
- Bonds are contracted between the borrowers and the lender that obligates the bond issuer to make payments to the bondholder over the life of the bond
- Creditors claims could be subdivided into two types:
#5 – Shareholder’s Equity
Stockholders’ Equity is the residual interest of the stockholders in the assets of the corporation. There are two primary sources of Equity – Paid-in Capital and Retained Earnings
Each share of common stock conveys certain rights to the
- Attend stockholders’ meetings
- Elect directors and vote on other matters
- Receive dividends as declared by the board of directors
- Preemptive right: The preemptive right is a shareholder’s right to purchase a proportionate amount of
any new stock issued at a later date
Shareholder’s Accounts need to be maintained for
- Par Value (Par value has no economic significance)
- Additional Paid-in Capital
Preferred stock has certain preferences or features not possessed by common stock
How to read Balance Sheet?
Balance Sheet provides useful information about company’s financial affairs. As an investor, you need to know how to read the Balance Sheet to be able to extract the most of it.
These are the steps that can help you read Balance Sheets –
- The first thing is really the first thing. You need to know the balance sheet equation. We have already shared the equation. You need to see whether the total assets and total liabilities & total shareholders’ equity are equal.
- Then you will look at the current assets. These assets will give ideas about the liquidity of the company and where the company expects to liquidate the assets from. These assets can easily be converted into cash.
- Then you should follow the non-current assets which include fixed assets and intangible assets (like patents etc.) as well. You need to find out the wear and tear (depreciation) and other expenses and whether they have been taken into account or not. Match it up with the income statement and cash flow statement to understand whether there is any loophole or not.
- Then you need to learn about the liabilities of the company. They can be both current and non-current. Current liabilities are items which can be dealt quickly and the keyword for it is “short term”. In the case of non-current liabilities, it takes longer for the firm to pay off which includes long-term loan and other payables.
- The last step is to look through the shareholders’ equity. Check out the retained earnings and compare it with a net profit. And you will get an idea about how much dividend is being paid (if any).
- It is important for you to know that you shouldn’t skip any step mentioned above. Don’t look at shareholders’ equity until you have completed looking at all other items in the balance sheet. The best way is to keep a pen and paper and take notes while looking through the items and matching them up with the other financial statements.
Colgate Balance Sheet Example
# 1 – Current Assets
- Cash and Cash Equivalents of Colgate was $970 million in 2015 and $1089 in 2014.
- Accounts receivables net of allowance was $1427 million in 2015 and $1552 million in 2014.
- We note that around 45% of current assets in 2015 consists of Inventories and Other Current Assets. This may affect the liquidity position of Colgate.
- When investigating Colgate’s inventory, we note that majority of the Inventory consists of Finished Goods (which is better in liquidity than raw materials supplies and work-in-progress).
# 2 – Current Liabilities
- Colgate’s Accounts payable stands at $1110 million in 2015 and $1231 million in 2014
- Current Portion of Long-term debt was at $298 million in 2015 and $488 million in 2014.
- Accrued Income Taxes was at $277 in 2015 and $294 million in 2014.
- Other accruals is close to 50% of the Total Current Liabilities.
#3 – Long Term Assets
- Long-term assets in Colgate’s Balance Sheet include the Property, Plant and Equipment, Goodwill, Other Intangible Assets, Deferred Income Taxes and Other Assets
- Property Plan and Equipment is the largest item in Colgate’s Long Term Assets. It includes Land, Buildings, Manufacturing machinery, and equipment etc.
- Goodwill and other intangible assets are also high in Colgate. Goodwill and indefinite life intangible assets, such as the Company’s global brands, are subject to impairment tests at least annually
#4 – Long Term Liabilities
- Long-Term Liabilities in Colgate’s Balance Sheet include the Long Term Debt, Deferred Income Taxes and Other liabilities.
- Weighted average interest rate on the Long-term debt is approximately 2.1%
- Colgate’s Long Term Debt (including the current portion) increased to $6567 million in 2015 as compared to $6132 million in 2014.
- Other liabilities primarily includes Pension and other retiree benefits and restructuring accrual
#5 – Shareholder’s Equity
- Shareholder’s Equity in Colgate’s Balance Sheet include Common Stock, Additional Paid-in Capital, Retained Earnings, Accumulated Other Comprehensive Income, Unearned compensation, and Treasury stocks.
- Treasury stocks are those stocks that Colgate buys back as a part of its Share Repurchase agreement. You may note that Shareholder’s equity of Colgate is negative primarily due to its share buyback.
- Colgate’s Accumulated other comprehensive income is at -3950 million in 2015 and -3507 million in 2014.
Colgate’s Balance Sheet Example – Vertical Analysis
For understanding Colgate’s Balance sheet trends over the period of time, we can perform Vertical Analysis. Vertical Analysis on the Balance Sheet normalizes the Balance Sheet and expresses each item in the percentage of total assets/liabilities. It helps us to understand how each item of the balance sheet has moved over the years.
- For each year, Balance Sheet line items are divided by its respective year’s Top Assets (or Total Liabilities) number.
- For example, for Accounts Receivables, we calculate as Receivables / Total Assets. Likewise for other balance sheet items
- Cash and Cash equivalents have increased from 4.2% in 2007 and are currently standing at 8.1% of the total assets.
- Receivables have decreased from 16.6% in 2007 to 11.9% in 2015.
- Inventories have decreased too from 11.6% to 9.9% overall.
- What is included in “other current assets”? It shows a steady increase from 3.3% to 6.7% of the total assets over the last 9 years.
- On the liabilities side, there can be many observations we can highlight. Accounts payable decreased continuously over the past 9 years and currently stands at 9.3% of the total assets.
- There has been a significant jump in the Long-Term Debt to 52,4% in 2015. For this, we need to investigate its SEC Filings further.
- Non-controlling interests has also increased over the period of 9 years and is now at 2.1%
In the final analysis
Learning to read a balance sheet is important if you want to be successful as an investor. And it starts with pulling out a balance sheet of a company and reading it through and through. If it’s your first annual report reading, then please do not get intimidated. Stay put. You will master the balance sheet analysis over a period of time.