What is a balance sheets and how do you read it?
So, you’ve probably been reading MapleMoney for a while. You know it’s awesome, especially on Thursdays, when Captain Handsome himself shows up. In fact, we’ve been nominated for about 27 Plutus Awards. If you don’t go and vote for us right now, we will come to your house and throw a pie in your face.
Because you’ve been following all the great advice here, your financial journey is well underway. You’ve paid off all your credit card debt. You have a reasonable mortgage that you can easily afford. You’re saving money each month, either by using a budget or paying yourself first. Congratulations on your achievements so far, but now it’s time to take the next step on your financial journey. That next step puts you into the unknown land of investing.
Over the next 3 weeks, I’ll teach you the basics of the 3 major financial statements issued by companies that trade on the stock market. It’ll just be the basics, since getting too in-depth on financial statements is scientifically proven to cure all forms of insomnia. Without further adieu, let’s get to it, starting with the balance sheet.
The balance sheet
The balance sheet is a snapshot of a company’s financial health at a particular date. The balance sheet is divided into assets, liabilities and shareholder’s equity.
Assets are everything that a company owns that has value. Examples include cash, inventory, any real estate the company owns or accounts receivable. To compare it to your own finances, your assets would include your house, RRSP, etc. Assets are divided into tangibles and intangibles. Tangible assets are assets you can see, feel and touch. Intangibles include goodwill (loosely defined as the value of a company’s good name) and other intangibles, which include patents and competitive advantages the company has.
Then we have liabilities. Just like your own personal finances, the biggest liability on a corporate balance sheet is debt. Also included are accounts payable, any income tax owing, or any long term leases the company has signed.
If you take assets and subtract liabilities, you get a value called shareholders’ equity. Shareholders’ equity is a company’s net worth. If a fictional company had 1 million in assets and 500,000 in liabilities, their shareholders’ equity is 500,000. This represents the value of the company that the shareholders actually own.
Still awake? Good. It’s really not that complicated of a document. Let’s look at what it tells you.
What you can see looking at the balance sheet
The balance sheet tells us the financial health of a company. Understanding a company’s financial health is imperative before investing in a company.
The first thing I look at is the level of cash and debt a company has. A large cash balance is always a good thing. It allows a company to whether any sort of storm that could come, or they can use the excess cash to buy back shares or pay either debt or shareholders dividends. Inversely, you want to look at companies with low levels of debt. Since companies have to pay interest on their debt, that can be a drag on the overall health of a company. It isn’t often you’ll find a company without any debt, since debt can be an effective tool for a corporation.
The second thing I do is figure out a company’s book value. It’s an easy thing to do. All you need to do is divide the shareholders’ equity by the number of shares outstanding. If our imaginary company from above (with the $500,000 shareholders’ equity) has 100,000 shares, that gives us a book value of $5 per share. If this particular company trades at $10 per share, it trades at 2 times book value.
Book value should only be one of the metrics used to value a company. Most of the time, an investor is paying a premium over book value. This is because a company is worth more than its net worth. Sometimes companies will value their intangible assets much lower than what they’re really worth.
Other important notes
Certain kinds of companies will have more debt than others. Any company that invests heavily in long term assets (things like utility providers, real estate companies and banks) will need long term debt to finance these assets. Rather than just looking at their debt levels on their own, compare them to their peers.
If you’re looking for some more information on each of the items of the balance sheet, you can dig further into the annual report. Most of the time, notes will accompany each item of the balance sheet.
The balance sheet gives the investor an important look into the health of a company. Next week, we’ll look at the income statement, which looks at the company’s ability to make money. Maybe by then, you’ll have woken up.
Very nicely explained article, thanks for that. I’m studying for my CFA exam due in Dec and there is an entire book covering companies financial statements. With all that utterly boring stuff about accounting principles and GAAP and IFRS thrown in you tend to lose sight of the basic concepts that you explained here.
Thanks, that was pretty simple and it help. Can you tell me whether there are different types of balance sheets for sole trader; partnership and limited liability and if so, can you please explain. Look forward to hearing from you. Thanks again.