- A balance sheet provides information on a company's assets and liabilities.
- Assets is what the company owns and can be broadly classified as current and non-current assets.
- Learn to look for healthy signs in assets and when to see warning signals.
Image ©123RF Stock Photo
We, at Amigobulls have always aimed to help you be a better investor. In our efforts to help you we shall be starting a new series aimed at helping you read a company’s financial statements better. This article on balance sheet is aimed at investors with intermediate knowledge of finance and accounting.
If you are an expert we request you to leave a comment below to help us improve the article further. And in case you are a novice, do not worry as we have a list of top internet stocks picked by our experts which you can look at.
Reading a balance sheet – The Assets
The Balance sheet is also known as a statement of financial position and that is what it essentially aims to do by revealing the assets, liabilities and shareholder’s equity. As an investor it is extremely important to understand what the Balance sheet reveals about the financial position of a company. However, it is even more important to understand what a balance sheet does not reveal.
To begin with let us set the first rule straight. Assets=Liabilities + Shareholder’s Equity. This is where we start and this is where we end. This is what is seen on the surface. What is important is what lies in the footnotes. So what are the potential areas which an investor must watch out for while reading a balance sheet?
In this first article we will be looking at how companies classify their assets and how to read between the lines.
The total assets are classified as current assets and other assets. More often than not, the distinguishing line being assets which the company expects to convert into cash in less than a year fall under the current assets. The balance sheet typically consists of the following heads:
(For example: Look at the latest balance sheet for Google)
Current assets including:
- Cash and cash equivalents
- Marketable securities
Non-current assets typically include:
- Property plant and equipment
- Goodwill and Intangibles
Healthy signs in a Assets
One of the easiest sign of a healthy company is its cash generating ability and the subsequent increase in its Cash position. For example, Google has seen its cash increase from just over $330 million to over $48 billion over the last 10 years!
Red flags in the assets
The first field to scrutinize in a balance sheet is the receivables. The practice of Channel stuffing can lead to a significant jump in revenues, which is accompanied by a similar jump in the receivables. In times when a company is missing its revenue targets, they often resort to this practice and record the despatched products as revenues. However this can be reflected in the receivables reported by the company for the quarter. Therefore it is advisable to compare the change in receivables to the change in revenues to better understand the source of a company’s revenue growth.
The investor must watch out for any surprising increase in the inventory totals. The sudden jump in inventory numbers can be a result of change in the way inventory is accounted for which is a cause for concern. The reason for change in inventory accounting is more often than not a negative sign and needs to be looked into deeply in order to understand its implications for the business. In general piling up of inventory indicates that the management had overestimated demand.
Goodwill and Intangibles
The next field of creativity within the balance sheet is Goodwill and Intangibles. These are often claimed to be ‘acquired.’ However it is always better as an investor to go through the goodwill treatment and accounting method which is often given as part of the underlying notes. In case of acquisitions and takeovers intangibles need to thoroughly scrutinized in order to decide whether or not the intangibles contribute to the business of the company. Often the increase in goodwill and intangibles due to acquisitions is also inclusive of the amount by which the company may have overpaid for the acquired firm.
Investments and advances
The next line item to be looked at carefully is the investments of the company. Often the investments include investments in order to move debt off balance sheet by setting up special purpose entities (SPE). The resulting SPE’s often have nothing but bad assets from the parent to support them. The case of Enron and SPE’s created by the company is something many have heard of but few really understand. The company used the SPE’s to transfer bad assets and debt from the company’s statements to those of the SPE’s.
In short anything appearing too complicated to understand means there is something funny beneath the surface numbers reported in the filings. Such complications demand greater scrutiny on part of an investor in order to be a safe. As a ground rule an investor must invest in only companies whose financials he understands without having to do much of a research. If making sense of the financial statements gets too complicated, more often than not there is a lot of window dressing in the numbers which the company wants you to see, rather than the actual numbers which they want to hide.
To see Google’s current price, please click here: Google (GOOG)