Fundamental analysts, when valuing a company or considering an investment opportunity, usually begin by examining the balance sheet. This is because the balance sheet is a snapshot of a company’s assets and liabilities in a single moment, not distributed over a year, as is the case with the income statement.
The balance sheet contains a lot of important information, some of which are more important to focus on in order to gain a general understanding of a company’s creditworthiness and business relationships.
- The balance sheet of a company is a snapshot of assets and liabilities in a single moment.
- Fundamental analysts focus on the balance sheet when considering an investment opportunity or evaluating a company.
- The main reasons it is important to analyze balance sheets are mergers, asset liquidations, a possible investment in the company, or if a company is stable enough to expand or pay off debt.
- Many experts believe that the most important areas on a balance sheet are cash, accounts receivable, short-term investments, property, plant and equipment, and other significant liabilities.
Why balance sheets are important for analysis
They say “the numbers don’t lie,” and that’s more true for financial analysis than anything else. Balance sheets are important for many reasons, but the most common are: when a merger is being considered, when a company needs to consider asset liquidation to shore up debt, when an investor is considering a position with a company, and when a company looks inward to determine if they are financially stable enough to expand or begin paying off debt.
Many experts consider the top line, or cash, to be the most important item on a company’s balance sheet. Other critical items include accounts receivable, short-term investments, property, plant and equipment, and the main items of liabilities. The three broad categories on any balance sheet are assets, liabilities, and equity.
All assets must be divided into current and non-current assets. An asset is considered current if it can be reasonably converted to cash within one year. Cash, inventories, and net accounts receivable are important current assets because they offer flexibility and solvency.
Cash is the headliner. Businesses that generate a lot of cash are often doing a good job satisfying customers and getting paid. While too much cash can be worrisome, too little can generate many red flags. However, some businesses require little or no cash to operate, and choose to invest that cash in the business to improve its potential for future earnings.
Like assets, liabilities are current or non-current. Current liabilities are obligations that mature within one year. Fundamental investors look for companies with fewer liabilities than assets, especially compared to cash flow. Businesses that owe more money than they contribute often run into trouble.
Common liabilities include accounts payable, deferred income, long-term debt, and customer deposits if the business is large enough. Although assets are usually tangible and immediate, liabilities are often seen as equally important, since debts and other types of liabilities must be settled before a profit is recorded.
The equity is equal to the assets minus the liabilities, and represents how much the shareholders of the company have rights; Investors should pay particular attention to retained earnings and paid-in capital in the equity section.
Paid-in capital represents the initial investment amount paid by shareholders for their ownership interest. Compare this to the additional paid-in capital to show the capital premium investors paid above face value. Equity considerations, for these reasons, are among the main concerns when institutional investors and private financing groups consider the purchase or merger of a company.
Retained earnings show the amount of earnings that the company reinvested or used to pay off debts, rather than distributing them to shareholders as dividends.
The bottom line
A company’s balance sheet provides a wealth of information about its creditworthiness and business relationships. A balance sheet consists of three main sections: assets, liabilities, and equity.
Depending on what an analyst or investor is trying to achieve, the different parts of a balance sheet will provide a different perspective. With that said, some of the most important areas to pay attention to are cash, accounts receivable, marketable securities, and short- and long-term debt obligations.