Publicly listed corporations are required to submit quarterly and annual balance sheets as part of their financial filings. A balance sheet, cash flow statement, and income statement are required components of these reports. The assets and debts of a business are detailed in the balance sheet.
When deciding whether or not to buy a stock, a thorough review of the company’s balance sheet is essential. After all, the financial accounts reveal the source of the company’s funding, whether or not it has adequate assets to satisfy its obligations, and much more besides.
How to Read a Company’s Balance Sheet for Investment
Most financiers prefer to put their money into established businesses. Checking through the balance sheet of a firm is a terrific approach to learn more about its financial situation.
The assets of a business are listed first on a balance sheet. There are two categories for these possessions: liquid assets and fixed assets.
Current Assets from Apple’s Consolidated Balance Sheet as of March 27, 2021. Every line item on the balance sheet has two columns of numbers: one for the current period, and another for the same period a year ago.
The term “non-current assets” is used to describe assets that a business plans to keep for a year or more. They are often separated into two classes, the titles of which vary with the organization delivering the report.
Real land, machinery, and other physical property are examples of tangible assets; intellectual property, brand names, copyrights, patents, and other intangible assets are also common examples.
The majority of publicly listed corporations have substantial liabilities, which is just another word for debt. On the balance sheet, total liabilities will also be separated into two sections: current and noncurrent.
Debts owing by a business that are due within a year are considered “current liabilities.”
Long-term debts that a business has been obligated to repay within a year or more are detailed in the balance sheet’s “non-current liabilities” column.
A company’s equity consists of the total value of the shares held by outside investors and insiders. Equity may be broken down into two main categories: retained earnings and shareholders’ equity.
Equity is the remaining claim on assets held by shareholders after liabilities have been satisfied. In the case of liquidation, this comprises both retained earnings and the amount of assets to which stockholders would be entitled. Having subtracted its obligations from its assets, a company’s net value is equal to its shareholders’ equity.
For many, the term “retained earnings” refers to the surplus of profits that remain after dividends have been deducted. This is the company’s unspent equity. An indication of a company’s success is an increase in retained earnings.
How to Interpret a Balance Sheet
Now that you understand the significance of each section of a balance sheet, you may put this information to work for you when making financial decisions. Financial ratios are used by investors to compare one measure to another. The most frequent ones are as follows:
Equation for a Balance Sheet
The balance sheet equation, sometimes called the accounting equation, describes the interplay between the balance sheet’s three most crucial components—liabilities, equity, and assets.
When you add up a company’s debts and shareholder stock, you get its total assets. The accounting equation reflects this fact:
- Total Assets = Liabilities + Owners’ Equity
Take a hypothetical firm with $75 billion in liabilities and $125 billion in equity. In this scenario, the company’s total assets would equal $200 billion, which is the sum of its liabilities plus its shareholders’ equity.
Many interesting facts about a firm may be gleaned from its balance sheet equation. If, for instance, you find that debt dominates equity, you might infer that the firm has financed most of its assets via borrowing money. However, if equity is significantly higher than debt, then the majority of the company’s assets have been financed through the sale of equity.
The debt-to-equity ratio
The debt-to-equity ratio evaluates a company’s financial position by contrasting its debt with its equity. The ratio is calculated as follows:
- Debt-to-Equity Ratio = Total Liabilities / Total Shareholders’ Equity
If a firm has a high debt-to-equity ratio, it means it relies heavily on debt to fund its operations and meet its substantial costs. A high debt-to-equity ratio indicates that the firm is employing leverage to grow, which is preferred by more risk-taking investors.
But if the ratio of debt to equity is low, then indicates that the business is funded mostly from internal resources, rather than external loan markets. Companies having a lower debt-to-equity ratio are more attractive to risk-averse investors due to their higher cash flow, lesser debt, and higher dividend payouts.
The Current Ratio
A company’s capacity to meet its short-term financial commitments, such as loans that mature within a year, is reflected by the current ratio, also known as the working capital ratio.
This is significant since it’s less risky to put money into businesses that actually have the resources to meet their financial obligations. The ratio is calculated as follows:
- Current Ratio = Current Assets / Current Liabilities
A current ratio below 1 indicates that the firm does not have sufficient liquid assets to meet its short-term debt obligations. In contrast, if the current ratio is greater than 1, it indicates that the corporation can pay its short-term loans in full if they were all due today.
There is a difference between the current ratio and the quick ratio. It’s a way to see if a business can pay its bills without selling up its assets or taking on more debt. We’ll go with the more popular of the two formulas for determining the quick ratio.
- Quick Ratio = (Cash & Cash Equivalents + Marketable Securities + Accounts Receivable) ÷ Current Liabilities
A fast ratio at over 1 means the corporation is able to satisfy its short-term commitments using rapid assets – cash, cash equivalents, and other assets it can access quickly. It’s important to note that most publicly listed corporations keep their quick ratio at or around 1. A quick ratio of 0.75 is considered healthy, but anything below 0.50 might be reason for worry.
Price-to-Book Value (P/B) Ratio
Price-to-book ratio analyzes the market price of a publicly listed corporation in relation to its book value. A company’s book value may be calculated by taking its entire assets and deducting its total liabilities. This is the equation for the P/B ratio:
- P/B Ratio = (Price per Share x Number of Outstanding Shares) ÷ Book Value
In general, a P/B ratio below 1 is seen as favorable, implying that shareholders are receiving a good deal when they purchase the stock.
In the IT industry, however, this percentage is typically much greater. This is because continuous innovation has made the IT industry well-known for its fast development.
Companies in this industry are valued more by investors than those in industries like utilities that aren’t as focused on innovation and quick expansion. As of early January 2022, Apple, for instance, had a price-to-book value ratio of more than 44.
Better returns may be expected from your investments if you take the time to learn as much as possible about the company you put your money into. Perhaps learning to read a balance sheet isn’t the most thrilling activity, but the impact it can have on your investment returns is too great to ignore.
Therefore, it is prudent to incorporate a review of balance sheets within your due diligence before making any changes to your stock holdings.