One of these financial reports is the balance sheet. Investors can use it to determine how a business is funded and structured. Learn how to read a balance sheet and some typical investor uses.
What Is a Balance Sheet?
A balance sheet lists the value of all of a company’s assets, liabilities, and shareholders’ (or owners’) equity. The format of the sheet is based upon the following accounting equation: The balance sheet has three sections, each labeled for the account type it represents. Balance sheets can follow different formats, but they must list the three components of the accounting equation. The most common are horizontally and vertically structured formats. For investors, the vertical format is the easiest to read because it lists the results of multiple periods in columns next to each other. This equation—thus, the balance sheet—is formed because of the way accounting is conducted using double-entry accounting. Each side of the equation must match the other—one account must be debited and another credited.
The Balance Sheet and Other Financial Statements
Two other statements are vital to understanding a company’s finances. The income statement records the company’s profitability for the same period as the balance sheet. The income statement lists the business’s net and comprehensive earnings from all sources. For instance, Johnson & Johnson’s comprehensive income statement includes income from securities, derivatives, hedges, and employee benefit plans. The statement of cash flows is a record of how much cash is flowing into and out of a business. There are three areas on this statement—operating activities, investing activities, and financing activities. Each of these areas tells investors how much cash is going into each activity. Used together, these three sheets tell investors how a company is financed (debt or equity), how much cash or cash equivalents it has on hand available to manage its obligations, and how much income it is generating using its assets, equity, and debts.
What Does a Balance Sheet Tell You About a Business?
The balance sheet is an annual financial snapshot. It is also a condensed version of the account balances within a company. In essence, the balance sheet tells investors what a business owns (assets), what it owes (liabilities), and how much investors have invested (equity). The balance sheet information can be used to calculate financial ratios that give investors a general outlook for the company. Some companies use a debt-based financial structure, while others use equity. The ratios generated from analysis should be interpreted within the context of the business, its industry, and how it compares to its competitors.
Understanding the 3 Parts of the Balance Sheet
The three parts of a balance sheet follow the accounting formula. Assets are listed first, then liabilities, then equity.
Assets
The assets section of the balance sheet breaks assets into current and all other assets. In general, current assets include cash, cash equivalents, accounts receivable, and assets being sold. Cash equivalents are assets that a company can quickly turn into cash, such as Treasuries, marketable securities, money market funds, or commercial paper. Current assets are combined with all other assets to determine a company’s total assets.
Liabilities
The liabilities section is also broken into two subsections—current liabilities and all others. These two subsections are combined to calculate total liabilities. It’s common to see companies combine liabilities and stockholders’ equity into one section called Liabilities and Shareholder’s Equity.
Stockholders’ Equity
The equity section generally lists preferred and common stock values, total equity value, and retained earnings.
How to Read a Balance Sheet
While it is required for publicly-owned companies to list all assets, debts, and equity on their balance sheet, the way a company accounts for and records them varies. This can sometimes make it difficult to understand what is listed in each section. As an investor, it helps not to be concerned about how a company records transactions and defines assets; instead, focus on the information that is provided. Vertical balance sheets list periods (usually one year) vertically next to each other. This lets investors compare the different periods to help them determine what a company might be doing. For instance, Johnson & Johnson’s balance sheet for December 31, 2020, lists $174 billion in assets. In 2019, it recorded $157 billion—they acquired $17 billion in assets over that period. Most notably, cash and cash equivalents decreased over the period. Inventories increased, along with prepaid expenses and receivables. Property, plants, and equipment value increased, along with a significant increase in intangible assets, goodwill, deferred taxes, and other assets. Johnson & Johnson increased its liabilities to $111 billion, up from $98 billion in 2019. It seems that most of their liability increases have taken the form of long-term debt due in 2025, 2027, the 2030s, 2040s, and beyond. From this limited and brief analysis, an investor can see that Johnson & Johnson has total current assets of $51 billion and total current liabilities of $42 billion. If current assets are liquid assets, and current liabilities are debts due within one year, the company has more than enough to pay off its short-term debts—even with a reduction in cash and cash equivalents. This is known as the current ratio, a measurement used by investors to test short-term financial risk—to calculate it, divide current assets by current liabilities. In this case, Johnson & Johnson has a current ratio of 1.2. Some businesses have higher and lower current ratios, depending on how they are financially structured. Generally speaking, a company with assets and debt should have a current ratio of above 1 to stay afloat. Other useful ratios derived from the balance sheet include:
Quick ratio: (cash + cash equivalents + temporary investments + accounts receivable) ÷ current liabilitiesDebt-to-equity ratio: total liabilities / total stockholders’ equityWorking capital ratio: current assets - current liabilities
The Bottom Line
It can be easy to get confused when looking over balance sheets from different companies. It helps to read the corporate reports and the Form 10-K. The 10-K is required to be filed with the SEC and summarizes financial decisions, internal controls, investment strategies, and much more. These insights can give an investor an excellent idea of what is going on inside a company. The balance sheet is one of three required forms that are important when analyzing a company. It is helpful on its own, but it is hard to fully understand its financial performance without its associated statements and annual reports.
