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Investing 101: Breaking Down the Balance Sheet

Each year, a public company will publish its annual report. This details how the company performed in the previous twelve months, who runs the company, and the future outlook for the firm. In many cases, a company also publishes a quarterly report, or a bi-annual report. While some investors may spend their time reading general information about the business, most will scroll straight to the nitty-gritty three main financial statements - the income statement, the balance sheet, and the cash flow statement. These three each offer "different information but remain interconnected; altogether they complement each other and provide a comprehensive view of a business." In this Investing 101 article, we're going to focus on the balance sheet - what it is, what it tells us, and why it's important.





The Balance Sheet


The balance sheet acts as a snapshot of the financial position of a company at a given point in time. If it is featured in an annual report, it will most likely reference the financial position of the company at the year-end (31st December). It is divided into three main sections - assets, liabilities, and shareholders' equity.


Assets


Assets are valuable resources owned by a firm that can be valued. A company can own physical assets such as property, equipment, and machinery. However, it may also own intangible assets - these include things like trademarks, copyrights, and brand names. If a firm has cash, this is also counted as an asset on the balance sheet.


The Assets section of a balance sheet is divided into current assets and non-current assets. The idea behind this may seem confusing, but in reality, is quite simple: assets are listed on a balance sheet based on their liquidity (how quickly they can be converted into cash). Current assets are those that can be expected to be converted into cash/sold within one year, whereas non-current assets are less liquid. An example of a current asset is stock inventory, while a non-current asset could be a factory or other property.


"Since non-current assets have a useful life for a very long time, companies spread their costs over several years. This process helps avoid huge losses during the years when capital expansions occur. Both fixed assets, such as PP&E, and intangible assets, like trademarks, fall under noncurrent assets."



Liabilities

Liabilities on a balance sheet are defined as " something a company owes to another business, usually a sum of money." In short, liabilities are what the business owes to others. This can be money (debt) that was borrowed from a bank for financing a new project or development, rent due for a property, payments to suppliers, etc.


"The liabilities are essentially any outstanding obligatory payments that the company has."


Generally speaking, as shown below in the illustration, liabilities are listed according to their due date. Current liabilities are those which are due within one financial year, while long-term liabilities are those which may be paid off over a longer time frame.





I can hear you crying out for a real-life* example of a liability, so here goes:


Your local McDonald's joint is sent 150,000 sesame-seeded burger buns each week by its supplier (in this example, the supplier is Kingsmill Bakery). This is a regular delivery that arrives every single week without fail, on a Monday morning. Each time the vast amounts of buns are delivered, the Kingsmill lorry drivers do not demand payment from McDonald's. Rather, it will invoice the fast-food chain for the purchase to streamline the dropoff and make payment easier for McDonald's.


The outstanding money that Ronald McDonald owes to Kingsmill is considered a liability. On the other side of the transaction, Kingsmill considers the money it is owed to be an asset (accounts receivable).


*Please note that, in the example above, all figures and deals are purely fictional.


Shareholders' Equity


The final section of the balance sheet concerns shareholder equity. If all assets were sold and all liabilities were fully paid off, the shareholder equity would be the remaining amount. It details the company's retained earnings and the capital that has been contributed by shareholders. The key accounting formula of the balance sheet is Assets = Liabilities + Shareholders’ Equity [3]. While the balance sheet displays the assets, liabilities and shareholders’ equity at certain time period, it does not show the flows in and out of the company’s accounts for the duration of the period, which is why it is important to take a look at the other statements.



Frequently Asked Questions About The Balance Sheet


Q: Why is it called a balance sheet?

A: The balance sheet is named in such a way because it is equal at all times. The common formula for a balance sheet is as follows:


Total Assets = Total Liabilities + Shareholders' Equity


Whether the balance sheet in question is a quarterly, bi-annual, or annual one, the top half (Assets) will always be equal to Liabilities and Shareholder Equity.


Q: Can a balance sheet be unbalanced?

A: Following the principle above, no, a company balance sheet cannot be unbalanced (unless there has been a mistake made in the calculations). Why is this? Well, let's use an example:

I want to buy a house that costs £500,000. To fund the purchase, I might use a £250,000 loan (debt) and £250,000 cash (equity). Once bought, I now have a £500,000 asset (the house), £250,000 in liabilities (debt), and £250,000 in equity. As always, when combined, the latter two are equal to total assets.



Q: What makes a balance sheet strong or weak?

A: A company in a strong financial position will tend to have more total assets than total liabilities. However, on a deeper level, a robust balance sheet will show:

- good working capital (a positive difference between current assets and current liabilities). To measure this, one could use the Current Ratio - a liquidity ratio that measures a company’s ability to pay short-term and long-term debts. The formula for this is as follows:


Current Ratio = Current Assets / Current Liabilities

- a low debt/equity ratio - while it depends on the type of company/industry, a company with a higher debt/equity ratio tends to be in a weaker financial position, as it needs to fund its operations through borrowing.

- a high return on assets - this is a whole other conversation, and so, for a simple summary, check out Investopedia's article here.



Final Thoughts


The balance sheet is fundamental to understanding the inner financial workings of a company. Is it borrowing large amounts of money? Are its assets growing each year? However, analysts know that the balance sheet alone does not tell the full picture - it should be reviewed in conjunction with the income statement and the cash flow statement. Together, they form a sort of holy trinity that will allow you to learn more about how a company operates.




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