Fundamental analysts, when valuing a company or considering an investment opportunity, normally start by examining the balance sheet. This is because the balance sheet is a snapshot of a company's assets and liabilities at a single point in time, not spread over the course of a year such as with the income statement.
The balance sheet contains a lot of important information, some of which are more important to focus on to get a general understanding of the solvency and business dealings of a company.
Key Takeaways
- A company's balance sheet is a snapshot of assets and liabilities at a single point in time.
- Fundamental analysts focus on the balance sheet when considering an investment opportunity or evaluating a company.
- The primary reasons balance sheets are important to analyze are for mergers, asset liquidations, a potential investment in the company, or whether a company is stable enough to expand or pay down debt.
- Many experts believe that the most important areas on a balance sheet are cash, accounts receivable, short-term investments, property, plant, equipment, and other major liabilities.
Why Balance Sheets Are Important to Analysis
They say that "the numbers don't lie," and that is true more for financial analysis than anything else. Balance sheets are important for many reasons, but the most common ones are: when a merger is being considered, when a company needs to consider asset liquidation to prop up debt, when an investor is considering a position in a company, and when a company looks inward to determine if they are in a stable enough financial situation to expand or begin paying back debts.
Many experts consider the top line, or cash, the most important item on a company's balance sheet. Other critical items include accounts receivable, short-term investments, property, plant, and equipment, and major liability items. The big three categories on any balance sheet are assets, liabilities, and equity.
Important Assets
All assets should be divided into current and noncurrent assets. An asset is considered current if it can reasonably be converted into cash within one year. Cash, inventories, and net receivables are all important current assets because they offer flexibility and solvency.
Cash is the headliner. Companies 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 raise a lot of red flags. However, some companies require little to no cash to operate, choosing instead to invest that cash back into the business to enhance their future profit potential.
Important Liabilities
Like assets, liabilities are either current or noncurrent. Current liabilities are obligations due within a year. Fundamental investors look for companies with fewer liabilities than assets, particularly when compared against cash flow. Companies that owe more money than they bring in are usually in trouble.
Items on the balance sheet are used to calculate important financial ratios, such as the quick ratio, the working capital ratio, and the debt-to-equity ratio.
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 usually considered equally as important, as debts and other types of liabilities must be settled before booking a profit.
Important Equity
Equity is equal to assets minus liabilities, and it represents how much the company's shareholders actually have a claim to. Investors should pay particular attention to retained earnings and paid-in capital under the equity section.
Paid-in capital represents the initial investment amount paid by shareholders for their ownership interest. Compare this to additional paid-in capital to show the equity premium investors paid above par value. Equity considerations, for these reasons, are among the top concerns when institutional investors and private funding groups consider a business purchase or merger.
Retained earnings show the amount of profit the firm reinvested or used to pay down debt, rather than distributed to shareholders as dividends.
The Bottom Line
A company's balance sheet provides a tremendous amount of insight into its solvency and business dealings. A balance sheet consists of three primary sections: assets, liabilities, and equity. There are several useful metrics or calculations that can help you demystify the information it contains.
Depending on what an analyst or investor is trying to glean, different parts of a balance sheet will provide a different insight. That being said, some of the most important areas to pay attention to are cash, accounts receivables, marketable securities, and short-term and long-term debt obligations.
FAQs
Many experts believe that the most important areas on a balance sheet are cash, accounts receivable, short-term investments, property, plant, equipment, and other major liabilities.
What are the main elements of a balance sheet? ›
A balance sheet typically includes the following items: assets (current assets and non-current assets), liabilities (current liabilities and non-current liabilities), and equity (common stock and retained earnings).
What is balance sheet answer key? ›
A balance sheet is a financial statement that contains details of a company's assets or liabilities at a specific point in time. It is one of the three core financial statements (income statement and cash flow statement being the other two) used for evaluating the performance of a business.
What is the main purpose of the balance sheet? ›
The purpose of a balance sheet is to reveal the financial status of an organization, meaning what it owns and owes. Here are its other purposes: Determine the company's ability to pay obligations. The information in a balance sheet provides an understanding of the short-term financial status of an organization.
What are the three main major parts of a balance sheet and which parts balance? ›
A business Balance Sheet has 3 components: assets, liabilities, and net worth or equity. The Balance Sheet is like a scale. Assets and liabilities (business debts) are by themselves normally out of balance until you add the business's net worth.
What is the most important thing on a balance sheet? ›
Many experts believe that the most important areas on a balance sheet are cash, accounts receivable, short-term investments, property, plant, equipment, and other major liabilities.
What are the three 3 key content features of a balance sheet? ›
A balance sheet is a financial statement that reports a company's assets, liabilities, and shareholder equity. The balance sheet is one of the three core financial statements that are used to evaluate a business. It provides a snapshot of a company's finances (what it owns and owes) as of the date of publication.
What is the key point of balance sheet? ›
The balance sheet provides information on a company's resources (assets) and its sources of capital (equity and liabilities/debt). This information helps an analyst assess a company's ability to pay for its near-term operating needs, meet future debt obligations, and make distributions to owners.
How to analyze a balance sheet? ›
The strength of a company's balance sheet can be evaluated by three broad categories of investment-quality measurements: working capital, or short-term liquidity, asset performance, and capitalization structure. Capitalization structure is the amount of debt versus equity that a company has on its balance sheet.
What are the keys to the balance sheet? ›
Key Takeaways
The balance sheet is split into two columns, with each column balancing out the other to net to zero. The left side records a firm's itemized assets, categorized as long-term vs. short-term. The right side contains a firm's liabilities and shareholders' equity, also separated as long-term vs.
The balance sheet provides a picture of the financial health of a business at a given moment in time — usually the end of a month or financial year. It can tell you if you owe more money than what you currently have, the current value of your assets and the overall value of your business.
What is the primary purpose of the balance sheet is to reflect? ›
The balance sheet reports the reporting entity's financial position by listing all its assets, liabilities, and net worth. It is the primary purpose of this financial statement to report the financial position, and it is prepared at a specific point in time.
What are the three most important financial statements? ›
The income statement, balance sheet, and statement of cash flows are required financial statements. These three statements are informative tools that traders can use to analyze a company's financial strength and provide a quick picture of a company's financial health and underlying value.
What are the main elements of the balance sheet? ›
The balance sheet lists everything that the company owns (its assets), everything that it owes (its liabilities), and shareholder equity. The difference between assets and liabilities is the equity in the company, which belongs to the owners.
What does a good balance sheet look like? ›
A balance sheet should show you all the assets acquired since the company was born, as well as all the liabilities. It is based on a double-entry accounting system, which ensures that equals the sum of liabilities and equity. In a healthy company, assets will be larger than liabilities, and you will have equity.
What are the main sections on a balance sheet? ›
A company's balance sheet is comprised of assets, liabilities, and equity.
What are the primary elements found on a balance sheet? ›
A company's balance sheet, also known as a "statement of financial position," reveals the firm's assets, liabilities, and owners' equity (net worth) at a specific point in time. The balance sheet, together with the income statement and cash flow statement, make up the cornerstone of any company's financial statements.
What five key components make up the balance sheet? ›
current assets, fixed assets, long term debt, shareholders equity and retained earnings.
Which of the following is an element of the balance sheet? ›
The balance sheet composes all assets, liabilities, and equity of the company. These components are the primary elements in the operation of the business.
