Wednesday, September 14, 2011

Explanation of the Balance Sheet

The second financial statement that you'll encounter in the annual report is the balance sheet. The basic concept underlying a balance sheet is simple enough: total assets equals total liabilities plus equity. A lot of investors tend to focus on the
income statement, but the balance sheet is just as important a source of information. You can use the balance sheet to determine the firm's liquidity, to see how leveraged the company is, or just to see all the specific assets and liabilities of the company. The following list will teach you how to read a balance sheet and use the information from it to find out the company's current financial standing.
  • Current Assets are the first numbers you'll encounter on the balance sheet. Current assets are defined as assets that can or will be converted into cash quickly (generally within one year). Current assets include, of course, cash and cash equivalents (money market accounts, etc.), but it also includes the company's inventories (unsold stock) and its accounts receivable (uncollected bills from its debtors).
  • Current Liabilities are the opposite of current assets. They are the money that the company expects to pay out within the next year. Current liabilities include accounts payables (bills the company must pay), interest on long term debt, taxes, and dividends.
  • Non-Current Assets and Liabilities are assets that cannot be turned into cash quickly or liabilities that are not due for over a year, respectively. This includes assets such as the company's plants, property, and equipment, and liabilities like long-term loans.
  • Ratios and Other Calculations can be calculated to analyze the balance sheet, just like you can calculate several different types of margins to help you analyze a company's income statement.
  • Debt/Asset Ratio: The debt/asset ratio can show you what percentage of the company's assets are financed through debt. You can calculate it by taking total liabilities and dividing by total assets. If the ratio turns out to be less than one, then that means that most of the company's assets are financed through equity. If the ratio turns out to be greater than one, then the company is financing most of its assets through debt. Companies that have high ratios are said to be "highly leveraged." This means that they are carrying excessive amounts of debt and could be in danger if creditors start to demand repayment.
  • Current Ratio: The current ratio is the opposite of the debt/asset ratio: it takes the total number of current assets owned by the company and divides by its total current liabilities. If this number is greater than one, then the company has enough current assets to cover its short term liabilities. A number that is much higher than one, however, might indicate that the company is hoarding its assets instead of putting them to use. A number less than one indicates that the company may experience problems with liquidity.
  • Acid Test: The acid test ratio is similar to the current ratio except that it subtracts out inventory from current assets. To calculate this ratio, you take current assets minus inventory and then divide by current liabilities. The reason why the acid test disregards inventories is because in many industries inventory is not easily liquidated into cash; thus it can't be used to pay off short term debt.
  • Shareholder Equity: Shareholder equity is equal to total assets minus total liabilities. This number shows you what part of the company is owned by the shareholders after all of its obligations have been met.
  • Working Capital: Working capital is calculated by subtracting the firm's current liabilities from its current assets. This number shows you how much in liquid assets the company has available to build its business. The number can be positive or negative, depending on how much debt the company is carrying. In general, companies that have lots of working capital will be more successful since they can expand and improve upon their operations. Companies with negative working capital may lack the funds necessary for growth.
  • Turnover Ratio: The turnover ratio is used to determine how many times a company "turns over" its inventory in a given year. It is calculated by taking the cost of goods sold and dividing by the average inventory for the period. A high turnover ratio is looked upon favorably because it is a sign that the company is producing and selling its goods or services very quickly. A low turnover ratio indicates that the company has large warehouses of inventory going unsold for long periods of time.
  • Leverage: Financial leverage is a measure of how much debt the company has assumed in order to finance its assets. It is calculated by dividing the amount of long-term debt carried by the company by the company's total equity. Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be unable to find new lenders in the future. Leverage is not always bad, however; it can increase the shareholders' return on their investment and often there are tax advantages associated with borrowing. The important thing is to be able to differentiate between a healthy amount of debt for good purposes and too much debt for questionable purposes.
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