Publicly traded companies are required to release a range of financial statements that detail how the company is doing. The balance sheet is one of four main financial documents, the others being the income statement, cash flow statement, and the statement of shareholder’s equity. Although it won’t tell you everything, the financial statement is a great place to start when looking into whether a company is a good investment opportunity for you.
What Is a Balance Sheet?
The balance sheet is divided into three categories:
- Assets: This includes everything the company owns, such as real estate, machinery, patents, inventory and accounts receivable. Types of assets include current assets, which are things a company expects to convert to cash within the next year like most accounts receivable or inventory, and noncurrent assets, which are things that aren’t expected to be sold within a year, such as factories or real stores that are owned by the company.
- Liabilities: A liability is any expense the company is obligated to pay, such as mortgages, accrued taxes, purchases, and accrued employee salaries and benefits.
- Shareholders’ equity: Shareholders’ equity equals assets minus liabilities. Essentially, if all of the assets were sold for book value, owners’ equity is the amount that the owners or shareholders of the company would receive after paying off all debts.
Balance Sheet Purpose
The balance sheet for a company shows you the company’s financial situation at one moment in time. However, even though a balance sheet shows a company’s assets and liabilities at a single moment, you can use multiple balance sheets to see how a company is changing over time. For a balance sheet example, you could compare last year’s balance sheet to this year’s to discover how much debt the company has paid down or taken on, and how that correlates with a change in the assets of the company.
Similarly, if you saw that last year’s balance sheet showed only $100,000 of inventory, but this year’s showed $2.5 million, that could raise concerns that the company’s products just aren’t selling. Of course, there could also be other explanations, such as the company is now gearing up for a massive launch of a new product, and it has a large inventory to make sure it can meet consumer demand.
Limitations of Balance Sheets
Balance sheets can’t tell you everything about a company. For example, most assets aren’t updated to their fair market value. So, a company might have real estate on their books valued at $1,000,000, but if the company has owned that land for 20 years, it could be worth double or triple what they paid for it.
The balance sheet also doesn’t tell you the company’s profit or loss. For example, even if the retained earnings went down, that could mean the company is losing money, or it could mean it paid a large dividend to shareholders. To determine whether the company is making or losing money, you need to look at the income statement.
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