How To Read a Balance Sheet To Guide Your Investment Decisions
A balance sheet is one of many financial documents that publicly traded companies are required to file with the government and make available to investors. At its most basic level, a balance sheet can help you gauge a company’s ability to pay for its near-term operating needs, meet future debt obligations and make distributions to owners.
How a Balance Sheet Works
A balance sheet is comprised of three different parts: assets, liabilities and shareholders’ equity. Assets reflect what an entity owns, while liabilities reflect what it owes. The equity section reflects the amount of money invested in a business. All provide indicators of a company’s financial health. Here’s a further breakdown of each category:
3 Aspects of a Balance Sheet
- Assets: These typically include items like real estate, machinery, patents, inventory and accounts receivable. Assets are broken down between current assets, which are items a company expects to convert to cash within the next year — e.g. accounts receivable and inventory; and noncurrent assets, which are items that aren’t expected to be converted to cash within a year, such as buildings and machinery.
- Liabilities: A liability is any expense the company is obligated to pay. It typically includes mortgages, accrued taxes, purchases, loans and accrued employee salaries and benefits.
- Shareholders’ equity: Shareholders’ equity equals assets minus liabilities. If all of the assets could be sold for book value, owners’ equity is the amount that the owners or shareholders of the company would receive after paying off all debts.
A single balance sheet shows you a company’s financial position at a specific moment in time. But as an investor, you should compare different balance sheets to see how that position has changed over time.
Signs of a Weak Balance Sheet
When a company is struggling financially, you can usually find evidence of it in the balance sheet. Here are some things to look for:
- Negative or deficit retained earnings: Retained earnings represent a company’s cumulative net income. When the balance is negative, it might indicate accounting losses over a prolonged period.
- Negative equity: Negative equity occurs when a deficit in the retained earnings surpasses the company’s total amount of capital, which is a red flag showing that the company is in distress.
Signs of a Strong Balance Sheet
A balance sheet also can let you know when a company is doing well. Here are a couple of key indicators of strength:
- High cash and short-term investment balances: If you see large amounts of cash and short-term investments such as certificates of deposit or Treasury bills, it usually means the company is in a strong financial position, with plenty of liquidity to cover current liabilities.
- Low or zero long-term debt: Companies that aren’t saddled with a lot of debt are usually in a good position to invest in growth.
The Bottom Line
Balance sheets can’t tell you everything about a company. For that, you’ll have to look at other financial documents like the income statement, cash flow statement and statement of shareholder’s equity. But a balance sheet can give you a decent snapshot of a company’s overall financial condition. Just remember to compare different periods to get the best indication of how the company has performed over the course of a few years.
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Michael Keenan contributed to the reporting for this article.
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- Latham & Watkins LLP. 2021. "Guide to Financial Statement Requirements in U.S. Securities."
- CFA Institute. "Understanding Balance Sheets."
- New Jersey Society of CPAs. 2020. "Understanding the Balance Sheet."
- The Street. 2020. "How To Read a Balance Sheet and a Company's Finances."