How to Read a Balance Sheet

A balance sheet reports what a company owns, what it owes, and what is left over, at one moment in time. That last part matters more than it sounds. The income statement covers a period, three months or a year of activity. The balance sheet covers an instant, the final day of that period. It is a photograph, not a film, and a company can look different the day before and the day after.

The name comes from the identity the statement is built on: assets equal liabilities plus equity. It always balances, by construction. A balanced balance sheet is not evidence of anything. It is arithmetic.

Assets: what the company controls

Assets are split by how quickly they turn into cash.

Current assets are expected to convert within a year. Cash and equivalents sit at the top. Accounts receivable is money owed by customers for goods already delivered. Inventory is goods made or bought and not yet sold.

Non current assets are the long lived items. Property, plant and equipment covers land, buildings and machinery, reported at cost minus accumulated depreciation rather than at what it would fetch today. Intangibles cover patents, trademarks and capitalised software. Goodwill is its own category and is discussed below.

Two current asset lines carry disproportionate information when read against revenue growth. If receivables are growing considerably faster than sales, the company is booking revenue it has not collected, which can mean loosened credit terms or customers in difficulty. If inventory is growing faster than sales, goods are accumulating rather than moving. Neither is conclusive alone and both are visible without any specialist knowledge.

Liabilities: what the company owes

Split the same way. Current liabilities come due within a year: accounts payable owed to suppliers, short term borrowings, and the portion of long term debt maturing inside twelve months. Non current liabilities are the longer dated obligations, chiefly long term debt, lease obligations and pension commitments.

The maturity profile is worth more attention than the headline total. A company with substantial debt maturing in seven years is in a different position from one with the same amount maturing in seven months, and the two look identical if you only read the total.

Equity: the residual

Shareholders equity is assets minus liabilities. It is not a valuation and it is not cash. It is what the accounting says is left if everything on the books were realised at book value, which is not what would actually happen.

Retained earnings sits inside equity and accumulates profits not paid out as dividends. A large retained earnings figure is not money sitting anywhere. It was spent on assets, used to repay debt, or held as cash, and the balance sheet says which.

Goodwill, and why it deserves separate attention

Goodwill appears when a company acquires another and pays more than the fair value of the identifiable assets. The excess has to go somewhere on the books, and goodwill is where it goes.

It is an asset that produces nothing directly and cannot be sold separately. When an acquisition does not perform as expected, the company writes goodwill down, which lands as a large non cash charge on the income statement. Companies that have grown mainly by acquisition often carry goodwill worth a substantial share of total assets, and that is a structural feature of the business worth knowing about before a writedown reveals it.

Three ratios that come straight off the page

• Current ratio. Current assets divided by current liabilities. Describes whether short term obligations are covered by short term resources. Below one is not automatically alarming: some business models collect from customers before paying suppliers and run there permanently.
• Debt to equity. Total debt divided by shareholders equity. Only comparable within an industry, since capital structures differ enormously between, for example, software and utilities.
• Book value per share. Equity divided by shares outstanding. Most useful for asset heavy businesses. For a company whose value is largely in people, brands and software written off as incurred, it undercounts substantially.

What the statement cannot tell you

Historical cost is the biggest limitation. Land bought decades ago sits at the price paid, which may bear no relation to current value. Internally developed brands and technology are largely absent, because the costs were expensed as they occurred rather than capitalised. A company can therefore be worth far more, or far less, than its balance sheet suggests, for entirely legitimate accounting reasons.

And the date is a real constraint. Quarter end figures are one day out of ninety, and a company that ends the quarter with an unusually strong cash position did not necessarily hold that position throughout it. Reading several consecutive balance sheets rather than one is the ordinary way around this.

One statement of three

The balance sheet is one of three statements and it answers only one question, about position. The income statement covers performance over a period and the cash flow statement covers movement of actual money. The gap between reported profit and cash generated is covered in cash flow vs profit, and the wider discipline this all belongs to is in what is fundamental analysis.

Fundamentals are one of the dimensions EquityBias reads per covered stock, alongside price behaviour, analyst activity and news sentiment. Where those four disagree, the disagreement is reported as divergence rather than averaged into a single number. Current readings by sector are in the coverage directory.

EquityBias is a market data research tool. Nothing here is financial advice. Financial statement figures are historical and do not indicate future performance.