Ten Things You Need to Know About Every Balance Sheet
By Tina Orem
Sometimes income statements seem to get all the attention in the financial world, leaving the balance sheet and the cash flow statement looking like ugly stepsisters. But with a little knowledge about how balance sheets work, you can gain -- and offer -- insight that the P&L-obsessed mobs might otherwise overlook. Here are ten simple things you should learn about balance sheets.
The Balance Sheet Needs to Balance.
The balance sheet has two sides: assets (or "the left side of the balance sheet") and liabilities plus shareholders' equity (or "the right side of the balance sheet"). Both sides have totals, and those totals must equal -- or balance. Balance sheets that don't balance are balance sheets with math errors.
The Balance Is a Snapshot, But Not Necessarily a Current One.
The balance sheet lists the value of all of company's assets, liabilities, and shareholders' equity, but those values hardly ever reflect what those things are worth right now. Rather, things generally go on the balance sheet at book value -- that is, their original cost -- and they usually stay that way. Companies do deduct the accumulated depreciation on the assets on their balance sheets, but the resulting "net book value" numbers hardly ever reflect what the company could get for the assets if they were sold today.
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The Balance Sheet Reveals a Company's Baggage.
A key part of the balance sheet is something called retained earnings. This number, shown down in the shareholders' equity portion of the statement, is the sum total of the company's profits since inception. The size of that number says a lot, relative to the size of the company. A long history of losses can offset years of profits, making for a paltry retained earnings number. So even if a company may be going gangbusters right now, a negative or barely positive retained earnings number suggests that the newfound prosperity may have been a long time coming.
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The Balance Sheet Reveals How Much Skin Is In the Game.
The shareholders' equity section also contains a line called additional paid-in capital ("APIC") -- a measure of how much money investors have pumped into the company since inception in return for equity. That's not something anybody can see on the income statement or the cash flow statement, but it's important if you want to know how much shareholders have paid to play and want to ponder whether management has used that money wisely.
The Balance Sheet Shows Who the Company Owes, and Who Owes the Company.
Although the income statement and the cash flow statement reflect the debt payments a company may have made during a certain period, these statements don't tell readers how much the company owes in total -- or who the company owes. They also don't indicate whether or how much the company is owed from customers or other entities.
The Balance Sheet, In Its Own Way, Can Answer the Question, How Do They Do It?
Although no one financial statement reveals the "secret recipe" behind a successful company, it does give readers a broad sense of what a company uses to produce revenue and thus generate cash. The balance sheet indicates what types of assets a company is employing and whether the company has borrowed money to pay for those assets. This is crucial for determining how effective and efficient the company's management is -- after all, companies that generate a heap of cash off of a tiny asset base tend to have more compelling stories than companies generating but a trickle off of a bloated asset empire.
The Balance Sheet Indicates Who the Owners Are Going to Be If the Company Gets Into Trouble.
Remember, when a company hits the skids and has to liquidate, the bondholders and other lenders get first dibs on the cash. This gives them far more influence over what happens during bankruptcy proceedings, mergers, and other high-stress situations. It's also not uncommon for bondholders to covert their debt to equity (thus becoming shareholders) and becoming "the boss." By virtue of disclosing who the lenders are and how much they're owed, the balance sheet is a display of the pecking order.
A Series of Balance Sheets Sheds Light On How a Company Has Brought About Change.
It's one thing to say that a company's new widget is a marketing success and is generating a lot of profit. But the balance sheet gives a lot of clues about how the company pulled it off financially. Did the company purchase a ton of assets, or did that new product come with very little new investment? Did the company have to borrow millions? Or did the shareholders pay for it? When the investor looks at changes in the balance sheet over time (that is, the investor compares the balance sheet from one period to the next, and so forth) the balance sheet gives the answers.
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The Balance Sheet Gives an Indication of a Company's Value, But It Does Not Offer the Indication of the Company's Value.
The Balance Sheet Predicts the Future... Sort Of.
Both the assets and the liabilities section of the balance sheet are broken into "current" and "long-term" categories. Assets that can be converted to cash in less than one year are considered current assets. The rest of the assets are considered long-term. Likewise, liabilities that must be paid within the next year are considered short-term liabilities and are considered current liabilities. The rest are long-term. By looking at the current assets and the current liabilities, the reader can get a sense of what cash should be coming in during the next year and what cash will be going out.