Balance sheet is a document which shows the status of a business in financial terms. It is a kind of a snapshot taken mostly at the last day of a financial period.
When reading the balance sheet an analyst must have in mind that the values given in the document may not represent the real value of the entity. Accountants, when preparing the document, could play with the numbers. For example they could value a building for 2 million dollars but in reality, when you go and try to sell it, you may not get the same amount. It could be lower or higher depending on the market conditions.
What I look in the balance sheet
Cash and equivalents
Good companies has plenty of cash, the opposite is a signal of a danger. Having lots of cash not always is a good sign, you have to find from where it is coming. It is a good sign only when the cash is coming from the operations of the business. Good companies have competitive advantage and have steady positive cash flows, I always look for such businesses. Be careful if the cash number is big and it is coming from:
If the number is small and the business barely keeps cash enough to manage its daily operations - it mostly mean that the business is in trouble.
- sale - like part of the business or a subsidiary;
- capital increase (asking shareholders to put more money into the business);
- bonds sale;
This records is not in my list of my favorites but it does not hurt to check it. You should be careful if the number is going up every period, it is a signal that the company can not collect the cash its clients owe it. It could be due to a bad period in the sector of its customers which could end with a bankruptcy for some of them or the company could be forced to make some discounts, in both cases it is bad for the business.
The inventory of a good company does not move up and down too much. If the number is going up every period, check how are the sales. If the sales are also going up it is a good sign, otherwise it is signal of a danger.
The type of the inventory is also very important. If the company produces food or fashion products, in any bad economic period the company may end up with a huge pile of unwanted inventory.
Property, plant and equipment
Good companies does not need replacement or upgrade of their equipment very often. Those who do may be hit on any bad economic cycle, because to stay competitive they have to invest no matter of the sales or economic conditions otherwise they will be swiped out by the competitors.
A good example of companies which need constant replacements are auto producers or manufacturers of memory chips like Micron. If you check their stock prices you will find big drops and bumps. Those type of companies could be bought only when the stock price is in the bottom and the net profits are mostly negative, not to mention that the stock purchase must be made very carefully because the company may not recover at all or stay low for a long period of time, let say for years. Good example for a such business is Opel which has not had positive profits for about 10 years in a row.
For some companies an increase in this record has huge reflection on the sales and earnings of the business.You should be able to calculate the earnings in the next periods or years looking at changes in this record value.
As Aswath Damodaran is saying, "the most useless record in the balance sheet". I compleatly agree.
It is important to understand what is hidden in this record. Mostly it is software, patent or brand value. It is hard to make an investment decision based on this value.
If the company has financial investments it is mostly a good sign. It means that the company instead of returning the cash to its shareholders, as dividends, it had saved the money wisely. In bad economic periods this money could help the company to sail without asking for extra cash its shareholders as many others do.
This record is a signal of a danger when it is going up each financial period and the sales and cash flows of the business are stable or negative. If the sales are going up, it is normal for the payables also to go up, it shows that the business is growing, I constantly look for such companies.
Short term debt
Debt is one of the most important records in the balance sheet if not the most important. Good companies have low or no debt and that is the kind of a businesses I am looking for. If the short term debt number is high it is a signal of a danger, it shows that the company is not trusted by the creditors and can not find long term debt.
Long term debt
It is good for a business to have no debt. the only case when it could be a positive sign is when the business is growing too fast and needs a lot of capital. In this case however you are betting that it will do well in the unknown future. It is very difficult to estimate the price of such a business. Investors like Warren Buffet try to stay away from such companies even if their sales are growing very fast.
This is maybe the most important record in the balance sheet after the net total debt. Good companies have huge amount listed under this title. Mostly a high positive retained earnings record is an indicator that the business has durable competitive advantage as Warren Buffet states it.
Some rations I use
Total Net Debt / EBIT
I prefer companies which could repay their debt in a year. If the business is growing too fast it may have a bigger number, my limit is 4, which means that the company should repay all its debt in 4 years.
Shareholders equity / Total Liabilities
I prefer companies with values above 1, higher the better.
Current Assets / Current Liabilities
It is important for this number to be above 1, companies having value below 1 may have issues in bad economic periods.
I prefer companies with growth above 20% a year.
Retained earnings growth
This number has to be growing with at least 20% and in synchrony with the net earnings figure. If there is a divergence you have to find the reason, mostly it is a bad sign.
Return on equity. I know investors who only check this number and make investment based on it. I rarely take investment decision based on ROE.
Return on assets. This is a number which Warren Buffet loves and is using a lot. It mostly works for companies which depend on the equipment they have. For businesses operating in the software industry mostly this record means nothing. Maybe that is why Warren Buffet stay away from them.
As a conclusion I could add that it is not possible to make an investment decision looking only at the balance sheet or the records for only one year or quarter period data. You have to further check other figures in the financial statement and look how they are changing for at least 5 years back.