Financial Analysis of the Balance Sheet (Part 1)
If you are like me, then doing your own proprietary research to formulate your own ideas sounds fun to you. If that sounds as far away from the real you as can be, then you’re probably similar to the majority of humans on this planet (must be nice). However, being different from the majority definitely has a few perks. Outside from the obvious perk of being a blast at parties, being different gives me the opportunity to source information about companies that the majority wouldn’t ever bother to look for. For example, if you go to any financial website that allows you to look up companies, you’ll see a bunch of ratios and statistics about the company. You might see a rating from “experts” and a nice little chart that shows you what you would’ve made if you invested $10,000 over a 10-year span. These are unarguably helpful tools that everyone should look at. The main problem is that’s where most investors stop. Investors see the front page financials and statistics of companies that are provided to the whole public and throw their money at these stocks, not realizing that they have no competitive advantage because anybody can do the exact same thing.
Separation for the investor happens when an investor does their own proprietary research and due diligence to form their own analysis of a company, rather than blindly trusting “expert” analysis that millions of people can read. However, to be able to perform proprietary research and due diligence, one must have the proper knowledge and tools to do so. This is where financial analysis comes into the picture, and to give a real world example, we are going to use Apple Inc.’s financial statements as our company of analysis in later articles. Once we have a solid understanding of what all the financial statements mean and how they operate, then we will do an actual analysis to see how the knowledge is applied.
The Balance Sheet and What it Means:
The only way we can conduct a proper analysis of Apple’s balance sheet is to first make sure that we understand what a balance sheet is and what a balance sheet is not. A balance sheet is a snapshot in time of a company’s financial history. For all companies, the balance sheet has been a since the inception of the company. Think of the balance sheet as a very deep water hole. At any point in time, you can always see how much water is in the hole and you can remember if the hole is fuller or less full than last time. This is important because the income statement and cash flow statements are the buckets of water that either deposit more water into the hole or take water out. The water hole is representative of all the previous buckets of water that either added or subtracted from the hole.
Now that we know what a balance sheet is in relation to a company, we need to know what it tells us. The balance sheet has a bit of intuition behind the name because ultimately, it has to balance (surprising, right?). The identity of a balance sheet goes as follows:
Assets= Liabilities + Shareholder’s Equity
Or, if this is a more intuitive way of thinking about it for you:
Assets- Liabilities= Shareholder’s Equity
No matter how you manipulate or rearrange the identity, there’s one thing that is very clear from looking at this. Whatever affects assets has to affect either liabilities and/or shareholder’s equity. An asset is anything that is in your control to make decisions with or that is owed to you that you can reasonably expect to provide you with some future benefit. Let’s take a look at some common assets on the balance sheet and see what they can tell us from a financial analysis standpoint.
Cash or Cash Equivalents:
The general thought when the word cash is used in a business is that more always equals better. While this may be the case in the actual operations of the business, it is not always the case when there are piles and piles of cash on the balance sheet. Cash is normally the first item at the top of the balance sheet. Probably because cash is the most fundamental aspect of business and it is the single necessity that any company needs to continue operations. The difference between a lot of cash coming from the operations of the business and a lot of cash on the balance sheet is that cash sitting on the balance sheet is not making any money. Of course, having ample cash on hand to cover short-term liabilities is essential, and the purpose of having cash on hand. However, there is a certain amount that might be considered too much and it might be viewed as an inefficient way to use the cash. As like most things in finance, the line where there is enough cash on the balance sheet to too much cash on the balance sheet is extremely subjective. This is why investing is an art, instead of an exact science!
An account receivable is essentially when a company has earned the right to compensation for goods or services that it has already provided, but it has yet to be paid. A high number of the accounts receivable line can be a red flag that a company is struggling to collect what it’s owed. However, a low number of the accounts receivable line can mean that people are not buying the products and it could be an indicator of low future cash flows. How do we tell if a number is high or low? The first way is to compare these numbers to close competitors of the company. If we are analyzing company X and their accounts receivable is 100% higher than their closest competitor Y, we would have to do some deep digging as to why there is such a discrepancy between the two. The second way we can analyze the size is by comparing it to previous years. If there is a large fluctuation from the average accounts receivable year-over-year, then it might be cause for concern. Did the company suddenly get extremely good at collecting what it owed? Or did they write the accounts receivables off as uncollectable? This is where the analysis begins to go beyond the simple numbers.
Analyzing the balance sheet of a company is one step out of a copious amount of possible steps that can be taken towards analyzing a company to see if it is a sound investment. Ultimately, the only way to get a competitive advantage when it comes to investing is to be consistently lucky or to have better information on a consistent basis. The best way to get consistently better information than the rest of the crowd is to conduct your own analysis. Great information that is shared with everyone doesn’t give you a competitive advantage; it just makes you another one of the crowd.