Financial Analysis of the Balance Sheet (Part II)

In my previous article, I teased you with two items from the balance sheet and how to interpret them (darn 1200-word limit).  It’s okay though because I am back to teach more about the balance sheet and how to interpret it (I know, such a relief).  Well, no words to waste today, only stick around if you really want to learn this time.

Remember, every line item I am using is talking about how to analyze and interpret the numbers on the balance sheet in a general way.  All analysis must be conducted in comparison to other similar companies; these numbers do not mean much in a vacuum.  We can also compare the numbers in relation to the same companies previous years, which is what I will be doing in this article since I am not currently using real companies.  Also, another very important factor is the industry of the particular company.  A technology company’s financial statements will indubitably have different interpretations attached to the numbers compared to a financial company. Here are a few line items that you will find on the balance sheet and how to interpret them when you are analyzing potential investments.

Short Term Investments:

Short term investments are under the current assets section of the balance sheet.  Normally, companies that have a strong cash position will also have a section of their balance sheet that they use for short-term investments.  In the previous article, I said how having too much cash on your balance sheet can actually be a bad thing because it is not generating a return for the company.  Well, this is where short-term investments come to play because instead of a company having cash sitting around collecting dust, they can invest in short-term, extremely liquid securities that generate a small return. 

You may be saying, “What’s the point of a .2% return?”  Well, a .2% return on $5 billion for 90 days is enough to buy you lunch for the next 5 years.  Therefore, we would like to see short-term investments used more frequently than large cash positions, simply because the company has liquidity and their money is not collecting dust.

Prepaid Expenses: 

You’re scared of dying right?  No?  If you have any sense of your own mortality, then you probably have some form of insurance.  Whether it is dental or home insurance, insurance is something that is considered a prepaid expense.  Basically, you pay some expense now in order to receive the goods or services at some future date.  This makes a prepaid expense an asset because you’re owed something, and if it isn’t provided then you get your money back.  Prepaid expenses can be a sign of a company’s financial health because they are able to pay their expenses early, rather than putting them off for long periods of time. 

Since prepaid expenses are an asset, as the firm receives the good or service, the prepaid expense goes down on the balance sheet and is expensed on the income statement. You may be saying, “Why are the expenses recorded on the income statement after the benefit is received, rather than when the payment is made?  Wow, you ask super interesting questions.  This phenomenon is called the matching principle, which states that expenses should be recorded during the period in which they are incurred, regardless of when the transfer of cash occurs.  Therefore, in the accounting world, it becomes an asset when a company pays for a good or service before they receive the benefit from that payment. They only incur an expense when they receive what they paid for.  Prepaid expenses can be a sign of a company’s health, but it’s important to follow where the money is really going.  If a company has a lot of prepaid expenses, it will bring their future earnings down once they receive the goods or services they have paid for.  A prepaid expense shouldn’t be looked at as an item fundamentally different than a normal expense; they are simply paid beforehand.

Goodwill:

What’s the value of McDonald’s Golden Arch brand?  Or the NBA’s logo of Jerry West dribbling?  Is it the value of the material it’s made on, or is it worth much more?  Any rational person would say that these items are worth much more than the material they’re made on.  These are examples of intangible assets.  Goodwill arises when a firm acquires another firm and pays a premium over the fair market value of the assets and liabilities of the company.  Essentially, the company pays more money to buy a company because there have valuable customer relationships, a popular brand name, proprietary technology, or anything else of that nature that is valuable beyond the fair market value of the assets.  Therefore, if a company pays $400M for another company that has the assets valued at $300M, then the acquirer will have $100M of goodwill on their balance sheet.  Goodwill is difficult to analyze because it’s extremely subjective to how the company values it.  Goodwill isn’t amortized over time; instead, it is reviewed annually to see if it needs to be written down. 

As an investor, you need to be careful with a company that has a lot of goodwill in relation to their overall assets. If they originally overvalued their goodwill and then they have to write it down, it will undoubtedly reduce the value of the company.  On the other hand, investors can see goodwill as a positive item because that company is supposedly receiving some intangible benefit from their acquisition of a company.  If a company is really making acquisitions of companies that are way more valuable than their assets imply, maybe the company is making positive decisions and synergizing their company correctly!  The only way to know is to dig into the historical 10-k’s, decipher the acquisitions, and decide if that logic has come to fruition since the purchase.

Inventory:

Inventory, as boring as it sounds, is actually an interesting item to analyze on the balance sheet.  Inventory is recorded on a cost basis rather than a market value which means that what you see on the inventory item is what the company paid to receive it.  Inventory is listed under the current assets portion of the balance sheet and it goes hand in hand with the cost of goods sold, which is on the income statement.  We can actually figure out the cost of goods sold by knowing the method of accounting that inventory is under (LIFO, FIFO, weighted average) and by checking the difference between inventory levels between different accounting periods. 

Inventory is something that investors need to keep a close eye on because too much inventory can result in cash flow problems and too little inventory can result in the company not being able to meet the demand for their product (looking at you, Tesla).  If you really want to have a deep understanding of how a company is managing their inventory then you need to learn LIFO, FIFO, and weighted average methods and which one the company is using.  Unfortunately, my 1200 words are almost up again.

As you can probably see by now, performing any analysis is extremely subjective because analysis implies taking objective information and applying your own thoughts to them.  Therefore, you can have two identical companies, but two educated people will have wildly different opinions about what the data means.  It takes practice to properly interpret what you are seeing. The first step before practice is being able to understand what the data means in an objective manner, which is why you love reading my articles.