Stock Investing: Fundamental Analysis Using Company’s Balance Sheet
What if you find out that the company you have invested in has filed for bankruptcy because of heavy debt the company had? How much debt and shareholder equity do companies like Johnson & Johnson, Proctor & Gamble, Coca-Cola, Texas Instruments have? Do you want to be a well-informed investor so that you can identify and invest in companies that can endure a severe but temporary downturn in its business, provide steady returns on assets, and are low on debt?
In this article, I will explain how you, as an investor, can make use of an important financial statement called a balance sheet to get an insight into the company’s financial health. In my previous article, I explained how to analyze a company’s profitability using an income statement. Here, I will discuss about how you can combine that analysis with the insights obtained from understanding the key parts of a balance sheet to find good stable businesses that you can hold for the long term.
Key Parts of a Balance Sheet
To put it simply, the balance sheet tells you what a company owns, what it’s borrowing, and where it gets the money to keep itself in operation. Thus, you can think of the balance sheet as a snapshot of what a company is worth on a given day.
Note: The balance sheet is also known as the “statement of financial condition”
The fundamental building block of the balance sheet is:
Assets = Liabilities + Equity
- Assets: Things a company owns which are expected to provide future benefits.
- Liabilities: Things a company owes.
- Equity: Assets minus liabilities at a specific point in time equals equity. It represents the part of the company that is owned by shareholders, thus, it’s commonly referred to as shareholders’ equity. It is also referred to as net assets, or net worth.
Important Point: One of the most important things to understand about the balance sheet is that it must always balance. Total assets will always equal total liabilities plus total equity.
Lets dig deeper into the various parts of a balance sheet with an example. In fig.1 below, I use the assets section of Johnson & Johnson (Ticker: JNJ) balance sheet for the years 2013–17.
Covering your bases with assets
Current assets: A company’s current assets are things it owns that could theoretically be sold for cash within a year. These are things the company can tap reasonably quickly to meet immediate cash obligations.
- Cash and Cash equivalents: Generally, cash is held in low-risk, highly liquid investments such as money market funds which can be liquidated quickly with little or no price risk. This is considered money that can be used for any purpose the company wants.
- Short-Term Investments: This represents money invested in bonds or other securities that have less than one year to maturity and earn a higher rate of return than cash.
- Accounts Receivable: Think of receivables as bills that a company sends its customers for goods or services it has provided but for which the customer has not yet paid but is expected to pay within the next year. In other words, these are sales (found on the income statement) that haven’t been paid for yet with cash.
Tip: If accounts receivable are growing much faster than sales, it generally means a company isn’t doing a good job collecting the money it is owed. This could potentially be a sign of trouble because the company may be offering looser credit terms to increase its sales, but it may have difficulty ultimately collecting the cash it’s owed.
- Inventories: This is the money spent by a company to accumulate the things it plans to sell. There are many different types of inventories, including raw materials, partially finished products, and finished products that are waiting to be sold.
Tip: The value of inventories shown on a company’s balance sheet should be taken with a grain of salt because of the way inventories are accounted for. If inventory levels are growing much faster than a company’s sales, it may be making or buying more goods than it can sell. That may force the company to lower its prices, which results in lower profits for each item sold and lower profitability for the company. In some cases, it may have to reduce prices to levels below the value of the inventory itself, resulting in losses.
Additionally, inventories tie up capital. The cash that was used to create inventory can’t be used for anything else until it’s sold. Thus, you should also monitor how fast a company is able to sell its inventory.
- Other Current Assets: These include other assets the company may have that are expected to turn into cash within the next year. However, some current assets will not turn into cash, the most common of which are known as prepaid expenses. Note: Even though it’s called prepaid expenses, it’s actually an asset. If a company pays a bill ahead of time, it has a credit with the supplier or merchant. That credit is an asset, because it reduces what the company must spend in the future.
- Long-Term Investments: This is money invested in either bonds with longer terms than one year or the stock of other companies. These aren’t as liquid as cash and short-term investments, and prices may fluctuate, so it’s possible that the value shown on the balance sheet may be too high or too low.
Tip: If it’s a big enough balance, you may want to dig into the details to make sure you’re comfortable with the kinds of risks the firm is taking with shareholders’ money.
- Property, Plant and Equipment (PP&E): Assets that cannot be turned into cash in a year are called long-term assets which includes PP&E. These assets include buildings and other machinery and computers a company might own.
- Goodwill and Other Intangible Assets: Intangible assets are the ones that can’t be touched and are generally not going to turn into cash. The most common form of intangible assets is goodwill. Goodwill is formed when one company buys another and pays more than the target company is worth.
Tip: You should view goodwill with high levels of skepticism because most companies tend to pay too much when making acquisitions. Therefore, the value of goodwill that shows up on the balance sheet is often higher than what the intangible assets are really worth.
Getting in touch with a company’s liabilities
Fig.2 below shows the liabilities & shareholder’s equity section of Johnson & Johnson (Ticker: JNJ) balance sheet for the years 2013–17.
Current liabilities: These are bills that are due within a year’s time.
- Accounts Payable: Accounts payable represents bills the company owes for goods or services it hasn’t paid for yet. Note: If a company can postpone paying what it owes for a longer period of time, without getting in trouble, it will hold on to its cash for a longer period of time, an advantage for cash flow.
- Short-term debt: This refers to money the company has borrowed for a term of less than one year.
Tip: The amount of short-term borrowings is an important figure, especially if a company is in financial distress or pays a high dividend, because the entire amount must be paid back relatively quickly, leaving little wiggle room.
- Current portion of long-term debt: This is the portion of the long-term debt that is generally due within a year.
- Long-term debt: Since the costs of starting and maintaining a business are massive, you should closely monitor the company’s long-term debt. This is because if the company is unable to pay the debt, the company may default.
- Other long-term liabilities: These are liabilities due in more than a year, that don’t fit in any other categories.
Curious Note: These liabilities are provided in a detailed breakdown in the company’s quarterly report(10-Q) or annual report (10-K).
Taking stock in a company’s equity
- Retained earnings: This represents the total profits the company has earned since it began, minus whatever has been paid to shareholders as dividends. Because this is a cumulative number, if a company has lost money over time, retained earnings can be negative.
- Treasury stock: This shows how much of its own stock a company has repurchased.
Tip: Because repurchasing stock is analogous to paying dividends to investors, you should take note of changes in this account to see how much stock a company is repurchasing from one period to the next.
- Total shareholders equity: This measures the value of shareholders’ stake in the company. It represents the total claim investors have on a company’s assets, free-and-clear of debt.
Analyzing the balance sheet with common-sizing
In my previous article on analyzing income statement, I talked about common-sizing and how it can be used to keep a tab on company’s expenses. Similarly, you can perform common-sizing on the balance sheet depending on what you are trying to common size.
To common size
- Assets: Divide each type of asset by the company’s total assets.
- Liabilities: Divide each type of liability by the company’s total liabilities and stockholders’ equity.
- Equity: Divide each category of equity by the company’s total liabilities and stockholders’ equity.
Note: If you like to convert the figures from the three preceding items into a more understandable percentage, multiply the results by 100.
Tip: Common-sizing can help you discover how much of a company is bankrolled by debt, versus investors ponying up the cash to buy stock. A company’s decision to sell stock, versus borrow it, has huge ramifications on its profitability going forward.
In 2017, JNJ had % of liabilities and shareholders’ equity
- Accounts payable = 4.53% [( 7.13/157.38) * 100]
- Short-term debt = 1.51% [(2.41/157.38)*100]
- Current portion of long-term debt = 0.95% [(1.5/157.38)*100]
- Total current liabilities =19.40% [(30.54/157.38)*100]
- Long-term debt = 19.49% [(30.68/157.38)*100]
- Total shareholder’s equity = 38.2% [(60.16/157.38)*100]
This analysis indicates that JNJ receives its financing from a balanced number of sources, but relies more on equity.
Tip: Common-sizing a company’s liabilities gives you an instant view of where it gets the money to keep itself going, or its capital structure. This helps you understand how well it’s positioned to withstand an economic downturn or how profitable it will be during strong economic growth.
Note: When a company relies on borrowed money to pay of their operations, it’s called leverage. Leverage can greatly enhance a company’s returns for stockholders as long as the company can comfortably keep up with its interest payments.
Appreciating working capital
Analyzing working capital helps you determine whether a company can handle its short-term bills. It is a measure of short-term liquidity and tells you whether a company can access cash needed to pay its most pressing bills over the coming year.
Working capital = Current assets — current liabilities
Tip: If current assets are less than current liabilities, that means if a company’s business suffers a temporary downturn, it may be forced to extreme measures to pay its bills, including selling off property, plants or equipment on a sale.
With the ability to analyze a balance sheet, you should get some sense of a company’s financial health, a key consideration in deciding whether or not to become an investor in that company.
“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”— Warren Buffett
Stay tuned for my next article where I will discuss about understanding the company’s cash flow statement which tells you how much cash a company is generating from one period to the next.
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Thank you for reading.
The content in the above article is for information and educational purposes only. It is not intended to be an investment advice. Please consider the risk involved and your personal financial situation before investing or seek a duly licensed professional for investment advice.
Other articles by me
- Fundamental Analysis Using Key Ratios: https://firstname.lastname@example.org/stock-investing-fundamental-analysis-using-key-ratios-ed02f32e88ae
- Fundamental Analysis Using Company’s Income Statement: https://email@example.com/stock-investing-fundamental-analysis-using-companys-income-statement-37b0d80531f1
- Fundamental Analysis Using Free Cash Flow Statement:https://firstname.lastname@example.org/stock-investing-fundamental-analysis-using-free-cash-flow-statement-454beaa7f00
Amrut is a Full Stack Software Engineer who is passionate about tech and software development in Web and Mobile. He likes to write about coding, investing, finance and neuroeconomics. He strongly believes in adding value to people’s life through quality work. He also loves to watch and discuss about American Football.