Stock Investing: Fundamental Analysis Using Company’s Balance Sheet

Key Parts of a Balance Sheet

Note: The balance sheet is also known as the “statement of financial condition

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.

Figure 1: Johnson & Johnson Assets (Source: https://www.marketwatch.com/investing/stock/jnj/financials/balance-sheet?ns=prod/accounts-mw)

Covering your bases with assets

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.

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.

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.

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

Figure 2: Johnson & Johnson Liabilities & Shareholder’s Equity (Source: https://www.marketwatch.com/investing/stock/jnj/financials/balance-sheet?ns=prod/accounts-mw)

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.

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

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.

Analyzing the balance sheet with common-sizing

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.

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.

Appreciating working capital

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.

“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”— Warren Buffett

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