During my latest episode of Fantastic Female Fridays, I took our #SavvyWomenInvestors community through “how to read a balance sheet”.
First, as I was deciding which stocks to pick, I reflected back to the Hot Stocks Panel that I was kindly invited on to by Glenn Thompkins and Steve Chappell at VectorVest. (https://www.youtube.com/watch?v=hjNf1mguF_s&t=3s). Steve referred to Dollar General (DG) during his contribution so I thought I might take a look around the sector.
I settled on Target and Walmart as they were in the same industry (i.e. Stocks in Retail (Major Chains) and had a similar RS (Relative Safety) rating. You can see the full episode here at )
Next, I pointed out six key questions to ask when examining a balance sheet:
- What are the key components of a balance sheet and how do they work together?
A balance sheet consists of assets (i.e. what a company owns), liabilities (what a company owes) and equity (the residual value for shareholders). In essence, the assets equal the liabilities plus the equity. That’s why it’s called a balance sheet!
- What key things might you look out for and where can you find them?
I always lookout for the cash balance because that is the resource that every company can use right away to sort out problems or to take advantage of opportunities. (In particular, we discussed this during the last episode with Mary McKenna relating to the Future of Travel). You can find this under “Current Assets”. Secondly, I look at the Long Term Debt figure (under “Current Liabilities) as this is always a source of financial risk in difficult times. Finally, I look for Goodwill (under “Noncurrent Assets”) to see if the company has been growing through acquisitions or organically. Also, it’s worthwhile knowing how that M&A activity worked in the context of cultural cohesion to produce earnings.
- What red flags might you find and where do you look for them?
I look out for problems that could come down the line. Here are three that are particularly easy to catch. Using my “Control F” function, I search the entire document for “Off-Balance Sheet” arrangements or financing. These can be complex, tricky arrangements where debt doesn’t sit on the balance sheet but is related to the company if something adverse happened. The second is “stock options”. If many, many people hold stock options and they trigger them at a later date, the earnings then have to be distributed across more people and thus the Earnings per Share (which has a real influence on share prices) can fall. The way to spot this is to identify whether there is a big difference between Basic and Diluted Earnings per Share. Finally. I compare the cash balance to the Receivables or Debtors figure. This tells me whether the company has more liquid cash or is waiting for its customers to pay up before it can pay its debts. The business model can have a big impact on this as I explain in the video. (Naturally, retail is a business where people pay upfront to the business but the business might pay it’s suppliers with a certain amount of pre-agreed credit so that’s likely to be particular to the two companies I used as case studies rather than the general case).
- How do you know if a company is liquid?
There are two key metrics I give for this are the Current Ratio and the Asset Test Ratio. The Current Ratio is a simple comparison between Current Assets and Current Liabilities. Ideally, for every dollar that a company owes in the short term (i.e. its Current Liabilities), it would have a dollar of Current Assets to pay for it. In other words, the Current Ratio should be at least 1.
The Acid Test Ratio is a nuance on this as it examines the Current Assets less Inventories (or Stock) divided by Current Liabilities. This assumes that the company wouldn’t be able to generate money quickly from its stock and thus would be relying on its cash, receivables etc to pay for the Current Liabilities. This is the “acid test” of liquidity.
- How do you know if a company is solvent?
Quite simply, if the assets are greater than the liabilities, or the equity figure is positive, then the company is solvent. It may be that a company is unprofitable and insolvent too! While it might sound like an oxymoron, it’s possible that a company has brought in assets that aren’t due to the be paid back and thus, it has more assets than liabilities whilst those assets haven’t been generated through profitable operations. I gave an example in the video and VectorVest had pointed out it had a negative EPS and PE ratio too.
- How does the earnings fit into the balance sheet?
At the bottom of the balance sheet, in the Equity section, is the figure “Retained Earnings” or “Accumulated” profits. This is the sum of all the profits generated over the years that the company has been in existence. Specifically, if you look at the Retained Earnings for this year and last year, the difference will be this year’s profit. That is because the Retained Earnings has increased this year by this year’s profit.
One last thing! You can view and download your own version of the Google Sheet used here:
Source: The Positive Economist