A company’s financial statements—balance sheet, income and cash flow statement—are an important source of data for analyzing the value of its stock investments. Stock investors, whether they do it themselves or follow the guidance of investment professionals, do not need to be analytical experts to perform financial statement analysis. Today, there are many independent stock research sources, both online and in print editions, that can perform “number calculations” for you. However, if you want to be a serious stock investor, you must have a basic understanding of the basic principles used in financial statements. In this article, we will help you become more familiar with the overall structure of the balance sheet.
Structure of the balance sheet
The company’s balance sheet consists of assets, liabilities, and equity. Assets represent valuable things that the company owns and owns, or things that can be received and objectively measured. Liabilities are what the company owes to others-creditors, suppliers, tax authorities, employees, etc. They are obligations that must be paid within certain conditions and time frames. The company’s equity represents the retained earnings and funds contributed by its shareholders, and they accept the uncertainty caused by ownership risks in exchange for the good return on investment they hope to obtain.
The relationship between these items is expressed by the basic balance sheet formula:
Assets = Liabilities + Equity
The meaning of this equation is very important. Generally speaking, sales growth, whether fast or slow, determines a larger asset base—a higher level of inventory, accounts receivable, and fixed assets (plant, property, and equipment). As the company’s assets grow, its liabilities and/or equity tend to grow to keep its financial position in balance.
How assets are supported or financed through the corresponding growth in accounts payable, debt liabilities, and equity reveals a lot of information about the company’s financial health. For now, according to the company’s business line and industry characteristics, having a reasonable combination of liabilities and equity is a sign of a company with good financial status. Although the view of the basic accounting equation may be too simplistic, investors should regard the greater equity value compared to debt as an indicator of the quality of active investment, because having a high level of debt increases the likelihood of a company facing financial distress .
Balance sheet format
Standard accounting practices present the balance sheet in one of two formats: account format (horizontal display) and report format (vertical display). Most companies prefer the vertical reporting format, which does not fit the typical interpretation in the balance sheet investment literature, which is to have balanced “both sides”.
Regardless of whether the format is top-down or side-by-side, all balance sheets conform to a presentation that divides various account entries into five parts:
Assets = Liabilities + Equity
• Current assets (short-term): items that can be converted into cash within one year
• Non-current assets (long-term): more permanent projects
As total assets, these =
• Current liabilities (short-term): obligations due within one year
• Non-current liabilities (long-term): obligations that are due over one year
These total liabilities +
• Shareholders’ equity (permanent): shareholder investment and retained earnings
In the asset section mentioned above, the accounts are arranged in descending order of liquidity (the speed and ease of their conversion into cash). Similarly, liabilities are listed in the order of priority of their payments.In financial reporting, the terms “current” and “non-current” are synonymous with the terms “short-term” and “long-term” respectively, and can be used interchangeably.
It is not surprising that the balance sheet account presentation reflects the diversity of listed companies’ activities. The balance sheets of utilities, banks, insurance companies, brokerage and investment banking companies, and other specialized companies are very different from the balance sheets generally discussed in the investment literature in terms of account presentation. In these cases, investors will have to consider and/or listen to expert opinions.
Finally, there is almost no standardization of account naming. For example, even the balance sheet has alternative names such as “statement statement” and “statement statement.” The same phenomenon exists in balance sheet accounts. Fortunately, investors can easily access an extensive dictionary of financial terms to clarify unfamiliar account entries.
The importance of dates
The balance sheet represents a company’s financial status at the end of its fiscal year, for example, the last day of its fiscal period, which may be different from the calendar year we are more familiar with. Companies usually choose the end period that corresponds to the time when their business activities reach the lowest point of their annual cycle. This is called the natural business year.
In contrast, the income and cash flow statement reflects the company’s operations for the entire fiscal year (365 days). Given this difference in “time”, when using data from a balance sheet (similar to a photo snapshot) and income/cash flow statement (similar to a movie), use the average of the balance sheet amounts. This approach is called “averaging” and involves taking year-end (2019 and 2020) figures—say, total assets—and adding them together, then dividing the total by two. This exercise provides us with a rough but useful approximation of the balance sheet amounts for the full year of 2020. This is what the income statement figures (assuming net income) represent. In our example, the total assets figure at the end of 2020 will exaggerate the amount and distort the return on assets (net income/total assets).
Since the company’s financial statements are the basis for analyzing the value of stock investments, the discussion we have completed should provide investors with a “big picture” to understand the basics of the balance sheet.