A company balance sheet is a key document used to assess how well a company is financially faring. That's why the company balance sheet is one of the first documents to check when considering an investment. Within this vital document, an investor can see a snapshot of the business's assets, liabilities, and equity at a particular time.
The financial professional uses this document to check a company's liquidity, debt levels and equity structure. This can help build a picture of how viable a business it is. From the balance sheet, the professional can ascertain its asset quality, equity position and if the company has been making or losing money in recent periods.
A lot can be gleaned from this snapshot, including the quality of earnings, diversification of assets and liabilities, off-balance sheet financing, contingent liabilities, management's use of accounting policies, and trends and developments in the industry.
By carefully considering the data, financial professionals can get an immediate sense of how risky an investment it would be.
Liquidity and Current Ratio
A highly liquid company is able to pay its debts, which is a positive sign.
Here, financial professionals look at the company's current ratio, which is calculated by dividing its current assets by its current liabilities. A current ratio of 1.5 to 2.0 is generally considered healthy, indicating that the company has sufficient liquid assets to cover its short-term debts.
Company Debt Levels
Another critical aspect investing professionals look at is the company's debt levels and how that debt is structured.
A key metric here is the debt-to-equity ratio, which is calculated by dividing its total liabilities by its equity. A high debt-to-equity ratio indicates the company could be using excessive debt to finance its business. This is not what investors necessarily want to see, as it raises the company's risk profile and suggests a lack of stability in its financial structure.
Tangible and Intangible Assets
The details of a company's tangible and intangible assets are not immediately clear from the balance sheet. However, a finance professional can still gauge the quality of these assets. Tangible assets include property and equipment, while intangible assets include intellectual property such as patents and trademarks.
Equity Profile
The professional investor is also likely to look closely at the company's equity position and how it is structured. This may comprise common equity (including retained earnings), total shareholders' equity, and accumulated minority interest. Retained earnings are the portion of profits the company has kept aside rather than allocated to shareholders as dividends. The retained earnings will likely be used for reinvestment, mergers, repaying debt, or other corporate activity.
Close assessment of all these metrics gives financial professionals a clear picture of the company's financial status. Then they can move on and read the company's income statement to help build on this picture.
In addition to liquidity, assets, liabilities and the equity profile, here are several more factors finance professionals are likely to note from the balance sheet:
Quality Of Earnings
While profitability is important, the quality of a company's earnings is another factor worth looking at. What is driving the profits, and is it likely to last? If the company has made substantial profits on one-time gains or strategic accounting maneuvers, that is not as appealing as a steady stream of profitability from reliable means. Therefore, the more sustainable the profits look, the more attractive investment in the business becomes.
Diversification Of Assets and Liabilities
Diversification spreads risk, which is why finance professionals look at the company's assets and liabilities for signs of diversification.
If the business assets include a mix of cash, investments, and property, this is likely to appear less risky than a company reliant on one asset class. And likewise, for liabilities, investors look for a mix of short-term debt, long-term debt, and equity as it indicates more financial stability than a company heavily reliant on debt.
Off-Balance Sheet Financing
Sometimes businesses will finance their operations with items such as operating leases, special purpose acquisitions or derivatives contracts. This is not always disclosed on the balance sheet and is therefore referred to as off-balance sheet financing. This is a red flag for investors to watch out for, as it can significantly impact the company's overall financial health.
Management's Use of Accounting Policies
Finally, the way businesses present their accounts can vary, and it's worth noting if the company uses GAAP or Non-GAAP reporting methods.
Sometimes a management team will have some discretion in distinguishing revenue and expenses, so it's helpful to understand how this will impact the picture presented to the investor.
A company using aggressive accounting procedures is likely to pose a riskier investment than a company with more conservative approaches.
GAAP vs. Non-GAAP
Generally Accepted Accounting Principles (GAAP) are standards and guidelines for financial accounting. Accounting firms use this method to prepare and present financial statements consistently and transparently. GAAP principles provide a basis for financial reporting and help to ensure that financial statements are consistent and comparable across company peer groups and industries.
Non-GAAP accounting refers to financial reporting based on principles other than GAAP. Non-GAAP measures are not necessarily compliant with GAAP and may include additional or adjusted items not included in the GAAP financial statements.
Non-GAAP reporting is typically used to provide additional information to stakeholders or to highlight specific parts of a company's performance that might not be apparent from the GAAP financial statements.
Understanding the difference between GAAP and non-GAAP accounting is helpful because non-GAAP measures may not be comparable across different companies and industries and may not provide a complete picture of a company's financial performance. It is also essential to carefully consider the implications of any adjustments or exclusions made in calculating non-GAAP measures.
We hope the information presented here gives you a more detailed understanding of what an experienced financial professional might look for when analyzing a company's balance sheet.
As always, it's important to consider the company's overall financial health and do your due diligence before making investment decisions.
Why not continue your investing education journey with some of our other informative articles:
How to Find Investment Opportunities
How to Read Financial Statements