Balance sheets are part of financial filings required by publicly traded companies that happen on a quarterly and annual basis. These filings must include a balance sheet, cash flow statement, and income statement. The balance sheet outlines the balance between the company’s liabilities and its assets.
Balance sheets are crucially important when making the decision whether to invest in a stock you’re considering. After all, these financial statements explain whether the company is funded by debt or shareholder equity, whether or not it has the financial resources necessary to meet its obligations, and much more.
How to Read the Balance Sheet of a Company for Investment
Most investors want to invest in companies with a solid financial foundation. A great way to get a full understanding of a company’s financials is to look into its balance sheet.
The first part of a balance sheet details a company’s assets. These assets are divided into two sections: current assets and non-current assets.
The image below shows the Current Assets section of Apple’s Consolidated Balance Sheet for the quarter ended March 27, 2021. The first column of figures is for the current period, while the second column shows the data for the same period one year ago, as is the case for every line item on the balance sheet.
The image shows six line items outlining current assets. These are high liquidity assets that will generally be turned into cash within the next year. They include:
- Cash and Cash Equivalents. Cash is the most liquid asset in the world. This section shows the amount of money the company has in cash or short-term investments that reach maturity in 90 days or less. Of course, companies with a strong cash position set the stage for long-term success.
- Marketable Securities. These investments could be included in cash equivalents if they’re intended to be sold within a short period of time. These are securities that can be sold in the open market, such as stocks the company owns. Some companies use a separate line item for them since these securities don’t always have maturities.
- Accounts Receivable. Accounts receivable is an accounting of the bills owed to the company. Like with cash equivalents, it is generally expected that these bills will be paid and be converted into cash within the next 90 days.
- Inventories. In general, companies tend to stock enough inventory — including raw materials, work-in-process goods, and finished goods — to get through a year or less. These inventories are considered current assets because it’s assumed the current inventory will be depleted within one year.
- Vendor Non-Trade Receivables. Like accounts receivable, this line item outlines amounts due to the company. However, unlike accounts receivable, vendor non-trade receivables are funds owed to the company for activities other than the normal provision of products and services. For example, loans owed to the company by employees who requested payday advances would be considered vendor non-trade receivables.
- Other Current Assets. Other current assets is a catch-all that covers any assets not listed that are expected to be liquidated within the next year.
Non-current assets are assets the company intends to hold for a year or longer. They are generally broken down into two categories, although the categories will have different names depending on the company providing the report. They typically boil down to tangible assets — like real estate, machinery, and other physical property — and intangible assets like intellectual property, brand names, copyrights, patents, and other assets that have value but can’t be held physically.
Below is a snapshot of Apple’s non-current assets section of its balance sheet for the quarter ended March 2021:
While most companies outline tangible and intangible assets, Apple outlines its non-current assets in three categories:
- Marketable Securities. These are securities that come with maturities of one year or longer or investments in equities that the company intends to hold for longer than one year.
- Property, Plant, and Equipment. This line item reflects the value of real estate and equipment owned by the company.
- Other Non-Current Assets. This is the line item where Apple includes its intellectual property and any other assets it intends to hold for longer than one year not listed in the other two non-current asset line items.
While non-current assets are long-term assets, it’s important to remember that their values will change over time, even if the company doesn’t add or remove any assets from these lists. The changes are the result of depreciation or appreciation in price over time.
Liabilities is a fancy way of saying debt, and the vast majority of publicly traded companies have plenty of it. Like with assets, total liabilities will be broken into two primary categories on a balance sheet: current and non-current liabilities.
Current liabilities are debts owed by the company that are due within one year.
Here’s a snapshot of the current liabilities section of Apple’s consolidated balance sheet. Like on the rest of the balance sheet, the first column of figures is for the current period, and the second is for the same period one year ago.
Here’s the breakdown of each line item:
- Accounts Payable. Accounts payable is the accounting term for bills the company owes. For example, a bill owed to a provider of basic materials used in the development of a product would be included in accounts payable.
- Other Current Liabilities. This is a catch-all for all short-term debts that aren’t significant enough for their own line item on the balance sheet. For example, a restaurant in a restaurant chain may have hired a lawn care service for $300 per month. Since $300 per month is nothing in the grand scheme of a multibillion-dollar business, but still must be accounted for, this kind of expense would be included in the other current liabilities section.
- Deferred Revenue. Deferred revenue is money the company has received for products or services that have not yet been delivered. Until those products or services have been provided, these deferred revenues are considered to be debt.
- Term Debt. The term debt line item points to short-term debts with maturities within the next year. For example, a company may take out a loan with a six-month maturity to buy the basic materials needed to manufacture a large order. With such a short maturity date, this would be considered short-term debt.
The non-current liabilities section of the balance sheet outlines the long-term liabilities of a company, or debts that will need to be repaid in one year or longer. See the non-current liabilities section of the Apple balance sheet below:
As with most other companies, there are only two line items here apart from the totals at the bottom of the table. Here’s the breakdown of these line items:
- Term Debt. Term debt relates to debt owed by the company that will mature in one year or longer. While most term debt will have maturities ranging from one to 10 years, some debts can have maturities as far away as 30 years.
- Other Non-Current Liabilities. This is a bucket line item that includes any long-term liabilities that aren’t considered term debt. For example, a revolving loan with no maturity date would be accounted for in other non-current liabilities.
Equity is essentially shares of the company owned by investors or insiders of the company. There are two primary types of equity: retained earnings and shareholders’ equity. See the snapshot below to see how this is displayed in a balance sheet:
Shareholders’ equity is shareholders’ residual claim on assets after all debts have been paid. This includes both retained earnings and the amount of assets shareholders would have rights to once all debts were paid by the company in the event of a liquidation. The total amount of shareholders’ equity is the net worth of the company, equating to the company’s assets minus its liabilities.
Often referred to as an earnings surplus, retained earnings is the net amount of earnings that remain after accounting for dividends. Essentially, this is equity held back by the company. Increasing retained earnings over time shows corporate growth.
How to Analyze a Balance Sheet
Now that you know what each line item on a balance sheet means, it’s time to use this data to your advantage as you make your investment decisions. To do so, investors use a series of financial ratios that generally compare one metric to another. Here are the most common:
Balance Sheet Equation
The balance sheet equation, also known as the accounting equation, outlines the relationship between the three most important aspects of a balance sheet: debt, equity, and assets.
A company’s total assets are equal to the sum of its liabilities and owners’ equity. This is reflected in the balance sheet equation:
Total Assets = Liabilities + Owners’ Equity
For example, say a company has liabilities amounting to $75 billion and shareholders’ equity amounting to $125 billion. In this case, its total assets would come to $200 billion, the sum of liabilities and shareholders’ equity.
The balance sheet equation can tell you a great deal about the company itself.
For example, if you notice there’s far more debt than equity in the equation, you can conclude that the company has funded its assets primarily through debt. On the other hand, if there’s far more equity than debt, the company’s assets have been primarily funded through the sale of equity, or shares, in the company.
The debt-to-equity ratio compares the amount of debt a company has to the amount of shareholders’ equity on its balance sheet. The formula for the ratio is:
Debt-to-Equity Ratio = Total Liabilities / Total Shareholders’ Equity
A high debt-to-equity ratio indicates the company uses debt more often to finance its operations and cover large expenses. More aggressive investors often prefer a high debt-to-equity ratio that shows the company is using leverage to grow.
On the other hand, a low debt-to-equity ratio suggests that the company relies more heavily on equity to finance its operations. Risk-averse investors prefer companies with a lower debt-to-equity ratio because these companies have more cash flow, less debt, and are more likely to pay dividends.
The current ratio, also referred to as the working capital ratio, reflects a company’s ability to pay its short-term financial obligations, or debts that mature within one year. This is important because it’s safer to invest in financially sound companies that have the assets available to pay their debts as agreed.
The formula for the ratio is:
Current Ratio = Current Assets / Current Liabilities
If the current ratio is less than 1, it means the company doesn’t have the cash needed to cover all its short-term liabilities if they were all to mature immediately. Conversely, a current ratio at or above 1 suggests the company has the money it needs to cover its short-term debts, even if they were all due tomorrow.
The quick ratio is similar to the current ratio, but there’s a twist. It measures whether a company would have the ability to cover its current liabilities without liquidating its inventory or going further into debt.
There are two formulas for calculating the quick ratio, but for simplicity’s sake, we’ll focus on the most commonly used formula:
Quick Ratio = (Cash & Cash Equivalents + Marketable Securities + Accounts Receivable) ÷ Current Liabilities
A quick ratio at above 1 suggests the company is able to meet its short-term obligations with quick assets — cash, cash equivalents, and other assets it can access quickly.
It’s worth noting that most publicly traded companies maintain a quick ratio below 1. In general, a quick ratio of 0.75 is acceptable, but lower ratios — those below 0.50 — may be cause for concern.
Price-to-Book Value (P/B) Ratio
The price-to-book value ratio compares the price of a publicly traded company to the net value of its assets, or its book value. To determine the book value of a company, subtract its total liabilities from its total assets.
The formula for the P/B ratio is as follows:
P/B Ratio = (Price per Share x Number of Outstanding Shares) ÷ Book Value
Traditionally, any P/B ratio under 1 is considered a good ratio, suggesting buyers of shares are getting a good price.
However, this ratio varies widely by sector, with tech sector values often being many multiples higher. This is because tech is known for rapid growth due to constant innovation. As a result, investors are willing to pay higher valuations to be involved in these companies than in companies in other sectors that aren’t driven by constant innovation and rapid growth, such as utilities.
For example, Apple had a price-to-book value ratio of over 44 as of early January 2022.
As an investor, you’ll find the more you know about the companies you sink your hard-earned money into, the better your returns are likely to be. Getting familiar with balance sheets may not be the most exciting task in the world, but the difference it can make in your investment outcomes is hard to ignore.
As such, it’s wise to include analysis of balance sheets in your research process when deciding to add or remove equities from your portfolio.