Financial Statements, Part Two - The Balance Sheet

If you want to invest in stocks, you need to understand how much money a company makes. However, a company that makes a lot of money is not necessarily financially secure. Even a business with strong sales can run into trouble if it has too much debt. So how can you find out what a company owns and how much it owes? One place to look is its balance sheet. A balance sheet is a financial statement that shows what a company owns, what it owes, and how much belongs to its shareholders at a specific point in time. To understand a balance sheet, you need to learn three basic concepts: assets, liabilities, and shareholders' equity. Imagine someone decides to open a coffee shop. Before opening, the owner needs to pay a security deposit for the space, buy an espresso machine and furniture, and purchase supplies such as coffee beans and milk. The business also needs cash for everyday expenses. Let's assume it takes $100,000 to get everything ready. However, the owner only has $40,000. To cover the remaining $60,000, the owner takes out a bank loan. The coffee shop now has $100,000 to spend on everything it needs to start operating. How would this situation appear on a balance sheet? First, assets are resources with economic value that a company owns or controls. For the coffee shop, these might include cash in its bank account, the security deposit, its espresso machine, furniture, and coffee beans. For other businesses, assets can also include factories, buildings, patents, and money that customers owe but haven't paid yet. In other words, assets include much more than just cash. Next, liabilities are obligations that a company must pay or fulfill in the future. The coffee shop's $60,000 bank loan is a liability. But loans aren't the only type of liability. Money owed to suppliers for goods already received and wages owed to employees can also be liabilities. Finally, shareholders' equity is the amount left after subtracting liabilities from assets. If the coffee shop has $100,000 in assets and $60,000 in liabilities, its equity is $40,000. Put simply, equity represents the shareholders' remaining claim on the company's assets after its debts and other obligations are accounted for. Equity can increase when a company earns profits and keeps them in the business. It can also decrease when the company suffers losses. These three concepts are connected by one simple equation: Assets = Liabilities + Shareholders' Equity. In our coffee shop example, the $100,000 in assets equals $60,000 in liabilities plus $40,000 in equity. This relationship must always hold true on a balance sheet. Does that mean a company with more assets is always a better company? Not necessarily. Imagine two companies that each have $10 million in assets. The first company has $2 million in liabilities, while the second has $9 million. Although both companies have the same amount of assets, the first has $8 million in equity, while the second has only $1 million. The second company depends much more heavily on borrowed money and other obligations. Of course, borrowing money isn't always a bad thing. A business might take out loans to build a new factory or expand its operations. Borrowing can help a company grow. However, too much debt can create problems when the company needs to make interest payments or repay its loans. When reading a balance sheet, it's also important to look at the types of assets a company owns. For example, a business might own valuable buildings and expensive machinery but have very little cash available to pay its immediate expenses. On the other hand, a company with plenty of cash may be better prepared to handle unexpected costs or difficult business conditions. This is why investors should look not only at the total value of assets but also at what those assets actually consist of. Another important feature of a balance sheet is that it shows a company's financial position on a particular date. For example, a balance sheet dated December 31 shows the company's assets, liabilities, and equity as of that day. It doesn't tell you how much money the company earned throughout the year. To understand its revenue and profits, you would look at the income statement. To see how cash actually moved into and out of the business, you would examine the cash flow statement. It's also useful to compare balance sheets from different periods. Has the company's cash increased since last year? Is its debt growing quickly? Has it steadily built up more equity? Looking at these changes can help you understand whether the company's financial position is becoming stronger or weaker. However, an increase in assets doesn't automatically mean the company is doing better. You also need to understand why those assets increased. There's one more important distinction to understand. The shareholders' equity shown on a balance sheet is not the same as the company's value in the stock market. Investors determine stock prices based on many factors, including expectations about how much money the company might earn in the future. Also, the value recorded for an asset on a balance sheet may be different from the price that asset could actually sell for. Ultimately, a balance sheet shows what a company owns, what it owes, and how much of its net assets belong to its shareholders. By reviewing a balance sheet before investing, you can get a better understanding of the company's financial stability. After all, evaluating a company isn't just about knowing how much money it makes. It's also about understanding how strong its financial foundation really is.