The balance sheet shows the state of company’s Assets and Liabilities:
- Assets: We can consider this category of items as the investment made by the company to grow the business.
- Liabilities: We can consider this category as the items indicating the obligations of the company.
Effectively, Liabilities primarily show the sources of cash for the business (please note that expenses like salaries to be paid to the employees are also included in liabilities as they also represent obligations of the company). Assets most likely show the uses of cash.
In case of Hot dog example, the owner uses his savings along with the money he borrowed from the bank to setup the company. These become the sources of cash for the company and hence, the liabilities, i.e. the company owes this money back to the bank and the owner himself.
When the company uses the cash to buy the Stalls and ingredients to make hot dogs, it is creating assets that can be used to generate more income. Please see below a sample balance sheet indicating the state of hot dog business:
| HOT DOG BUSINESS | ||||
| BALANCE SHEET | ||||
| ASSETS | LIABILITIES | |||
| INGREDIENTS | $1,000 | BANK LOAN | $5,000 | |
| STALLS | $11,000 | OWNER’S EQUITY | $7,000 | |
| $12,000 | $12,000 | |||
As mentioned in Benjamin Graham and David Dodd’s Security Analysis, an investor can derive the following by carefully going through the Balance Sheet:
“
- It reveals how much capital is invested in the business.
- It reveals the easy or stringency of the company’s financial condition, i.e. the working capital position.
- It contains the details of the capitalization structure.
- It provides an important check upon the validity of reported earnings.
- It supplies the basis for analysing the sources of income.
“
A typical balance sheet looks as below:
| TYPICAL BALANCE SHEET | ||||
| ASSETS | LIABILITIES | |||
| CURRENT ASSETS: | CURRENT LIABILITIES: | |||
| CASH & EQUIVALENTS | PAYABLES | |||
| INVENTORY | ACCRUED EXPENSES | |||
| RECEIVABLES | SHORT TERM DEBT | |||
| OTHER CURRENT ASSETS | OTHER CURRENT LIABILITIES | |||
| NON-CURRENT ASSETS: | LONG TERM DEBT | |||
| PLANT & PROPERTY | OTHER LIABILITIES | |||
| GOODWILL | ||||
| INTANGIBLES | SHAREHOLDERS’ EQUITY | |||
| LONG TERM INVESTMENTS | PREFERRED STOCK | |||
| OTHER ASSETS | COMMON STOCK | |||
| RETAINED EARNINGS | ||||
| TREASURY STOCK | ||||
| OTHER ITEMS (INCL. RESERVES) |
I will touch upon the specific items in chapters ahead. We need to understand that studying the balance sheet is also a requisite for being a value investor. Sometimes, the opportunities arise in the stock market when the market punishes a company’s stock based on poor earnings announcements, while a careful look at balance sheet may suggest that the price of the share is better than the value indicated by the balance sheet.