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How to read a balance sheet
Balance sheets explain a company’s finances. Here are some ways to read a balance sheet to keep track of the health of your investments.
When you’re trading stocks, you need to keep a close eye on the value of your investment. A balance sheet shows how a company’s finances are performing so investors can determine if that stock is a good choice for their portfolios.
What is a balance sheet?
A balance sheet is a summary of a company’s net worth, assets and liabilities. The balance sheet is determined by this equation: Assets = liabilities + shareholders’ equity. The equation is in the same order because the left side of the equation must always equal the right side. When you’re reading a balance sheet, check for these details of the balance sheet equation.
Assets are a corporation’s resources. Assets can be split into two categories: current and noncurrent. Current assets are assets that will be turned into cash in a year. Noncurrent assets are long-term and won’t be converted into cash within a year.
There are also some other types of assets that may be included in a balance sheet.
- Cash and cash equivalents. These are assets that are cash or can be easily converted to cash. Cash includes any currency, whereas cash equivalent examples include bank accounts or certificates of deposit.
- Accounts receivable. Accounts receivable are the funds that a corporation is owed from its customers.
- Inventory. Inventory is a collection of goods available for sale. Macy’s clothing is an example of inventory.
- Long-term investments. A long-term investment is an asset that a corporation holds for a long period. Stocks and Treasury bonds are examples of long-term investments.
- Property, plants and equipment. Property, plants and equipment are a corporation’s physical assets. A company’s buildings, machinery and furniture are examples of property, plants and equipment.
- Intangible assets. In contrast to property, plants and equipment, intangible assets can’t be seen or touched. Copyrights, trademarks and patents are intangible assets.
Liabilities are funds that a company owes to debtors. Similar to assets, there are short- and long-term liabilities. Current short-term liabilities must be paid off within a year. Noncurrent liabilities are due after more than a year.
A balance sheet might feature different types of liabilities.
- Accounts payable. Accounts payable are the funds that a company owes its creditors.
- Current debt and notes payable. Current debt is a debt that must be paid within a year. Notes payable are promissory notes saying that a current debt must be repaid within a year.
- Long-term debt. A debt that must be paid after more than a year.
- Bonds payable. These are long-term debts issued by corporations.
A company’s balance sheet will often mention shareholders’ equity. But what is it exactly?
Shareholders’ equity is calculated by subtracting a corporations’ liabilities from its assets. If a company’s shareholder equity is positive, that shows it can cover its liabilities. When a shareholders’ equity is negative, that’s a troubling sign that a company has too many liabilities.
What does a balance sheet tell you about a business?
While you’re learning how to read a balance sheet, you’ll also learn a lot about a corporation. If a company has a strong balance sheet with high liquidity, that shows a company has a lot of cash on hand and can have long-term viability. However, if a company has too many liabilities, this can be a sign the company has too much debt.
In addition to a balance sheet, look at a corporation’s income statement to see its revenue. Also, check a company’s cash flow statement to analyze the expenses and cash flow.
How to read a balance sheet
Apple balance sheet (Photo Credit: apple.com)
By looking at Apple’s balance sheet (Link from apple.com), you can determine the company’s performance over the past six months. Here, you can see how Apple’s March 2021 balance sheet compares to its balance sheet in September 2020.
Many balance sheets are issued on a quarterly, semiannual or annual basis. Look for these key numbers in a balance sheet:
- Cash and cash equivalents. This aspect of the statement shows how much cash Apple has on hand.
- Accounts receivable. This is the amount that Apple is owed by creditors.
- Accounts payable. Accounts payable shows how much Apple owes debtors.
In addition to these facets of a balance sheet, here are some other ratios that you can check out to measure a company’s performance.
- How to find it. Current assets ÷ current liabilities
- What it shows. The current ratio shows if Apple has enough money to cover its liabilities.
- A current ratio is the total of a company’s current liabilities divided by its current assets. For example, a current ratio compares Apple’s assets and liabilities. If a company has a current ratio of less than one, it may have less liquidity. Apple’s (Nasdaq:AAPL) current ratio is 1.14.
- How to find it. (Current assets-inventories) ÷ current liabilities
- What it shows. A quick ratio determines a corporation’s short-term liquidity.
- A quick ratio is the total of a corporation’s current assets minus its inventory, and that number is divided by its current liabilities. This ratio, however, excludes some assets. When you’re reading a balance sheet, a quick ratio can tell you if Apple has enough money available to cover its current liabilities. Apple’s quick ratio is 1.33, meaning Apple can cover its current liabilities 1.33 times over.
- How to find it. Total liabilities ÷ shareholders’ equity
- What it shows. The debt-to-equity ratio measures how much leverage a company uses.
- In a balance sheet, a debt-to-equity ratio equals a company’s total liabilities divided by its shareholders’ equity. It shows how much debt a corporation is using to finance itself. For context, 2.0 is generally considered a good debt-to-equity ratio, meaning two-thirds of a company’s capital financing comes from debt and a third from shareholder equity. A good debt-to-equity ratio varies greatly between industries, and some sectors like manufacturing could see debt-to-equity ratios above 2.0 because they rely heavily on fixed assets for operations. Apple’s debt-to-equity ratio is 1.76.
Working capital ratio
- How to find it. Current assets – current liabilities
- What it shows. A working capital ratio shows you the assets available after a company’s liabilities are paid off.
- A working capital ratio means that a company’s current liabilities are subtracted from its current assets. A working capital ratio below 2.0 is considered healthy. Apple’s working capital ratio is 1.14, which is a good working capital ratio.
- How to find it. Total assets – total liabilities
- What it shows. A company’s net worth shows the value of a business after its liabilities are paid off.
- Apple’s net worth on a balance sheet shows its total liabilities deducted from its total assets. For example, Apple’s net worth is $2 trillion, making it the most valuable company in the world.
- How to find it. Beginning retained earnings + net income ÷ loss – dividends
- What it shows. A corporation’s retained earnings demonstrate how much revenue a company has after dividend payments to its shareholders.
- Apple’s retained earnings are the section of a company’s profits that are reserved for reinvestment. Apple’s retained earnings are $15.26 billion.
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Once you know how a company is doing, you’ll need a brokerage account to trade its stock.
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When you’re investing in a stock, reading the company’s balance sheet is crucial to know how well it’s performing financially. If you want to find stocks to invest in, compare different brokers to find out which stocks have the best balance sheets to add to your portfolio.
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