"The Balance Sheet of a Company Logs a Lot
of Financial Data - Allowing Analysts To
Calculate Ratios - and Make Informed Decisions"

Introduction

'The Balance Sheet' tells us how much money a company has in the bank and what the company owes. 

Subtracting the money that is owed from the money that is in the bank and the result is the net worth of the company.

'The Balance Sheet' of a company is published on a particular day.  It is a snapshot of how the company is faring on that particular day.  Accountants usually prepare these statements every quarter (i.e. 3 monthly intervals). And, of course, at the end of the fiscal year.

From this Financial Statement, investors can calculate, or the calculations are done for them, on Financial Ratios such as:

  • Current ratio
  • Acid test ratio
  • Debtor day and creditor days
  • Stock days and stockturn
  • Gearing
  • Price/cash ratio
  • Burn rate
  • Return on capital employed
  • Return on average equity
  • Net tangible asset value
  • Premium (or discount) to net asset value
  • The "Z score"

"What is The Balance Sheet?"

Warren Buffett spends hours and hours poring over company 'Financial Statements' trying to find that golden nugget: the  Durable Competitive Advantage.

He knows that if he finds what he wants by way of his number crunching, he will have found another gem. He will also number crunch other 'Financial Statements' i.e.  The Income Statement and The Cash Flow Statement of a company to make sure the numbers that he has "crunched" meet his criteria. 

This crunching of numbers may take him a long time.  Sometimes weeks, or months even. But he's meticulous.

'The Balance Sheet' is not produced to cover a specific period (e.g. a quarter) like 'The Income Statement' or 'The Cash Flow Statement' are.  'The Balance Sheet' is generated for a specific day of the year.

The Balance Sheet is broken down into two sections: 

  1. Assets and
  2. Liabiities plus Shareholder Equity. 

    Both sections have to be exactly equal, hence the term 'balance'.

'Assets' include things like cash, receivables, inventory, property, plant and equipment.

'Liabilities and Shareholders' Equity' are not that straight-forward.  Liabilities are broken down into Current Liabilities (monies that are owed within a year) and Long-Term Liabilities (monies that are owed for a year or more).

Current Liabilities include accounts payable, accrued expenses, short-term debt, and long-term debt.

Long Term Liabilities include money for goods bought, unpaid taxes, bank loans, and bond loans.

If all the Liabilities are subtracted from the Assets we are left with the company's 'Net Worth' otherwise known as  'Shareholders' Equity'.

Assets - Liabilities = Net Worth (or Shareholders' Equity)

In our example below this would look like:

£60,303 - £16,460 = £43,843 (x Millions)

"How is The Balance Sheet Made Up?"

The Balance Sheet typically would look like the following:

£ x million

Assets                                             £ Million       Liabilities                       £ Million

Cash and Short Term Investments     8,356          Accounts Payable              2,530
Total Inventory                                    4,341          Accrued Expenses           10,244
Total Receivables, Net                        6.401         Short-Term Debt                11,888
Prepaid Expenses                               4,140         Long-Term Debt Due             258
Other Current Assets, Total                    543         Other Current Liabilities         476 
Total Current Assets                          23,781         Total Current Liabilities      25,396                   

Property/Plant/Equipment                  15,895        Long-Term Debt                 6,501
Goodwill, Net                                        8,008        Deferred Income Tax         3,776                
Intangibles, Net                                   15,507       Minority Interest                    276               
Long-Term Investments                      14,776       Other Liabilities                   5,907 
Other Long-Term Assets                       4,896       Total Liabilities                  16,460               
Other Assets                                         1,221                                                                 
Total Assets                                         60,303       Shareholders' Equity     

                                                                              Preferred Stock                        0
                                                                              Common Stock                   2,500    
                                                                              Additional Paid in Capital  15,494 
                                                                              Retained Earnings             71,555
                                                                              Treasury Stock-Common  -45,706_
                                                                              Total Shareholders' Equity  43,843    

                                                                              Total Liabilites and              60,303
                                                                              Shareholders' Equity                               

You will observe that in The Balance Sheet, the Total Assets balance exactly with the Total Liabilities.

"What Financial Ratios Are Derived From
The Balance Sheet?"

The Current Ratio 

It has been commonly recognised that if you subtract a company's current liabilities from its current assets then it's a good indication that the company can meet its short term obligations if that number is large and positive. But not very defining in itself.

Then, some boffin came up with what they dubbed 'The Current Ratio'. Which can be derived by dividing the current assets by the current liabilities.

The formula for this ratio is: 

current assets / current liabilities = current ratio

And in our example, it would look like:

23,781 / 25,396 = 0,94

It has normally been accepted that a Current Ratio greater than 1 is reckoned to be good. And anything less than 1, not so good.

Sounds simple enough.  In fact - too simple.

Let's not forget: what we are really looking for with our study of ratios.  And that is to find companies that have the 'Holy Grail'. 

Companies that have a Durable Competitive Advantage (DCA), are what we are looking for (because Warren Buffett says so).

Alas, companies with a Current Ratio less than 1 can also have a DCA.  It's not just companies with a Current Ratio of more than 1. 

So, whilst the Current Ratio is another indicator for our collection, it is not a very useful one.  At least, not in the pursuit of our Holy Grail.

What the Current Ratio does indicate however, is a company's liquidity.  A company with a Current Ratio above 1 would be better placed to pay its current liabilities when they become due (as opposed to a company with a Current Ratio of less than 1).

The Return on Total Assets

Investors like to know how efficient a company is in putting its assets to use.  They have therefore developed a ratio called the Return on Equity Ratio which is determined by dividing net earnings by total assets.

In our example, the Return on Assets would be:

5,888 / 60,303 = 9,76%

To sum up: our fictitious company has £60,303,000 in total assets with net earnings of £5,888,000 giving a Return on Assets of 9,76%

Most analysts would like to see a Return on Assets as high as possible.  But our friend Warren, has figured out that really high numbers may indicate some kind of weakness.

So again, we have a financial ratio that is a guide but not necessarily leading to the Holy Grail.

Debt to Shareholders' Equity Ratio

Has been used in the past to identify companies that are using debt or equity to finance their operations.

Warren Buffett is always, always on the lookout for companies that have that Durable Competitive Advantage - the Holy Grail as we call it.

And those companies use equity to finance their operations.  Companies without a Durable Competitive Advantage use debt.

The formula for calculating this ratio is:

Total Liabilities / Shareholder's Equity = Debt to Shareholders' Equity

And in our model, this figure would be:   

16,460 / 43,843 = 0,375

Some companies actually have a negative value.  Stay away from these like the plague.

Generally speaking, the lower the ratio the better.  0,375 is very low and would, in isolation, suggest that our fictitious company is a real gem.  Of course, it is only one ratio - but it's looking good.

Book Value

What is Book Value? 

If Total Assets are divided into Total Liabiities the result is the net worth of a company.

Net worth is also known as the Book Value.

In our little example the value is:   

£60,303 / £16,460 = £43,843 (x Million)

Return on Shareholders' Equity

Shareholders' Equity comes from 3 different areas:

      1.  The capital raised selling stock to the public

      2.  Any further stock sold to the public

      3.  Any accumulation of retained earnings

Our favourite friend, Warren Buffett discovered that companies with a Durable Competitive Advantage showed higher than average Return on Shareholders' Equity.

Here's the formula: 

Net Earnings / Shareholders' Equity = Return on Shareholders' Equity

Inputting some figures into our example gives us:   

5,888 / 43,843 = 13,43%

Warren would regard this figure as a tad on the low side.  Figures in excess of 30% are better.  But there, again, this is only one parameter. 

Good analysis means looking at all the ratios and then forming an opinion.

Leverage

Leverage is the borrowing of money to finance growth.

In our example, if the company could borrow money at less than 13,43% interest then it can make even more money.

For example, if the company were to borrow money at 8% then with a Return on Shareholders' Equity of 13,43% it could make more money, thus giving the impression that it has a Durable Competitive Advantage. 

Warren Buffett has learned to shy away from companies that use leverage to help in generating earnings.

"Books About Financial Statements
That Will Help Your Understanding"

Financial Ratios are a BIG help to private investors. 

They give enough information, at a glance, without having to root amongst the actual Financial Statements.  That can be left to the number crunchers.

Below are some excellent books that we refer to almost every week.  What is not within their pages, is not worth knowing about.

Warren Buffett and The Interpretation of Financial Statements by Mary Buffett and David Clark

We have to say, this is a great primer.

This book is so well-written which makes a stodgy subject like The Balance Sheet and other Financial Statements easy to read and understand.  Not only does the book go into just about the right kind of detail for the private investor but it is specifically written around the methods of the man himself - Mr. Warren Buffett.

If you want to learn and understand anything about company financials, this is a great book to get you started.  Just click on the link below:

Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with a Durable Competitive Advantage

Warren Buffett Accounting by Stig Brodersen and Preston Pysh

This book analyses important aspects of company accounts. It covers subjects such as:

1. Methods of calculating the Intrinsic Value of a company

2. Detailed instructions on how to read an The Income Statement, The Balance Sheet, and The Cash Flow Statement

3. How to calculate important ratios enabling you to evaluatee any company.

Get yourself a copy of this book by clicking the link below:

Warren Buffett Accounting Book: Reading Financial Statements for Value Investing

Ratios Made Simple by Robert Leach

Understanding financial ratios is a good way of beginning to understand company accounts. 

Finding ratios is easy - simply divide one figure by another, but the really useful information is in the trend.  Comparing one ratio with another over a period can reveal a lot about a company and where it is heading.

Ratios Made Simple covers over 30 different ratios and leaves the reader in no doubt as to the meaning and its importance in evaluating a company.

You can access a copy of this fundamentally valuable book by clicking the link below:

Ratios Made Simple

Magic Numbers by Peter Temple

Knowing all the 33 financial ratios in this volume will not make you a financial genius, no book can do that.  But it does enable you to extract valuable information about the company under study.

The book is written in plain language, ideal for private investors who want a jargon free explanation.

This resource gives dozens of worked examples with real companies.

Get this book AND its later version (see below). You can pick up very good condition used books, as well as new ones, by clicking on the link below:

Magic Numbers: The 33 Key Ratios That Every Investor Should Know

Magic Numbers for Stock Investors by Peter Temple

This volume is an up-dated version of the previous 'Magic Numbers'.

The book contains 25 ratios covering all aspects of The Balance Sheet, Income Statements, and Cash Flow Statements.

Everything that you need to be able to ascertain whether you would be paying over-the-odds for your investments.

Get this volume, and the previous 'Magic Numbers' (see above) by clicking the link below:

Magic Numbers for Stock Investors: How to Calculate the 25 Key Ratios for Investing Success

Conclusion

The Balance Sheet is one of the three Financial Statements that need to be covered.

Schlep on over to The Income Statement and The Cash Flow Statement for the other two.

As a private investor you don't have to be a financial whiz.  Just a minor understanding of statements and in particular, the Financial Ratios that are derived from them, will suffice.

Study the three statements and you will have a very good grounding in valuing stocks.

And if you want to know more - read around the subject.  It's not as boring as you first think.  Besides, it will make you into a better investor.

On this webpage we took a glimpse at :

  • Current Ratio
  • Return on Total Assets
  • Debt To Shareholders' Equity Ratio
  • Book Value
  • Return on Shareholders' Equity
  • Leverge

Not one of the above by themselves would tell you an awful lot, but collectively they are pieces of the jigsaw that, when complete, will give you the full picture.

Go to The Income Statement, and The Cash Flow Statement for more pieces of the jigsaw.

And, need we repeat ourselves?  Read around the subject.  Warren Buffett has spent his whole life studying this very topic.  Shouldn't you spend just a little of your time?

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