Strive for a Good Balance

In my last post, I talked about what makes a good buy based on the numbers you find on a company’s stock information page on Google or Yahoo finance. All of this information is helpful and necessary, but you should know where they came from.

Much of the information originated from the companies’ finance statements, 3 of which are the most talked-about: the balance sheet, income statement, and cash flow statement. These can be found under the heading "Financials," or "Financial Statements" on Google or Yahoo. Today, we'll talk balance.

A balance sheet is a “snapshot” of the company’s current financial health. It tells you how much the firm has in cash and other assets, liabilities, and equity at this moment in time.

For the sake of simplicity, we’ll call assets “what we have” or “what we’re owed.” Assets include cash (like, checking account balances), property, and accounts receivable (the amount other people owe the company). Same as with a person’s finances, companies generally want to maximize assets; who wants to be in debt?!

Speaking of debt, companies have liabilities, which are also found on the balance sheet. Liabilities include anything owed to others: accounts payable and long- and short-term debt. Again, like individuals, companies generally try to minimize their liabilities, but debt is not all bad. Companies get a special tax break for having debt, so some will take out debt just for that purpose. So don’t count a company as irresponsible for not being debt-free like LULU.

Finally on the balance sheet, you’ll find “equity.” This can be most closely related to a house: down payments and any increase in value adds to the house’s “equity.” For a company, equity is in terms of the stock it has issued and profits it has accumulated over time. This cannot be spent, but still counts as value.

If you look at a balance sheet, you’ll see that the total amount of assets will equal the total amount of liabilities plus the total amount of equity. This will ALWAYS happen. Sort of a law of nature. Assets = liabilities + equity. So, if the company has a lot of liabilities, it has to make up for it in assets and/or decrease its equity.

Why is this important to you as an investor?

It is the best way to determine the company’s financial health. It’s important to know what the company is doing with its money, but even more important to know if it has any money to begin with. If liabilities are more than 2 times the amount of cash the company has, then you should question how it plans to pay the debt down.

Look at the amounts over time. Is cash growing? If it is going down, is debt also going down? (That would mean the company is paying down excess debt.) Is debt growing? If so, is property growing? (Sometimes, you have to take out debt to buy property, of course.)

Always ask questions. The financial statements are a puzzle that all fit together; one affects the others just as well it affects other parts of itself.

Next up, income statement = profitability. Stay with me!