Reading a Balance Sheet: Essential Financial Metrics

Used correctly, the balance sheet can unlock many insights into any company’s state. That’s why many investors go to lengths to learn them, which is the basis of this guide. Beyond covering core principles, this guide delves into essential metrics, advantages, disadvantages, and more related to balance sheets. By its end, you’ll have learned how to use them effectively in your stock investments and analysis.

What’s a Balance Sheet?

To effectively answer this question, let’s revisit the purpose of setting up a business. Ask any business person the motivation behind their venture, and they’ll tell you it’s value creation. Now, creating that value requires ownership of certain factors of production (assets). Those, in turn, attract expenses in the form of capital injection and liabilities.

And for a business to remain viable, it must find the right mix of its assets and expenses. Here’s where a balance sheet comes in. This document outlines a company’s assets, obligations (liabilities), and shareholder equity. 

You may imagine it as a company’s financial barometer measuring its effectiveness in resource utilization. The tool is an offshoot of the fundamental accounting equation:

Total Assets = Total Liabilities + Shareholder Equity 

This equation must always balance, which explains the document’s name. It also underscores its importance in profitable stock investing. 

What Makes a Balance Sheet?

From the preceding section it’s clear that a balance sheet’s primary components are its assets, liabilities, and the owner’s equity. Here, we take a detailed view of the three, starting with the assets.

Assets

An asset is anything of value that the business owns. Again, as we’d explained earlier, assets are critical components of the production process. The balance sheet reveals two primary types of assets: current assets and noncurrent assets.

The difference between the two is in their level of liquidity. On one hand, current assets (liquid assets) are those that the business can liquidate in a year. These include cash, cash equivalents, account receivables, and inventory.

On the other hand, non-current (fixed) assets are those the firm intends to hold for the long haul. Some may remain the company’s property for the venture’s lifetime. Examples include land, plant and machinery, buildings, natural resources, and patents. 

A typical balance sheet is T-shaped and lists assets on the left hand side. Moreover, it arranges them in order of liquidity. That means the most liquid ones appear first, with the least coming last.

Liabilities

These are a business’s outstanding debts and are of two kinds: current and non-current liabilities. The former are financial obligations that the enterprise must settle within a year. Examples include short-term debt, accounts payable, accrued expenses, deferred revenue, taxes owed, etc.

Meanwhile, the latter are debts due and payable in the long-term, i.e., in over a year. These can be long-term loans, deferred taxes, bonds payable, or leases extending over a year. The standard balance sheet lists both liabilities on the right, beginning with the most current ones.

Shareholders’ Equity

Startups need capital to set off, and the primary source of these funds is the owners/founders themselves. As the business picks, they may raise more capital by selling shares in the company to new players. These monies are what we call shareholders’/owners’ equity.

In a nutshell, shareholders equity is what the company owes its shareholders.  In other words, it’s what’s due to the owners when the company liquidates its assets after settling its debts. Besides the owners’ contributions, it includes any retained/reinvested profits.

You can calculate the owners’ equity by rearranging the balance sheet equation to:

Shareholder Equity = Total Assets – Total Liabilities

Example:

A company’s assets are worth $1,000,000, and its liabilities are $750,000. Its shareholders’ Equity is $1,000,000 – $750,000 = $250,000.

Some Essential Balance Sheet Metrics

With the basics out of the way, it’s time to move to the balance sheet’s fun part: making sense of it. In this section, we’ll show that balance sheets are more than numbers;  they tell a company’s story. 

That narrative is borne in some key performance indicators (KPIs) or financial ratios, some of which we’ll cover here.

1. Current Ratio: Can the Company Pay Its Short-Term Bills?

The current ratio measures a company’s ability to pay its bills due within the next year. Here’s how to calculate it:

• Current Ratio = Current Assets / Current Liabilities

Example: 

A company has $500,000 in current assets and $300,000 in current liabilities. Their current ratio is $500,0000/$300,000 =1.67, meaning they have $1.67 in current assets to cover every $1 of short-term debt, a good sign. 

A healthy current ratio is generally above 1. That indicates that the company can comfortably meet its near-term obligations.

2. Quick Ratio (Acid-Test Ratio): Paying Off Debts Right Now

Like the current ratio, the quick ratio looks at short-term debt but is stricter. It only considers assets that can be quickly turned into cash:

• Quick Ratio = (Current Assets – Inventory) / Current Liabilities

Example: 

The same company above has $200,000 of inventory. Their quick ratio would be (500,000 – 200,000) / 300,000 = 1. This is decent but less comfortable than their current ratio.

The quick ratio gives a more critical view of immediate liquidity. Ratios below 1 could mean trouble meeting debts in a pinch.

3. Debt-to-Equity Ratio: How is the Business Financed?

This metric tells you how much debt a company carries relative to shareholder investments:

• Debt-to-Equity Ratio = Total Debt / Total Shareholder Equity

Example: 

A company has $1 million in debt and $2 million in shareholder equity. Its debt-to-equity ratio is 0.5, meaning they have $0.50 of debt for every $1 of equity.

There’s no “perfect” number, as good ratios vary by industry. But in general, a lower ratio is better. High debt levels can mean more risk if the business experiences a downturn.

4. Debt-to-Assets Ratio: Another Look at Leverage

Similar to the above, but instead, it looks at debt relative to all assets:

• Debt-to-Assets Ratio = Total Debt / Total Assets

Example: 

Our company above has $3 million in total assets. Its debt-to-asset ratio would be 1,000,000 / 3,000,000 = 0.33, meaning 33% of its assets are financed with debt.

A ratio above 1 means a company has more debt than assets. While manageable in some cases, it can signal higher financial risk.

5. Return on Equity (ROE): Profitability for Shareholders

ROE reveals how well a company uses the money invested to generate profits:

• ROE = Net Income / Shareholder Equity

Example: 

A company earns $200,000 in profit with $1 million in shareholder equity. Their ROE is a solid 20%. It’s good to compare a company’s ROE to others in the same industry. A higher ROE generally means more efficient use of investors’ money.

Additional Considerations

Remember that context is key, so don’t view these ratios separately. Compare them across a company’s history,  competitors, and general industry norms. Additionally, qualitative factors also matter. Balance sheets don’t tell the whole story. Therefore, consider a company’s management, market position, and prospects as well.

What are the Advantages and Disadvantages of Balance Sheets?

This guide has so far shown the balance sheet to be a vital document to any investor. But like any other company analysis tool, it isn’t foolproof. So, knowing its pros and cons can be a boon to your stock investment journey.

Pros

• It provides insights into a company’s financial standing at a given time
• You can use it to calculate key financial ratios for comparing companies you’re interested in.
• It’s easy to read as it presents information in a scannable format.
• It allows you to look inside the company’s affairs, enhancing transparency in their dealings with you.
•  You can use balance sheets to track a company’s performance over time.

Cons

• There’s a danger of a company window dressing figures, thus misleading investors.
• Balance sheets deal with historical information, so you can’t use them alone to predict future performance.
• Some may use investment jargon, which may be off-putting to many investors.
• It overlooks vital non-monetary aspects like the company’s human resources.

Final Thoughts

The balance sheet’s importance arises from how it reveals the interplay between a company’s assets, liabilities, and owner’s equity. Understanding this relationship clues you in on its financial health, which is vital to sound investments. But remember, it isn’t foolproof. So, use it with other company analysis tools to guide your stock selection.

FAQs

What’s the owner’s equity?

This is the amount of money that a business owes its investors. You calculate it by deducting total liabilities from the total assets.

What’s the balance sheet equation?

The balance sheet equation, also known as the accounting equation, is:

Assets = Liabilities + Equity

This equation represents the fundamental principle of accounting, which states that a company’s assets must be equal to the sum of its liabilities and equity.

What’s a balance sheet’s purpose?

A balance sheet gives you a brief overview of a business’s financial standing at a given period.