Understanding the Balance Sheet

Doc Maher continues with his series on Fundamental Analysis.

At the heart of Fundamental Analysis is the ability to understand what the health of a company is. One of the bits of information that is available to you is the financial statements that are filed by the company. The financial statements are meant to convey information about the company to the public, however if you don’t understand what the information is or how to read it they are useless.

Now some of you are accountants or are very familiar with these statements. For you this will have little value. However for many the financial statements are written in Greek. I know that as an engineer I had no concept of how to read or interpret financial statements. It wasn’t until I went to business school that I learned how to glean anything from them. I’m not going to try to give you a course in accounting; however just some basic information should help. So if you are like me this will be valuable information.

I used to think that the only place to find financial information was on the balance sheet. I was surprised to learn that there are three interrelated financial statements. These are the Balance Sheet, the Income Statement, and Cash Flow Statement. All three contain valuable information about the company and how well it’s doing, however today we’ll only talk about the balance sheet.

At left is a balance sheet for CAT (Caterpillar). You can find this information on the TradeKing site under Quotes + Research > Financials. Then enter the ticker of the company you want to review.

Financials are reported on both a quarterly and an annual basis. The images here are of an annual balance sheet for the years 2003 through 2007.

In most cases, balance sheets are presented in left and right side format. On the left side of the page are Assets and on the right side of the page are the Liabilities and Equity. In the format shown here, these items are listed from top to bottom instead of left to right. The top section is labeled Assets, the middle section is labeled Liabilities, and the bottom section is labeled SHAREHOLDERS’ EQUITY. We’ll begin with Assets. (See next image.)

Click the table for a larger image.

Assets as you might expect are the things (resources) that the company has that are worth something. They are listed here with their values. Most of these things are familiar. For instance “Cash & Investments” is pretty self-explanatory; some of the others are a little less obvious. Some of the Assets are also summed up into “Current Assets - Total”. Current Assets are simply things that are cash or easily converted into cash in a short amount of time, such as Receivables. The Assets that are listed after that are longer term assets such as “Property, Plant & Equipment.” Notice that “Accumulated Depreciation” is subtracted from this.

For CAT the total assets for 2007 were $54,579 million. So what does this mean? Is this what CAT is worth? Could CAT be liquidated for the $54,579 million that appears here? We’ll not exactly. We’ll get into more explanations later. One point to be made here is while assets are meant to be listed at actual value this may not be the case. For instance assets that are “depreciated” may show up as having little or no value on the balance sheet but may have a much greater “market” value. (This was the case with Kmart. It had real-estate on its books that had been totally depreciated but that could be sold for considerable sums. This is one of the things that helped it when it came out of bankruptcy. Of course Kmart is long gone and known as Sears Holdings.) Click the table for a larger image.

The next section in the middle is named Liabilities. Liabilities are obligations that the company has to outside parties who have provided resources. In essence, these outside parties may have lent money or other supplies to the company and therefore are owed repayment from said company. These outside parties do not have ownership in the company. They are also known as “Creditors”.

Items under Liabilities are “Accounts Payable”, “Income Taxes Payable” etc. Note that Current Liabilities, which are short term, are listed separately just like Current Assets were. The Total Liabilities for CAT for 2007 were $45,696 million. Notice that the Assets outweigh the Liabilities. Does this mean that the difference between the Assets and the Liabilities is the amount that CAT is worth? Again, not exactly.

Remember that I said that the balance sheet usually has a left and right side. The left side has the Assets and the right side has the Liabilities and Equity. The reason for this is that a balance sheet always has to “balance” right and left. Here we have $54,579 million in assets on the left and only $45,696 in liabilities on the right. So there has to be another $8,883 million on the right to make this even or balanced. Click the table for a larger image.

This brings us to the bottom section: Shareholders’ Equity. You will notice that the Common Equity is exactly $8,883 million. Equity is capital that is obtained from sources other than “Creditors”. What are these sources? Well there is “Paid in Capital.” This is the money that investors paid the company for the stock during the initial public offering in order to become shareholders. “Paid in Capital” is also the capital raised from any subsequent offerings or sale of new stock. Keep in mind this is not the current price of the stock.

However this does not make the two sides balance. This brings us to the concept of “Retained Earnings”. What the heck are Retained Earnings? Well basically it’s the amount that makes the balance sheet’s two sides even. The idea is that it is the income that has been kept (retained) by the company over the years. It is not a pile of cash sitting someplace. It is the amount of money that “belongs to the shareholders” that comes from there being more assets than liabilities and “Paid in Capital”. If you can’t get you mind around this concept don’t feel bad, it’s not obvious.

For CAT we see that Retained Earnings were $17,398 million in 2007. So theoretically CAT has put back into the business over $17 billion to make the company more valuable. Unfortunately you can’t do anything with that, it’s just an accounting device. However if Retained Earnings is growing that is usually a good sign. If it’s shrinking or if it’s negative (yes it can be negative) that’s generally a bad sign. Click the table for a larger image.

So what can we tell from a balance sheet? Unfortunately, a balance sheet by itself cannot tell us that much. Balance sheets always balance Assets with Liabilities and Shareholders’ Equity. A balance sheet (in fact all accounting) only reports on things that can be measured in money so it is an incomplete picture of the business. By itself it doesn’t tell us the health of the company nor will it give an accurate picture of how much the company is worth.

So why do we look at the balance sheet? Well when combined with the other two financial statements (The Income Statement and the Cash Flow Statement) we can get a better picture of what’s going on in the company. Also we can analyze trends over time. As we go further into this topic, we will discuss how we can use this information and what else to look for.

--Doc Maher

"Income Trader"

DocMaher Trading LLC

All-Star Commentator

Doc's previous posts: Three Factors that affect Execution Price and Three new tools: EPS, P/E, and PEG 
Click here for a list of previous TradeKing All-Star blogs.
Nicole Wachs contributed to this post.

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Jonathan F. Maher, PhD has a professional business relationship with TradeKing.