One of the most important financial statements for investors to understand is the balance sheet. This records the state of the company at a single point in time. It can be manipulated to a certain extent, but by checking the balance sheet each year, we can see how the financial health of a company is changing and whether that company’s stock is a worthy recipient of our hard-earned investment cash.
The accounting equation
Most people will be familiar with the accounting equation, but if not here it is: Assets – Liabilities = Equity
Equity, or shareholder equity, is what is left over once the liability holders have taken their share. If the company were to go bust tomorrow, then the liability holders would have first claims on the assets, with any leftovers going to the equity holders.
The accounting equation is important because it is the assets of a business that are important. Clearly, the assets have to be of a high enough quality to generate value for the business, and ultimately its owners, we shareholders.
Check the company’s assets year-on-year
By looking at how the financial health of a business changes every year we can see how healthy the business is and this will help us decide whether we should hold on to our shares or potentially take the plunge with a firm. If cash has increased substantially, then it’s worth checking out the cause of that consequence.
Was it because the business was cash generative? We can check the operational cash flow statement here? Or was it because the company sold a lot of equity for cash and diluted shareholders? We can check the financing cash flow statement here.
How have the company’s tangible assets changed? It is worth checking management’s policy on depreciation here, and again for amortisation when checking the company’s intangible assets.
Check current and non-current liabilities
The company’s liabilities are very important. This is because if the liability holders become too nervous, they can call in their loans. If the company is not in a financially stable enough position to pay these off and survive, then the business cannot continue.
Check the company’s current debt — debt that is to be paid in the next 12 months. This can be trade payables or administration expenses.
Also check also the company’s non-current debt — debt that does not need repaying in the next 12 months. This can be bank debt, or loans from shareholders or other directors.
One thing to be aware of too is if the directors are lending money to the company and whether they are then incentivised to see the business collapse so they can pick it up cheaply. This is a very real risk with some firms and something of which to be aware.
The balance sheet and other financial documents
The company’s health is carefully laid out in the balance sheet, and for any serious investor it is important to check this alongside cash flow statements in order to make proper sense of the business.
Look at how much the company is burning through per period, and check the company’s cash balances. This will ensure that we are not buying shares in a business that will be launching a dilutive equity placing not long after we buy. Happy investing!
Views expressed in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.