The Purpose of the Balance SheetHow many times have you flipped to the back of a company's annual report or 10K and found yourself blankly staring at the pages of numbers and tables? You know that these should be important to your investing decision, but you're not quite sure what they mean or where to begin. What is a balance sheet? Why does it matter? Why are professional investors so obsessed with studying it, and even more importantly, how are they able to use it to reduce their portfolio risk and make better, safer decisions when it comes to putting their own money to work?
In this investing lesson, I'm going to help you take your first major step towards changing that by teaching you about the balance sheet. Smart investors have always known that financial statements are the keys to every company. They can warn of potential problems, and when used correctly, help determine what a business is really "worth". An investor who understands financial statements will never have to ask "is this company a good investment?".
The Role of the Balance Sheet In the Financial StatementsFor every business, there are three important financial statements you must examine: The Balance Sheet, the Income Statement, and the Cash Flow Statement. The balance sheet tells investors how much money the company has, how much it owes, and what is left for the stockholders. The cash flow statement is like the checking account; it shows you where the money is spent. The income statement is a record of the company's profitability. It tells you how much money a corporation made (or lost).
In this lesson, we are going to learn to analyze a balance sheet. There are two segments. In the first, we will go through a typical balance sheet and explain what each of the items means. In the second, we will actually look at the balance sheets of several American corporations and perform basic financial calculations on them.
My goal for many of you by the end of this series of financial statement analysis lessons is to give you the basic skills to pick up the financial statements and use the balance sheet, income statement, and cash flow statement together to perform calculations that provide an idea of how much debt the business has relative to its equity, how quickly customers are paying their bills, whether short-term cash is declining or increasing, the percentage of assets that are tangible - factories, plants, machinery - and how much comes from accounting transactions, whether products are being returned at higher-than-average historical rates, how many days it takes, on average, to sell the inventory the business keeps on hand, whether the research and development budget is producing good results, whether the interest coverage ratio on the bonds are declining as an early sign of trouble, the average interest rate a company is paying on its debt, where the retained profits that aren't being sent to owners in the form of dividends are getting spent or reinvested, and much more. Accounting is the language of business and these three financial statements, the balance sheet among them, are the report card.
Let's Get Started on Teaching You How to Analyze a Balance SheetAre you ready? Grab a cup of coffee, a nearby calculator and let's begin! If you have a few annual reports your stock broker has sent you, you may want to grab those, too, so you can see how real-world balance sheets sometimes differ slightly in presentation and formatting.
As you click through the balance sheet lesson, realize that I tried to organize each, individual topic on its own self-contained page so you wouldn't be overwhelmed. I highly recommend you do not move forward until you fully understand, and have mastered, the page you are reading because I designed the balance sheet tutorial to be worked through sequentially; topics will be built upon what was discussed earlier, and some examples, such as sample financial ratio calculations, will be pulled from earlier data with which you've already become familiar.
This page is part of Investing Lesson 3 - Understanding the Balance Sheet. To go back to the beginning, see the Table of Contents. If you have already read this lesson, you can skip directly to the Balance Sheet Quiz.