What the Balance Sheet Can and Cannot Tell YouOnce again, congratulations. You now have the tools necessary to analyze a balance sheet. Before you go running out wielding your new-found power of fundamental analysis, you have to understand the limitations of the balance sheet. If I were going to sell you the local grocery store or corner gas station, you would not make an offer based solely on the balance sheet. Instead, you would take into consideration the profit the business generated, the future prospects for the business, the local competition, etc. That is precisely what you are doing when you look at a publicly traded company; you must make a decision just as if you were purchasing a private business. The balance sheet is just one key in making that decision; it is the theoretical value of the enterprise if you were to purchase it, liquidate the assets, and shut its doors. The liquidation value is not the true value of a business - what is important is how much cash it can generate for the owners in the future. Only in exceptionally rare cases (where a company is trading for less than its working capital, for instance) could you make an investment decision based solely on the balance sheet.
Often times, the information you find on the balance sheet isn't valuable in and of itself; it must be compared with something else. There were a few calculations we looked at that required the use of the income statement, which is the focus of Lesson 4. As you progress through these lessons, you will find that by using the three financial statements together, you can garner nearly all of the secrets of any business.
Now, get ready to put your skills to the test. We're going to analyze a few balance sheets together.
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.