Pretend that you are going to apply for a loan to put a swimming pool into your backyard. You go to the bank asking to borrow money, and the banker insists that you give him a list of your current finances. After going home and looking over your statements, you pull out a blank sheet of paper and write down everything you have that is of value (your checking and savings account, mutual funds, house, and cars). Then, at the bottom of the sheet your write down all of your debt (the mortgage, car payments, and your student loan). You subtract everything you owe by all the stuff you have and come up with your net worth.
Congratulations, you just created a balance sheet.
Balance Sheets Required by the Securities and Exchange CommissionJust as the bank asked you to put together a balance sheet to evaluate your credit-worthiness, the government requires companies to put them together several times a year for their shareholders. This allows current and potential investors to get a snapshot of a company's finances. Among other things, the balance sheet will show you the value of the stuff the company owns (right down to the telephones sitting on the desk of their employees), the amount of debt, how much inventory is in the corporate warehouse, and how much money the business has to work with in the short term. It is generally the first report you want to look at when valuing a company.
Before you can analyze a balance sheet, you have to know how it is set-up. That is what this lesson aims to teach you.
What makes a corporate, limited liability company, or limited partnership balance sheet different from the ordinary household balance sheet is that there are a lot of complex items on the books of an operating enterprise. Companies have to deal with all sorts of difficult questions that most people do not; how to depreciate and cost out a jumbo jet, how to account for the construction expenses of a power plant, dealing with lease obligations for retail space in a busy shopping mall, valuing large inventory stockpiles that might have gained or lost value since acquired, establishing reserves for potential future losses on bank loans made to borrowers, and translating multiple currency assets and liabilities back to a reporting currency are just a few examples.
It might seem overwhelming, but when you break it down into the individual parts, you realize that there is nothing particularly difficult about any of it. The entire purpose of the balance sheet is to answer three questions:
- What do we have? (Assets)?
- What do we owe? (Liabilities)?
- What is left over for the owners? (Book value or net equity)?
Note: Unlike other financial statements, the balance sheet cannot cover a range of dates. In other words, it may be good "as of December 31, 2009", but can't cover from December 1 - December 31. This is because a balance sheet lists items such as cash on hand and inventory, which change daily. You'll find that the way to deal with this when calculating many ratios, which I'll explain later, is to take the "average weighted" figures of a balance sheet. For example, if you wanted to know the average inventory value for the year, you would take the inventory value at the end of last year, add it to the ending inventory value this year, then divide by two. It's a quick trick that helps you avoid distortions by ending period figures that may or may not reflect what was going on for most of the year. One illustration: If a manufacturing business paid off all of its debt, and showed $0 in liabilities on the balance sheet, yet you saw a line for interest expense on the income statement, you might be confused. By weighting the average debt outstanding from the balance sheet for the same period, you'd get a better idea of what was going on and why there were interest costs.
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.