Reading a balance sheet: Assets

Balance sheets provide a snapshot of how the company's assets (the value a company takes in) are balanced out against its liabilities (what the company must pay out). When assets equal liabilities plus equity, that's when the statement is said to be in balance.

Assets include company resources that are worth something. Many of these are self-explanatory like cash and investments. Others are less familiar, like current assets, which refers to the value of assets that are readily converted into cash, such as inventory or receivables.

Longer-term assets vary depending on business type, but may include such things as property or equipment values. Since long-term assets gradually decrease in value over time, accumulated depreciation is subtracted from this. Note that depreciated assets may show up as having little or no value on the balance sheet but may have a much greater market value if sold.

Reading a balance sheet: Liabilities

Liabilities are obligations the company has made 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. It's important to note these outside parties do not have ownership in the company; they are creditors.

Items under liabilities include accounts payable, the amount the company may owe suppliers, and income taxes payable, which is self-explanatory. Note that current liabilities, which are short-term, are listed separately like current assets. This section may also contain long-term debt obligations. For example, if the company has taken out bank loans to finance equipment or real estate, or if the company has issued corporate bonds to investors.

A figure called the quick ratio helps investors determine if a company's assets and liabilities are in a healthy balance. The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assets. The higher the quick ratio, the better the financial position of the company. It's calculated as follows:

Note that the quick ratio is more conservative than some other liquidity measures, like the current ratio, because it excludes inventory from current assets. If you believe the company might have difficulty turning their inventory into cash, then the quick ratio might give a more accurate picture of the company's short-term financial strength.

Reading a balance sheet: Equity

In a fundamentally healthy company assets will outweigh liabilities. The difference between the two is called equity. Again, a balance sheet balances when Assets equals Liabilities plus Equity (A=L+E). This brings us to the bottom section of the balance sheet: shareholders' equity. Equity is capital obtained from sources other than creditors. What are these sources? Paid in capital refers to money investors paid the company for the stock during the initial public offering in order to become shareholders. Paid in capital also includes capital raised from any subsequent offerings or sale of new stock. Keep in mind this does not equal the current price of the stock.

Here's some background on retained earnings. Mathematically speaking, this is the amount that evens both sides of the balance sheet. Retained earnings refers to the income that is kept by the company. It's not a pile of cash sitting around. It's the amount of money that belongs to the shareholders: the value the company has generated beyond paid in capital and assets that exceed liabilities. Investors generally like to see retained earnings growing over time.

A company's balance sheet gives you a high-level picture of a business, but by itself it tells only so much. Balance sheets always balance assets with liabilities and shareholders' equity. You'll need to delve deeper into income and cash-flow statements to learn more about the health of the company and whether its growth is trending up or down over time.

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