Island Investing: Balance Sheets

Q. What kind of information should I be looking at on a company’s balance sheet?

A. You’re in luck, dear readers. There is simply no way to teach balance sheet analysis in a 350-word column. The official definition of “current liabilities” itself is 200 words long. My hunch is that many of you would rather get a hot poker in the eye, anyway.

Fortunately, there are many resources out there for the motivated investor – the best being Graham and Dodd’s Security Analysis. I’ll cover just a few highlights here.

And rest easy, math-phobes. There is only one equation you need to remember: Assets = liabilities + shareholders’ equity. Or, the stuff on the left must equal the stuff on the right, so the two sides “balance.” Hey, nobody hires accountants for their creativity.

The balance sheets of companies in the finance, utility and railroad industries are a bit specialized. Most retailers and manufacturers, however, use fairly consistent terminology and formatting. At a high level, then, on the left side are assets, or what the company owns; on the upper right side are liabilities, or what the company owes; and on the lower right side is shareholders’ equity, or what has been invested in the company. Liabilities are listed above equity on the balance sheet to remind you that the debtors have a higher claim on assets than stockholders. So don’t get too cocky. Also remember that a balance sheet is a snapshot at a given point in time, not a record of changes.

In his book, Ben Graham summarized a key point in balance sheet analysis: “The liabilities are real, but the value of assets must be questioned.” Except for cash, the value of assets is often up to management’s accounting philosophies. The value of liabilities is not subjective, however, and it’s usually not worth the effort to scrutinize shareholders’ equity. So to analyze balance sheets well, focus on assets.

While the balance sheet can be a strong indicator of the health of a business, it’s also backward-looking. It doesn’t tell much about future income. We’ll get to that next.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.
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