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Analyzing Financial Statements – The Balance Sheet

Investors would be aware that looking at company financial statements are one of the important parts of stock analysis. Ratios derived from such financial statements are not the be-all and end-all to the decision-making process but they play a vital role. They provide an understanding of the financial health of the company and ease the evaluation process. You would have read about some key stock ratios in an earlier post.

There are three components to a financial statement, namely,

  1. Balance Sheet
  2. Earnings
  3. Cash Flow

This series will take a look at all three of them in some detail and address a few ratios that can be deduced from them.

Consolidated Balance Sheet

The balance sheet of a financial statement provides information about a company’s assets, liabilities, and shareholders’ equity on a quarterly or annual basis. The balancing formula for the sheet is as follows:

Total Assets = Total Liabilities + Shareholders’ Equity

The “Assets” section of a balance sheet will include cash, cash equivalents, short-term investments, inventories, account receivables, plant and equipments, and intangibles. Assets that are non-physical in nature such as intellectual property (patents, brand names, etc.) and goodwill (the amount paid in excess of its book value for an asset) are grouped under intangible assets.

The “Liabilities” section involves short and long-term debts, account payables, and other debt resulting in a cash outgo. The “Shareholders’ Equity” section would comprise of common stock, preferred stock (if applicable), retained earnings, and additional paid-in capital.

There are several ratios that could be computed from the data available on a balance sheet.

Debt Ratio

This is a measure of the total liabilities to the total assets of a company and differs from the current ratio that only considers current assets and current liabilities.

Debt Ratio = Total Liabilities / Total Assets

The lower the debt ratio, the better the financial shape of the company. A ratio higher than 1.0 means that the company has more debts than assets. However, startup firms will have a high debt ratio as they may not have started to see the fruits of their labor yet.

Debt to Equity Ratio

This metric measures the ratio of total liabilities to the shareholders’ equity.

Debt to Equity Ratio = Total Liabilities / Shareholders’ Equity

The lower the debt to equity ratio, the better for shareholders as this implies that the investors have a fair share of equity contributing to the company’s bottomline.

Capitalization Ratio

This is a measure of the long-term debt of a corporation to its total capital (assets). Total assets include long-term debt and shareholder’s equity.

Capitalization Ratio = Long-term Debt / (Long-term Debt + Shareholders’ Equity)

The lower the capitalization ratio, the lesser the chance of financial instability as this indicates that the amount of financial leverage is low. A ratio of 1.0 would mean that there is no shareholder equity in the company and the total assets reported are based on debt.

Do you read financial statements? Do you use the above ratios in your decision-making process apart from others (to be discussed in following posts)? Did any one of the above become a red flag, i.e., a high ratio, to reject a stock?

About the Author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism.  You can read his other articles here.

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About the author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism. You can read his other articles here.

{ 7 comments… add one }
  • Juan September 7, 2011, 8:04 pm

    It can also be important to be able to differentiate between long term and short term debt. In a practical sense debt is usually impactful to a business to the degree that it impacts cash flow. Long term debt obligations can come to maturity during the most importune times. As an investor it is best to know all that is possible to know about the debt structure of a given company.

  • Clark September 7, 2011, 9:49 pm

    Good point, Juan! The maturity of long-term debt could turn out to be very important.

  • Sarlock September 8, 2011, 1:17 am

    I read the financial statements for all of the companies that I invest in… the most important statements, in order of importance to me, are the Balance Sheet, Cash Flow Statement and lastly the Income Statement. Yes, profits are nice, but the most important thing is the balance sheet and cash flow. A company can be making a profit and still go bankrupt if it isn’t being run properly. Being able to read financial statements is a major asset for the DIY investor.

  • Ralph September 8, 2011, 10:53 pm

    When I started looking at consolidate balance sheets of companies I noticed some of them declare “total current” and “total non-current liabilities”. Do I just add the 2 to get total liabilities? Also there is current and non-current assets, should both be added as well to get total assets?

  • Market Maker September 9, 2011, 12:03 am

    This is such a difficult topic for so many people. I’m glad that you’re giving it a shot. I think your explanations were good. What about talking about the famous PE ratio?

  • Clark September 9, 2011, 6:37 pm

    @Ralph: Total liabilities = (total current + total non-current) liabilities. In other words, (short-term + long-term) liabilities. Same goes for assets.

    @Market Maker: Thanks! I will not be addressing the P/E ratio as FrugalTrader has already covered it in an earlier post (see below).
    https://www.milliondollarjourney.com/how-key-stock-ratios-work-price-earnings-price-book.htm

  • Jean September 10, 2011, 11:10 pm

    Nice summary, theres alot of different ratios you can make out of the balance sheet and financial statements.Just gotta make sure you use the ones that are the most significant for what you are trying to measure, as certain ratio combinations will be misleading but incredibly helpful with a combination of other ratios.

    -Jean

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