The first step in finding potential investment opportunities is to be able to go through and evaluate a company’s financial report. In this article we evaluate the Balance Sheet.
In addition to the Balance Sheet, companies also release an Income Statement and a Statement of Cash Flows.
The Balance Sheet is one of three financial statements released by a company every quarter that allow investors an inside look into the company’s books. The Balance Sheet shows the company’s assets, liabilities and shareholder’s equity at a specific time.
The Balance Sheet, Income Statement and Cash Flow Statement are all found within a company’s 10-Q (Quarterly report) or 10 – K (Annual report) filed with the Securities Exchange Commission.
Before you begin investing in individual companies you must have a basic understanding of what these 3 financial statements tell you. There is no better way to truly assess a company’s standing than taking the time to read these reports. How does a company make its money? How much money does the company make? Can the company afford to pay its bills? All of these questions can be answered from a basic understanding of a company’s financial statements.
Sometimes this is no easy task. Annual reports are typically hundreds of pages long.
In this article we go through several examples of evaluating a company’s balance sheet and help you determine what information is significant and how to use that information to make an informed investment decision.
By being able to comb through these documents, you will know information that only a small percentage of investors know. Why?
Simply put, many investors are lazy and purchase stocks based on TV news coverage or co-worker tips. Very few do based on research of a company’s financial statements.
Later in this article I will show you how taking the time to read the 200+ pages of Facebook’s first financial filing would have given investors clues to stay clear of Facebook after its IPO (Initial Public Offering) and collectively saved investors billions of dollars. Clearly showing how important these documents are – and how little they are read!
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These reports can be found on the SEC’s EDGAR Database found here, Or can be found listed on the company’s webpage in the “Investor Relations” section.
Let’s start with an example company,show how to find their reports on the SEC’s database and their investor relations website and then use that information to determine if the company is in good financial standing. For this article we will look at Praxair, Inc. Ticker Symbol PX – A company that sells atmospheric gases such as helium and oxygen.
(Incase you are wondering – I have no direct investments in Praxair)
Investor’s taking a first look at Praxair will see basic information such as Praxair’s Yahoo finance page, shown below:
How many investors buy this stock today based only on this information, or less?
Although it is useful, in order to get an accurate view of the company’s financial standing you need to dig deeper.
Praxair’s financial statements can be found in 2 places:
From the SEC’s EDGAR database, start by searching by ticker symbol PX
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From this search you will see a long list containing every filing Praxair has submitted to the SEC. Lets look for the most recent 10-K, or annual report.
For those reading this article in the future – we are bringing up 2011’s 10-K.
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There are several ways to bring up the report.
The blue Interactive Data button brings you to a page where you can view the company’s balance sheet along with lots of other information, by selecting the appropriate box on the left side of the page. From here you can also download the data into Excel (circled in green in the picture below), which is my preferred way to view the data tables.
Or instead of clicking the blue “Interactive Data” button, you can click the white “Documents” button to the left and download the filing in PDF format. Click the .htm link circled in green below to open up the 107 page document. These 107 pages contain much more than just the balance sheet. Over time BegintoInvest.com will have articles covering everything within this document. For this article – all we are concerned with is the sections dealing with the company’s balance sheet.
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Companies’ financial filings are also available on their websites in the “Investor Relations” section.
From Praxair’s home page, go to the Investor page
From the Investor’s page, there are tons of interesting links; PowerPoint presentations given at conferences or shareholder meetings, the latest news from the company and stock data. For now, we are just interested in the “SEC filings” or the “Investor Package” links on the left, both of which will direct you to the latest 10-K filing.
No matter what company you are looking into, nearly all will have an investor relations page containing this information.
Getting into the Report
Now that we have the report up – lets run down the terms that make up a company’s balance sheet and discuss why they are important.
The following chart is located on page 50 of the company’s 10-K
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A balance sheet is normally broken up into two main sections, Assets and Liabilities.
Assets – What the company owns – Includes cash, product inventory, buildings, land etc.
Liabilities – What the company owes – Mainly the company’s debt.
With just a quick glance at these two numbers investors can start to gauge the financial health of the company. If liabilities far exceed assets it can serve as a warning to the investor that the company is burdened by too much debt.
Never get too overwhelmed by all these numbers or definitions. Evaluating a balance sheet is a lot of common sense – don’t make it more complicated than it is. For example:
If a family has only $5,000 cash in the bank (assets) and $100,000 in credit card debt (liabilities), is the family in good financial standing?
Compare that to a family with $100,000 in the bank and only debt is $5,000 left on car loan. Are they in good financial standing?
You don’t need a CFA certification to see which one of these families is in better financial shape. The numbers on company balance sheets will be larger, but don’t let that overwhelm you.
Of course, just these two numbers alone don’t tell the whole story. There may be such things as “good debt” for a company – maybe a low interest loan to build a larger factory so the company can grow. There are also assets that are not nearly as significant for the company, like goodwill or other intangible assets (defined below).
To help us figure out whether these are “good debts” or “bad assets”, the balance sheet breaks down the assets and liabilities into other sub-categories:
Cash and Cash Equivalents – Cash, just as it sounds is the money the company has in the bank. Cash Equivalents include other forms of liquid savings, such as U.S. Government treasury bills, Certificates of Deposits (CDs) etc.
Accounts Receivable – The money owed to the company by those which it does business with.
For Praxair, they may have shipped the customer a product but have not billed them for the product yet or have not received payment yet.
Inventories – Includes products ready to be sold, products currently being assembled, raw materials and other supplies.
On Praxair’s balance sheet you see those 3 terms above added up and all totaled as current assets.
Current Assets – Assets of the company which can be quickly converted into cash or change into cash. Typically assets that are expected to be converted to cash within one year are considered “current”.
Current assets are what the company will use to pay off current debt and other current liabilities.
Intangible Assets – Assets which are not of physical form. Intangible assets include things like patents, trademarks or brand names. The value of which is not certain, so management assigns a value. A company may value its brand name or a patent as worth a certain amount of money. Whether they are worth what management says or not is up to the investor to decide. Often this is a way for companies to overstate their assets to make their balance sheets look better.
Goodwill – Is one form of an intangible asset. Goodwill that is held on the balance sheet is put there to reflect what management believes will be future profits resulting from intangible assets. Goodwill usually appears from the excess costs of acquiring a business from its tangible assets.
For example, If Praxair purchases another company for $1 Billion dollars, but the company’s assets are only worth $500 million, Praxair may add $500 million on its balance sheet as “Goodwill”.
On the Liabilities side of the balance sheet:
Accounts Payable – The money the company owes to those in which it does business.
For Praxair, it may have ordered and received supplies from a company, but has not yet paid the bill for those products.
Short Term Debt – Debt to that is due within a year.
Current Portion of Long Term Debt – Payments to be made within a year on long term loans.
Accrued Taxes – Taxes from sales thus far in the year. Typically, companies will ‘set aside’ expected taxes due ahead of time.
Current Liabilities – Current liabilities represent the total amount of money required to be paid within a year for debt, taxes or other payments.
Long Term Debt – represents the total debt of the company that is not due within a year.
Evaluating a company based on its balance sheet
Now that we know how to get these numbers and what they mean, how should we use them to determine if a company is a good investment?
To start lets look at a few popular ways to value a company:
An important and widely used ratio called the “current ratio” is simply current assets divided by current liabilities.
This ratio describes the company’s ability to make its payments on its current liabilities.
A high current ratio means the company has much more cash or short term investments than it does short term loans and loan payments that are due. A high current ratio shows that the company is in good shape to make payments for debt or other liabilities due this year.
A low current ratio indicates that a company will have a hard time paying back its loans. It may have to sell off assets or take on further debt in order to make payments on time.
As an investor, you always want to look for a current ratio greater than 1. Meaning simply, the company has more current assets than current liabilities and therefore should not have to sell off assets or take on further debt in order to pay back its debt due this year.
Using Praxair’s balance sheet for 2011, we see that they had a current ratio of 1.02.
Total current assets – $2,607 million.
Total current liabilities – $2,535 million.
$2,607 ÷ $2,535 = 1.02
This indicates that the company is able to make current payments, however it is cutting it a little close.
Personally as an investor, I like to look for a higher ratio than 1.02. However, it is important to compare that number to other companies in its industry.
Utility companies as a whole may have a lower current ratio because their business does not require keeping as much cash on hand. Industrial manufacturing companies may on average have a higher current ratio just because of the nature of their business.
To get a better feel for Praxair’s numbers, let’s see how Praxair’s current ratio compares to its two biggest competitors.
- Airgas, Inc. (Ticker symbol ARG):
Total current assets – $ 1,274 million
Total current liabilities – $ 930 million.
For a current ratio of about 1.4.
- Air Products and Chemicals Corporations. (Ticker symbol APD)
Total current assets – $ 3,190 million
Total current liabilities – $ 2,342 million.
For a current ratio of 1.36.
We can see that Praxair is slightly behind its competitors on the strength of its balance sheet. It is not a sole reason to not invest in the company, but would be worth looking into deeper to determine why the company’s ratio is relatively low.
Recall that the current ratio calculation uses all current assets, including inventory. For a company with a current ratio very close to 1, such as Praxair with 1.02, this means that it would have to sell its entire inventory, which is hardly a given for businesses, in order to produce enough cash to cover its current liabilities. If demand for its products slows, it may not be able to convert its entire inventory into cash, and therefore not be able to make payments on its current liabilities without selling assets or taking on more debt.
For this reason, another popular ratio for evaluating a company’s balance sheet is the “Quick ratio” or also known as the “Acid Test ratio”. This is very similar to the current ratio, but does not include inventories.
This represents a more conservative evaluation of the strength of a company’s balance sheet than the current ratio. A ratio of 1 or greater shows that a company would still be able to make its payments on its current liabilities even if it does not sell any of its inventory.
For Praxair, we see that its Quick Ratio is:
[Total current assets ($2,607 million) – Inventories ($456 million)] ÷ Total current liabilities ($2,535 million).
Which comes out to about 0.85.
This indicates that Praxair is dependent on selling some of its inventory in order to be able to make its payments on its debt due this year.
Realistically, Praxair will be able to sell its inventory and make its payments. However, the Quick Ratio is used more as a “what if” ratio or a ratio for a worse case scenario. A value greater than 1 should give investors a little peace of mind because a company will still be able to make debt payments even in a severe slowdown of the economy.
Working Capital
Another gauge of a company’s short term financial health is the company’s Working Capital. Working Capital is the difference between a company’s current assets and current liabilities.
Working capital gives investors a specific number compared to a ratio like the current ratio. Working capital is used to determine two things; First, a company’s short term financial health by seeing if its current assets are enough to cover its current liabilities. A positive number indicates that a company should be able to meet its short term liabilities.
A steady increase in working capital can also be an indication of increased inefficiencies of the company selling and receiving payments for its products. If a company’s accounts receivables are increasing significantly, it may be a sign that they company is not collecting money as fast as they could be. This leads to the company potentially taking on additional short term loans to cover expenses until the company collects payment.
However also note that a increase in working capital could also be due to an increase in cash or cash equivalents, which don’t necessarily indicate these inefficiencies.
Book Value
The last term we want to define is a company’s “Book Value”. Book value is often defined as the “liquidation value” of a company, or how much cash it would receive if it were to sell off all its assets.
Put most simply, book value is total assets minus total liabilities.
The exact “book value” is really never known. It is unlikely that a company would get 100% of market value for all its assets if it were to try and sell everything at once. It is also dependent on the values for assets being correct on the balance sheet, which is never certain. We discussed earlier that some assets, such as intangible assets should rarely be included in the valuation of a company. Therefore a more appropriate definition of book value may be:
Total Assets – Intangible Assets – Total Liabilities
Theoretically, a company should always be worth at least its book value.
If you could buy a company whose assets are worth $1 million and only has a debt of $100,000 for $500,000, would you? Of course.
Comparing a company’s book value to its “Market Cap” is one common comparison investors make prior to investing in a company.
The market cap of a company, also known as its market value is the value of the company investors are willing to pay for according to the stock market.
The market cap is calculated by:
Market Cap = Number of Shares Outstanding * Share Price
This value is given on pages such as Yahoo finance, recall our image of Praxair’s yahoo finance page from earlier in this article:
Or market cap can also be determined by reading the companies 10-K.
Investors can compare the book value to the market cap, and see if investors are correctly evaluating the company. A stock trading at a market cap less than its book value may be a sign of a good potential investment. However, it is important to note that it should not be the sole reason for an investment into a company. A company having a market cap less than its book value may be a sign that investors believe a company’s assets are not worth what management thinks they are worth.
At times of financial panic, such as the markets decline in 2008, many companies could be found trading for less than their book value. Value investors bought for likely a sizable profit.
We can calculate Praxair’s book value from its 2011 10-K filing and compare it to the company’s market cap:
Book value = Total Assets – Total Liabilities
= $ 16,356 million – $10,339 million
= $6,017 million or $6.017 billion
Compared to its current market cap of $31.91 billion, this tells us that investors believe Praxair is worth much more than its book value.
From this “Book Value” we can also find a Price to Book ratio (or P/B ratio), which can be useful to compare Praxair’s value to investors with other companies in its industry.
For example Praxair’s “price” is its market cap of $31.91 billion, and its book value is $6.017 billion. By taking Praxair’s price and dividing by its book value:
$31.91 billion ÷ $6.017 billion = 5.30
Praxair’s P/B ratio is 5.30. By comparing this to other companies in Praxair’s industry we can find out if investors are overpaying for Praxair’s assets.
Why do company’s trade above their book value? Theoretically, if someone had $6.017 billion, they could re-create Praxair’s balance sheet and make as much money as Praxir (for only $6.017 billion, instead of today’s price of $31.91 billion).
But realistically, if you gave me $6 billion today I would not be able to just instantly create a company to compete with Praxair. I would not have any customers or any reputation. I would have no knowledge of the industry. My plants and equipment would probably be less efficient than Praxair’s because of this lack of knowledge. Etc.
This is why Praxair trades at such a premium to the “book value” of its assets.
In Summary
Remember a balance sheet is only part of a company’s whole financial picture. In the future we will also take an in depth look into other parts of the 107 page filing.
Also, a 10-K or 10-Q report is only a look into the company at one specific day. The balance sheet for January 4th 2012 will look different than December 31st 2011 as shown here. It is only a snapshot of the company’s books at that moment in which it was published.
The important thing is to look at how a company’s balance sheet changes over time. By comparing this year’s balance sheet to last years, and the years before, we can get an idea on if the company is moving in the right direction.
For this reason I like downloading all the companies filings to the SEC into an excel file.
I have excel spreadsheets created like the one below for many companies, and will reference them frequently in future articles, including an in depth look on how to make your own.
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Using the information downloaded into Excel from the 10-K filings, you can create a much better picture of the company’s financial health, and find investment opportunities.
This spreadsheet is set up to automatically update as companies release updated financial reports. Since all the company’s previous financials are on one document, we can create a spreadsheet showing how the company’s financials have changed over time and determine if there is value in investing in the company today.
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We will get into all these numbers and their meanings in later articles. I just wanted to preview what you can do with these numbers.
As a final conclusion, I want to give one example of just how important reading these annual reports can be before you invest. I believe if investors would have read Facebook’s filings before investing, they could have potentially saved billions of dollars.
Recently Facebook became public, which means that individual investors could buy shares of Facebook for the first time. Legally, Facebook had to release its financial data to the SEC before it could trade on a stock market exchange.
In early May 2012, 2 weeks before Facebook went public, I published an article titled: “Intelligent Investing Means not Buying the Facebook IPO”
In it, among many other things I noted a couple remarks deep within the filing that showed that Facebook would not be able to generate a profit for some time due to expenses from the IPO process.
You can read the article to find the exact quotes, but there was one line in Facebook’s filing that caught my attention:
“As of March 31, 2012, there was $2,381 million of unrecognized share-based compensation expense, of which $2,319 million is related to RSUs, and $62 million is related to restricted shares and stock options. This unrecognized compensation expense is expected to be recognized over a weighted-average period of approximately two years.”
What did this mean for Facebook? They had nearly $2.4 billion in expenses that were not yet on the company’s balance sheet! Facebook “only” made $1 billion dollars the year prior. This meant that nearly 2 years of Facebook profits would be washed away by recognizing these expenses!
Of course, not many people read all 200+ pages of the filing to see that remark. Therefore, it came as a shock to many when Facebook reported a loss during its first earnings release as a public company.
Of course to anyone who read Facebook’s initial filings with the SEC, this was no surprise.
Initial investors in Facebook have lost tens of billions of dollars collectively. Mainly out of ignorance and laziness. Facebook is down more than 50%. Although it may be a good investment some day, it certainly was not at the time of its IPO.
I show that example not to brag, but to show that any individual investor can make good investment decisions if they are willing to put in the effort to do so.
These reports issued by companies are the most important resource you have as an individual investor – don’t ignore them.
The next report, is the Income Statement, which we discuss in detail here.
There are several resources that have helped me over the years in reading and understanding company balance sheets and financial statements:
• The Interpretation of Financial Statements
This book is always by my side when I have company financial statements open. Gives real life examples, along with a great definitions section in the back of nearly every term you see on a financial statement.
• Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports
A very in depth guide for learning how to read company financial statements. The book contains real life examples of balance sheets, income statements and cash flows along with definitions of every term that will appear on those reports. This book walks you through the creation of a hypothetical company, “AppleSeed Enterprises, Inc” and how the balance sheet, income statement and cash flow statement evolve as the company grows. Great for investors of any level, and necessary to truly understand financial reports.
