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Understanding a Balance Sheet

Aug 26, 2007
There are three main sources of financial information that a company regularly makes available to investors. These 3 items are the balance sheet, the income statement, and the cash flow analysis. Most neophyte investors have no idea how to interpret these statements. A lot of stockbrokers are not too proficient at it either. You do not need to be an expert or a financial analyst to understand and evaluate financial information, but you should know what to look for so you can determine whether you should invest in a certain company. For our purposes here, we are going to discuss how to analyze a balance sheet, which is generally considered to be the most important tool for analyzing the financial health of a company.

The first thing to examine on the balance sheet are the assets. Assets are things that the business owns or will own in the future and have a value attached to them. The next important item is liabilities, which includes everything that a company owes, such as taxes, wages, loans to be repaid, etc. The other most important item to look at is equity, which is the earnings and money contributed by shareholders. You can calculate the shareholder equity by subtracting total liabilities from the total assets.

If Shareholder Equity is a very small number or a negative number, this does not bode well for investors. If the number is on the high side, that means that the company is profitable and able to share its earnings with stockholders by paying a dividend.

A balance sheet is normally presented in two different formats, depending on where it is published. Sometimes the statement is presented horizontally. Other times, it is presented vertically. The vertical presentation is used most often because it is easier to analyze. The five basic components of a balance sheet are:

Shareholder Equity (we already covered this)

Non-current liabilities (money to be paid more than 12 months from now)

Current liabilities (money to be paid within the next 12 months)

Non-current assets (non-cash items of a permanent nature)

Current assets (cash or items that will become cash within the next 12 months)

These components are categorized differently depending upon the industry the company inhabits. A telecommunications company would have different categories of assets and liabilities than a pharmaceutical company. Also, it is important to note, balance sheets for companies in a certain industry will show different levels of profitability. Just because a software company does not have the same level of shareholder equity as a retail business does not mean that the software company is not a good investment. The software business might have to meet a lot of short-term liabilities, such as paying programmers and investing in technology, in order to meet future sales goals. Once the software is finished, those liabilities might disappear, making them profitable. You need to take into account the operations of the company when reading a balance sheet.

Also, it is important to realize that balance sheets, though they always span a 12 month period, the beginning and ending dates can differ from one company to the next. A company will typically select a 12 month period that results in the lowest level of their business cycle being the end of the 12 months. So, some statements might run from December to December, while others might run from April to April.

I hope this information will help you understand a balance sheet.. Try to set aside some time and log on to a stock quoting website. Look up the stocks of companies you are currently invested in, and then click on the link for their balance sheet. Take a few moments to review it, and then call your broker if you have any concerns.
About the Author
Jim Pretin is the owner of http://www.forms4free.com, a service that helps programmers make email forms.
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