How can investors use both sides of the balance sheet?
Balance sheets are basic. They usually go from the most simple things to the most complex. The asset side starts with cash, moves through inventory, then fixed assets, like property and factories, and ends up with intangibles: goodwill, trademarks, patents. It’s easy to measure the value of cash or liquid investments. It gets more and more difficult to put a price on something as you move down the page. What’s the value of a brand, anyway?
The same is true on the other side. Liabilities start with payables, short-term debt, long-term debt, and then equity—what’s left over. There’s a reason why we start at the top and move down: if the creditors walk away, refusing to renew credit lines or short-term loans, there needs to be enough cash on hand to pay them off. A balance sheet that’s out of whack–where there aren’t enough current assets to fund current liabilities—is a balance sheet that’s dangerous.
The balance sheet works with the other financials to give a total picture, but it’s the balance sheet we start with. Another way to look at the balance sheet is to normalize everything. Assume that the assets and liabilities each add up to $100, and each line item is just part of that total. It’s easier, then, to see changes in the balance sheet’s structure over time. If something shifts significantly—say, inventory is rising, or the value of equipment and property is going down—then it indicates that something significant may be going on at the company. And on the liability side, if long-term loans are going down while accounts payable are rising … maybe you have a liquidity crisis coming!
ECB Assets over time. Source: Wikipedia
The balance sheet is a start. It gives us snapshot of a company’s financial health. And looking at how it changes over time gives a fuller picture of what’s going on. Reading a balance sheet is like reading a map. If we want to know where we’re going, we’d better start out by figuring out where we are.
Douglas R. Tengdin, CFA
Chief Investment Officer