Why are balance sheets important?
Balance sheets give a snapshot of a company’s finances. They list and value all their financial assets and liabilities. As such, they’re subject to abuse by any firm that wants to present a distorted picture of how it’s doing to investors or creditors.
These financial shenanigans usually appear on the income statement. After all, most investors focus on earnings, so that’s where the most pressure is play games. The company might record revenues a little early, or push current expenses out to a later period. So that’s also where many auditors focus their attention. But financial statements all tie together. One of my early exercises in financial statement analysis was to derive a periodic cash flow report from an income statement and a couple of balance sheets.
Image Source: Lexis/Nexis
A balance sheet has a normal layout. The simplest items go on top; the more complex issues are lower on the list. Cash is king—usually the first item listed. One simple way companies can obscure their financial picture is by mixing up this convention. There’s nothing fraudulent about this. But it can confuse or distract the casual observer. There’s nothing illegal about this. But it can make things confusing.
Then there’s valuation. Inflating an asset’s value is an old trick. One way to do this is by changing the way an asset is priced. It’s hard to misprice cash, although firms have done it. But more obscure assets are easier to manipulate. So investors should watch out for radical changes in these items, or any sudden and surprising adjustment. Also, check the footnotes for any changes in accounting methods.
Finally, there are reserves. If a company issues a warranty, that’s a liability on the balance sheet. They might have to fix or replace the item in the future. In 2007 Dell Computers got in trouble when they had to restate several years’ worth of earnings. They had boosted their bottom line by reserving too little for warranties. Astute investors noticed that these liabilities didn’t keep pace with sales, inflating profits. Some European companies have been notorious for creating fictional reserves during good times they can draw upon when times get tough. Such smoothing presents a false front as to how the business is faring.
Financials should be fair; balance sheets need to balance. Sometimes the best way to check on a company’s health is to give its balance sheet a little shove.
Douglas R. Tengdin, CFA
Chief Investment Officer
Leave a comment if you have any questions—I read them all!