Both Sides Now (Part 1)

Investors need to use both sides of their brains.

Yes, there’s the analytic side and the intuitive side. There’s numerical number-crunching and there’s aha-moment insight, the kind that gets into Apple at 30 and out of Google at 600. But that’s not the two-sidedness that I’m talking about.

I mean the balance sheet. Yes, that boring, accounting-level statement of what a business owns and owes. The statement of cash, receivables, inventory, property and equipment on one side, and payables, short-term loans, long-term loans, and equity on the other side: assets and liabilities—both sides.

For a long time the balance sheet was the Rodney Dangerfield of accounting: it didn’t get no respect. After the dot-com bust and Enron scandals analysts focused on earnings and cash-flow, respectively. But it took the financial crisis to raise the prospects of the balance sheet.

The balance sheet gives you a picture of financial health. Assets—and especially liquid assets—indicate how well a company can deal with stress. And liabilities, and particularly short-term borrowings, show where that stress might come from. When short-term loans are too high relative to cash and other liquid assets, creditors can shut down a company just by walking away. During the Depression some banks had three-quarters of their assets in cash, not because they were sick, but because they were healthy, and wanted to remain so.

The truth is, all three statements are important: earnings, cash-flow, and the balance sheet. In combination, and over time, they show what’s going on inside a firm. But it’s the balance sheet that shows the imbalances.

By | 2012-03-27T10:15:04+00:00 March 27th, 2012|Accounting, Global Market Update|0 Comments

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