We talked about how investors need to use both sides of the humble balance sheet to look for trouble. But how?
Balance sheets are basic. They usually go from the most simple item to the most complex. Assets start with cash, move through inventory, then fixed assets, like property and factories, and end with intangibles: goodwill, trademarks, patents. It’s easy to measure the value of cash or liquid investments. It becomes progressively more difficult as you move down the page.
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 a portion 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 plant and equipment is going down—then it indicates that something significant may be going on at the company.
The balance sheet is a start. It gives you snapshot. And looking at how its structure changes over time gives a fuller picture. But the other items—income and cash-flow—work alongside.