05 How to Read a Balance Sheet? Getting started with these key items

It is believed that one of the best ways to assess the financial position of a US-listed company is to go over its balance sheet.

A balance sheet provides a snapshot of a company's financial position. It shows the amount of assets, liabilities, and shareholder equity the company has at the end of the reporting period.

But a balance sheet has many items, and an investor may not have enough time to review them all.

What are the most important items to focus on?

First, let's take a look at the assets.

Based on their liquidity, items in the assets section can be categorized into current assets, which can be converted into cash within a year, and into non-current assets, with an expected conversion into cash in more than a year.

What current assets should you pay the most attention to?

First, cash, cash equivalents, and short-term investments.

These items show a company's liquidity as they are considered the most liquid assets

Cash is a critical resource the company needs to fund its day-to-day operations and meet its obligations.

The company is considered to have good liquidity if it has a cash reserve that can cover all of its interest-bearing debt.

Also, we can take a look at how the company's cash balance changes over the reporting period.

Excluding dividend payments and share buybacks, if a company continues to grow its cash, its liquidity might be improving as well.

The second item that deserves our attention is accounts receivable, which represent the money owed to a company by its customers.

Accounts receivable can reflect a company's bargaining power over its customers to some extent.

A company may require its customers to agree on shorter payment terms and thus have fewer accounts receivable if it has greater control over customers.

Conversely, if a company has a high percentage of accounts receivable to assets or the accounts receivable are growing faster than its revenue, it may suggest the company is struggling to collect payments or to sell its products and services.

Also, too many accounts receivable may lead to cash flow issues and increase the risk of bad debt.

Third, inventory. The amount of inventory can suggest how easy it is for a company to sell its products.

If a company's inventory constitutes a high percentage of total assets or revenue, or its growth outpaces its revenue growth, it may suggest the company faces challenges in selling its products.

Furthermore, a high percentage of inventory may indicate a high risk of inventory write-downs, especially for industries subject to changing consumer preferences, rapid technological changes, or limited shelf life. Examples of such industries include fashion and apparel, technology, and agricultural produce.

Let's move on to non-current assets.

The first non-current asset item that deserves attention is net fixed assets, which refer to the total value of a company's long-term tangible assets less accumulated depreciation.

Here, a widely used indicator is a company's net fixed assets as a percentage of total assets.

If the percentage is high, the company may be considered a heavy-asset company; otherwise, it is generally taken as a light-asset company.

Compared with light-asset companies, heavy-asset companies can have a financial edge over their competitors.

On the other hand, such a business model of a heavy-asset mode may require significant capital investments to acquire and maintain their assets, putting a strain on profitability and cash flow.

This is also the reason given by Charlie Munger to explain his dislike of the heavy-asset model.

Second, goodwill. Goodwill is the difference between the purchase price of a target company and its net assets.

Under Generally Accepted Accounting Principles (GAAP), goodwill is subject to impairment testing.

A company has to write down the value of the goodwill if the prospect of its target company worsens, which can affect profitability.

Therefore, if goodwill accounts for a high percentage of the total assets, we need to keep a close eye on the target companies, looking out for any triggering event that may occur and impair the company's goodwill.

We've covered some key items in the assets. Now let's dive into liabilities.

Liabilities can be categorized into current liabilities, which are due within a year, and non-current liabilities, which are not expected to be paid off within a year.

When looking at liabilities, we can first take a look at accounts payable.

Compared with accounts receivable which refer to the money owed to a company, accounts payable are the amount the company owes to its suppliers.

On the one hand, accounts payable suggest a company's ability to negotiate favorable terms with its suppliers.

If a company's accounts payable constitute a high percentage of total assets or revenue, it may suggest the company has a positive relationship with its suppliers, which can be good news to potential investors.

On the other hand, if a company's accounts payable rise sharply, it may suggest the company has financial issues.

In this case, investors should be aware of the risks.

Secondly, let's look at short-term loans, which are loans that are typically repaid within a year.

If a company's short-term loan exceeds its cash balance, it may suggest the company has issues in paying off its debt.

When a company starts defaulting on its debt, there is more of a likelihood that it will go bankrupt, which should be a red flag for investors.

When looking at non-current liabilities, we should pay attention to long-term loans.

Long-term loans refer to debt due to be paid in more than a year.

If the percentage of its net income is too high, it may indicate the company will struggle to repay its long-term obligations.

Finally, let's look at the shareholders' equity.

A company's shareholders' equity equals its assets less its liabilities, which can be seen as its net assets.

Shareholders' equity includes common stock, additional paid-in capital, retained earnings, and more.

Generally, we need to analyze the growth of shareholders' equity.

Excluding dividend payments and share buybacks, if it maintains strong growth, the company may be considered financially healthy.

As an example, let's use moomoo to take a look at Microsoft's 2022 annual report.

As the data suggest, Microsoft had $100 billion worth of cash and short-term investments, over all its liabilities combined, suggesting relatively good liquidity.

However, its cash and short-term investments were less than those of the 2021 fiscal year. This is due to large share buybacks and dividend payments.

Microsoft had around $44.26 billion in accounts receivable, accounting for 12.1% of total assets and 22.3% of operating revenue, not very high levels.

Microsoft’s inventory was valued at $3.74 billion, constituting 1% of total assets and 1.9% of operating revenue, respectively, which are also considered very low levels.

Its net fixed assets were $87.55 billion, 24% of total assets, which could be considered a light-asset model.

Microsoft’s goodwill was valued at $67.5 billion, accounting for 18.5% of total assets.

This ratio was high mainly because Microsoft acquired many companies, acquisitions which were detailed in its annual reports.

The company had approximately $19 billion in accounts payable. Though expanding, its accounts payable were not very high in absolute terms.

Generally, Microsoft can be considered financially healthy for the fiscal year 2022 despite its higher goodwill.

To wrap up, some of the key items in a company's balance sheet include current assets, such as cash and cash equivalents, short-term investments, accounts receivable, and inventory, non-current assets, such as net fixed assets and goodwill, liabilities, such as accounts payable, short-term loans, and long-term loans, and finally, shareholders' equity.

By reading through its balance sheet, investors can potentially identify investment opportunities and risks.