Reading a Balance Sheet

Reading a Balance Sheet

A Guided Tour from a Noted Investment Authority

John Train is well known as the author of The New Money Masters (Harper-Collins) and Most Remarkable Occurrences (Harper-Collins), and founder of Train, Smith Investment Counsel in New York. The following article, which originally appeared in Harvard Magazine, outlines Train’s basic approach to understanding a financial statement.

The most important single truth to grasp about investing is that when you buy a share of stock you become a partner in a business. The essence of investing is thus understanding business, companies.

Company event are reported in dollar terms. To invest sensibly you therefore need to understand what the company is trying to tell you in its financial statement, which is published in a conveniently stylized form, like a sonnet. Though the elements are fairly simple, I observe that many of my clients have trouble reading one. So here is a simple guide to help you started. A company’s financial statement comes in four parts: the balance sheet, the income statement, the cash flow statement, and the statement of shareholders’ equity.

The first of these, the balance sheet, is in essence a financial snapshot of the company at one moment in time, the end of its fiscal year. It is generally brought up to date each quarter thereafter.

The income (or profit and loss) statement shows how the business did during the period: that is, sales minus costs.

The cash flow statement shows where cash came from and what it was used for. The amounts don’t quite match those on the income statement, which includes, for example, purchases or sales on credit, where cash has not yet changed hands.

The statement of shareholders’ equity tells how much the company’s book value rose or fell during the period, whether because it made or lost money or took in new capital by selling stock. If the company made money, this statement will show how much of the profit was put back into the business and how much was paid out to shareholders.

A company’s financial statement ordinarily includes an auditor’s opinion. A “qualified” opinion often indicates trouble. The balance sheet is called that because it is set up to balance, like an equation: There is an implied equal sign between the two parts. On the left (or asset) side you show all the assets in the company at that moment – what it owns and on the right or liability side you show all the company’s debt – what it owes – plus the money that has been put up by the owners and kept in the business the shareholders’ equity. If you think about it, the money you have invested in a house – your equity – plus the mortgage – a debt – perforce corresponds to the physical structure: the asset.

Beware of Investing. Investing is a lot of fun. Photograph: Megan Jorgensen (Elena)

Here is an example. Let’s suppose the shareholders of a company put up $1 million, which goes to buy $1 million worth of gold. A simplified balance sheet would look like this:

Assets – Gold: $1,000,000.

Liabilities: + Shareholders’ equity, Shareholders’ Equity: $1,000,000.

Suppose we now borrow a million dollars from the bank and buy an additional million dollars woth of gold. Our simplified balance sheet would then looks like this:

Assets – Gold: $2,000,000/$2,000.000.

Liabilities + Shareholders equity:

Bank Debt: $1,000,000

Shareholders equity: $1,000,000

Total: $2,000,000.

In other words, the two sided of the equation still balance.

Good. Now suppose that during our first year business the price of gold doubles, and we happily sell half our hoard for the original cost of the entire amount. Our simplified income statement now looks like this:

Revenues: 2,000,000

Loss: cost of goods sold: $1,000,000

Profit before tax: 1,000,000

Loss: Provision for taxes – $250,000

Net income $750,000.

(Sales are ordinarily shown on an accrual basis – that is, what you are committed to –rather than a cash basis (when you actually take in the money).

We can use this $750,000 of free cash to pay down the bank loan, pay ourselves a dividend, build up our shareholders’ equity or buy back our own stock. Let’s look at the first case. After paying taxes, we pay down the bank loan:

Assets:

Cash – $1,000,000

Gold (at cost) $1,000,000

Total $2,000,000.

Liabilities + Shareholders’ equity

Common stock $1,000,000.

Retained earnings $750,000.

Total: $2,000,000.

(At market: $2,000,000. Accounting principles require that you show the lower of cost of market value).

“Retained earnings” on the balance sheet is where you put money the company has earned and left in the business, not paid out in dividends.

As interesting question arises when we add to our inventory at various prices. For instance, suppose that in our gold-trading activities we bought at different prices. The two major systems of showing these transactions are called “First In – First Out” or FIFO, and “Last In – First Out” or LIFO. When the costs of raw materials are rising, FIFO makes the profits look higher, since sales are taken against the earlier, low-cost purchases. LIFO makes the profits look lower. Why might you want to do this? (1)To improve the bottom line of the balance sheet; (2) to lower taxes.

Footnotes to the financial statements may include information that does not show up in any of the numerical tables, such as pending litigation, company restructuring, or prospective mergers. So always read the footnotes.

Perhaps the biggest difference between the way business professionals and non-professionals examine financial statements is that if you have actually been in business, you tend to look at the cash and equivalents, and at the cash flow section of the report. If a business is doing well, cash will be building up and can be put to work in useful ways: paying off debt, adding to plant, buying back the company’s own shares in the market. If things are going badly, the company will be short of cash, bank and other debt will be rising, and management will be run ragged coping with creditors, instead of improving its products. (A hot growths company may also want cash because it has so many opportunities, but that’s a more agreeable problem).

After you have worked with financial statements for a while, you get in the habit of calculating the return on equity, how fast the inventory turns over, the operating profit margin, and a hundred other things.

So much for the Shortest possible course. To continue on your own, send to Merrill Lynch for the excellent 28-page pamphlet called How to Read a Financial Report. (It may be sooner or later their “financial consultant” will call). After that, try Benjamin Graham’s admirable Interpretation of Financial Statements (HarperCollins). It’s out of print but should be available at your library.

The whole thing is a lot more fun than you might think. And consider this: Even if you’ve got this far, you’re already well ahead of the mass of investors!