Investing Lesson: Analyzing a Balance Sheet

Introduction to the Balance Sheet

Analyzing a Balance Sheet
••• Johnson & Johnson Balance Sheet

How many times have you flipped to the back of a company's annual report or 10-K and found yourself blankly staring at dozens, or even hundreds, of pages of numbers and tables? You know that these should be important to your investment decision, but you're not quite sure what they mean or where to begin. 

When you are looking at numbers like these, there's a good chance you are looking at a company's balance sheet.

What is a balance sheet? Why does it matter? Why are professional investors so obsessed with studying it, and even more importantly, how are they able to use that analysis to reduce their portfolio risk and make better, safer decisions when it comes to putting their own money to work?

In this investing lesson, I'm going to help you answer some of those questions by teaching you the basics of balance sheet analysis. Smart investors have always known that financial statements are among the keys to understanding a company. The balance sheet, especially when reviewed in conjunction with the other accounting records and disclosures, can warn of many potential problems. When used correctly, it can help you determine what a business is really "worth." By deciding that you are going to read this lesson, you have taken the first step on the road towards financial statement fluency.

The Role of the Balance Sheet In the Financial Statements

For every business, there are three important financial statements you must examine:

  • Sheet - The balance sheet tells investors how much money a company or institution has (assets), how much it owes (liabilities), and what is left when you net the two together (net worth, book value, or shareholder equity).  In this lesson, we are going to learn to analyze a balance sheet. 
  • The Income Statement - The income statement is a record of the company's profitability. It tells you how much money a corporation made (or lost).
  • The Cash Flow Statement - The cash flow statement is a record of the actual changes in cash compared to the income statement. It shows you where the cash was brought in and where the cash was disbursed.

    There are two segments to this lesson. In the first, I will walk you through a typical balance sheet and explain what each of the items means. In the second, we will actually look at the balance sheets of several American corporations together and perform basic financial calculations on them with me explaining what we are doing so you feel more comfortable when you try it on your own.

    My goal for many of you by the end of this series of financial statement analysis lessons is to give you the basic skills to pick up the financial statements and use the balance sheet, income statement, and cash flow statement together to perform a series of calculations that give us a full picture of a company's financial health. Accounting is the language of business and these three financial statements, the balance sheet among them, are the report card. From the balance sheet, we can learn:

    • How much debt the business has relative to its equity
    • How quickly customers are paying their bills.
    • Whether short-term cash is declining or increasing.
    • The percentage of assets that are tangible (factories, plants, machinery) and how much comes from accounting transactions.
    • Whether products are being returned at higher-than-average historical rates.
    • How many days it takes, on average, to sell the inventory the business keeps on hand.
    • Whether the research and development budget is producing good results.
    • Whether the interest coverage ratio on the bonds is declining.
    • The average interest rate a company is paying on its debt.
    • Where profits are being spent or reinvested.

    Let's Get Started on Teaching You How to Analyze a Balance Sheet

    Are you ready? Grab a cup of coffee, a nearby calculator and let's begin! If you have a few annual reports that you've downloaded online, you may want to have those handy, too, so you can see how real-world balance sheets sometimes differ slightly in how they are presented and formatted.

    As you click through the balance sheet lesson, realize that I tried to organize each topic on its own self-contained page so you wouldn't be overwhelmed. I highly recommend you do not move forward until you fully understand—and have mastered—the page you are reading because I designed the balance sheet tutorial to be worked through sequentially.  Topics will be built upon what was discussed earlier, and some examples, such as sample financial ratio calculations, will be pulled from earlier data with which you've already become familiar.