For many new investors, reading a balance sheet is no easy feat, but once you know how, you can use the data within to get a better sense of a company's value.
You can find a firm's balance sheet in its yearly Form 10-K filing, which also known as an "annual report." Every public company must file this document with the U.S. Securities and Exchange Commission (SEC).
The balance sheet contains details about the organization's capital structure, liquidity, and viability. It is divided into three parts. These parts include assets, liabilities, and equity. Subtract liabilities from assets, and you arrive at shareholder equity. This is a key metric of a firm's financial health. A firm with more assets than liabilities will give you a better return than one with negative equity.
What Are Assets on a Balance Sheet?
A firm can have many kinds of assets. Some are tangible, such as inventory, cash, or machines. Some are intangible, such as goodwill, brand recognition, or copyright. A company may list its tangible assets on its balance sheet in a few categories, such as:
- Current assets
- Long-term investments
- Other (this may include fixed assets such as property, plants, and equipment)
Defining Long-Term Investment Assets
A firm invests for the long term to help them sustain profits now and into the future. These long-term investments could include stocks or bonds from other firms, Treasury bonds, equipment, or real estate. On the other hand, current assets are often liquid assets. These are used in many of the immediate operations of the firm. They might be inventory, cash, assets held for sale, or trade and other receivables.
Asset Classification
Investments are seen as current assets if the firm intends to sell them within a year. Long-term investments (also called "noncurrent assets") are assets that they intend to hold for more than a year.
If the company intends to sell an asset—but not until after 12 months—it is classified as available for sale. If a firm intends to hold the asset until maturity, it is classified as held-to-maturity. For instance, a company might hold a bond until it matures.
Valuation Implications
Whether an asset is categorized as current or long-term can have implications for a firm'sbalance sheet.
For instance, say an insurance company buys $10 million worth ofcorporate bonds. It intends to sell these bonds at some point in the next 12 months.In that case, the bonds will be classified as a short-term investment. They will be subject to rules requiring them to be marked to market, or listed at current market value, at reporting time.
If the bonds decline in value to $9 million in a quarter, the $1 million loss must be posted on the company'sincome statement, even if the bonds are still held, and the loss is unrealized.
On the other hand, suppose this firm buys the same $10 million in bonds but plans on holding them until maturity. In that case, they're classified as a long-term investment.The asset is recorded at cost. As such, it may not reflect market changes in price.
Long-term investment assets such as plants and equipment decrease in value as they age. Depreciating these assets helps to keep fair market values assigned. It allows for spreading out the expense over time.
Using Asset Valuations in Financial Ratios
The valuation of long-term investment assets at each reporting cycle is a key factor in figuring a firm’s worth on its balance sheet. The ratios that you can figure out from these valuations are important, too. Two ratios include return on assets (ROA) and return on equity (ROE). Return on assets divides a firm's net income by total assets. Return on equity divides a firm's net income by total equity. ROA and ROE are different ways of showing a company's profitability.
If a company has negative equity, it means its liabilities exceed its assets. In that case, it can be considered insolvent.
Note
Startups may not have as many assets. They could have negative equity in the early phases of business.
Frequently Asked Questions (FAQs)
How does a short-term asset become a long-term asset?
Short-term assets, also called "current assets," are those that a company expects to sell or otherwise convert to cash within a year. If a company plans to hold an asset longer, it can convert it to a long-term asset on the balance sheet.
What does a balance sheet show?
A balance sheet provides an important picture of a firm's financial health. It shows a summary of all the company's assets, liabilities, and shareholder equity. The relationship among these three areas can tell an investor a lot about the state of a company's financial affairs and its future as a worthwhile investment.
I've delved extensively into financial analysis and investment strategies, specializing in dissecting balance sheets and financial statements to gauge a company's health and potential. Understanding these statements is pivotal for investors, offering a window into a company's value and financial stability.
The balance sheet, a cornerstone of financial reporting, encapsulates a company's financial standing. It delineates three fundamental elements: assets, liabilities, and equity. Assets encompass a wide array, from tangible (like cash and machinery) to intangible (such as goodwill or copyrights). The classification of assets as current or long-term is critical; current assets are liquid and aid immediate operations, while long-term investments sustain future profitability.
Long-term investments, like stocks, bonds, or real estate, serve as strategic assets. Classifying them appropriately, whether as held for sale, held to maturity, or available for sale, dictates their treatment in financial reporting. This categorization influences how changes in market value reflect on a company's income statement.
Valuation implications arise from these classifications. Short-term investments are subjected to market value fluctuations, impacting immediate income statements. Conversely, long-term investments are recorded at cost, often shielding them from market volatility.
Understanding asset valuations in financial ratios like Return on Assets (ROA) and Return on Equity (ROE) is pivotal. ROA measures a firm's net income against its total assets, while ROE compares net income to shareholder equity. Negative equity suggests insolvency, a warning sign for investors.
Startups might lack assets and could exhibit negative equity in initial stages. Nonetheless, analyzing these components aids in assessing a company's financial trajectory and investment potential.
Addressing the FAQs:
- Short-term assets transition to long-term assets when a company intends to hold them for more than a year.
- A balance sheet encapsulates a company's assets, liabilities, and shareholder equity, offering insights into its financial health and investment viability.
Understanding the nuances within a balance sheet empowers investors to make informed decisions about a company's financial stability and potential for growth.
