Financial Statements · Stocks Explained
Use the accounting equation
Assets equal liabilities plus shareholders’ equity. Assets include resources such as cash, receivables, inventory and equipment. Liabilities include obligations such as supplier balances, borrowings and certain provisions. Equity is the residual accounting amount.
Unlike an income statement, the balance sheet describes a particular date. Seasonal businesses can look unusually strong or weak at that point, so compare several reporting dates rather than relying on one photograph.
Work through a small balance sheet
Imagine assets of $200 million, made up of $20 million cash, $30 million receivables, $40 million inventory and $110 million other assets. Liabilities total $120 million. Book equity is therefore $80 million.
If the company has 10 million shares, book equity is $8 per share. A market price of $14 does not break the accounting equation. The market values future prospects and risks, while book amounts reflect accounting recognition and measurement.
Test liquidity and maturity
Current assets and current liabilities relate broadly to the operating cycle or near term under the applicable reporting rules. Suppose current assets are $90 million and current liabilities are $60 million. Working capital is $30 million and the simple current ratio is 1.5.
That ratio does not establish safety. Inventory may be difficult to sell, customers may pay late and debt may mature before cash arrives. Read the maturity schedule, restrictions on cash and unused committed financing.
Identify what the headline misses
Debt analysis should consider leases, guarantees and other relevant obligations, not only one borrowing line. Equity can include accumulated accounting effects that do not provide spendable cash.
Goodwill and other intangible assets may be valuable but cannot necessarily be treated as liquidity. Ask what can be converted into cash, on what timetable and at what cost if operating conditions deteriorate.
Try it yourself
A business has $150 million in assets and $95 million in liabilities. Does its $55 million equity balance mean it has $55 million available in cash?
Show the worked answer
No. Equity is assets minus liabilities. The cash balance must be read separately. Assets may consist largely of equipment, inventory or intangible assets.
Further reading
Educational material. Examples are hypothetical and do not recommend a security or a personal allocation.
