Valuation Tutor Lesson: Understanding the Balance Sheet


The balance sheet summarizes the financial condition of a company; in fact, it is sometimes called the “statement of financial position.” A detailed tour of the balance sheet is in Chapter 2 of the online text. The most important information in the balance sheet relates to the assets and liabilities of the company. The difference between the assets and liabilities is called the shareholders equity; it is what shareholders would receive if the assets were sold and the liabilities paid off. A sub-category is “current assets” and “current liabilities.” Current assets are those that can easily be converted into cash; current liabilities are those due within a year. The difference between these is a measure of the short term solvency of the company.

Evaluating the strength of a company with balance sheet information

You can see how strong a company’s balance sheet is in two ways: by looking at changes in the balance sheet over time, and by comparing the company to others (e.g. to its competitors). Let’s look at an actual company, 1 800 FLOWERS.COM:

When you bring up the balance sheet, the first five fields are plotted in the chart.  Since the company has reported data at two time periods (Jan 2012 and July 2011), you can see the changes visually: cash, receivables, and inventories have all risen in the six months between the two reporting periods.
One way to interpret whether the balance sheet has become stronger or weaker is to look at relative changes.  For example, take the fields that make up current assets.  How have these changed over the six months?  An easy way to see this is to plot these fields and then click the Pie Chart button.  The two resulting charts are:


The pie chart makes it easy to spot the change in the composition: you can see that the single biggest change is the increase in inventories (in green) and the second is the increase in receivables (in red).
Similarly, we can consider Liabilities.  How have the obligations the company face changed over time?  Two relevant charts are:


The above charts immediately reveal that the company has reduced their debt obligations (both current and non-current) but increased their short term liability Accounts Payable.  That is they have shifted their obligations from the financing decisions to their operating decisions along with the net effect being that Total Liabilities increased.

Relative changes such as this let you evaluate the strength of the company: while assets have risen over the six months, the primary drivers have been inventories and receivables.  While liabilities have increased the primary drivers have been the shift from financing to operating decisions.  What does this mean?  To evaluate this properly, you need to look at other parts of the statements: what has happened to sales?  What has happened to the cost of generating these sales? What has happened to the “cash flows from operations”?  We will come to these in subsequent lessons.


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