Stock Evaluation Concepts: An Introductory Guide

Disclaimer: Any companies that might appear in this article, under no circumstances are endorsed by the writer directly or indirectly. They only constitute examples for educative purposes and are not financial advice.

Why is it important for an investor to know a few things about balance sheets? It is a great source of information to evaluate the financial health of a company we might be interested in investing in.

In this guide, I will try to break down various concepts related to balance sheets, including long-term liabilities, stockholders' equity, and financial ratios.

The easiest way to access the financials of a company is through Yahoo Finance.

In the search tab, you insert the ticker Symbol of the company then navigate to the Financials tab. There you will have 3 sub-tabs: Income Statement, Balance Sheet, and Cash Flow. In this section, I will focus on Balance Sheet.

First and Foremost the most Basic Equation:

ASSETS=LIABILITIES+EQUITY

Assets:

Assets of a company are the resources or items of value that a company owns or controls. These can include tangible assets such as cash, inventory, buildings, and equipment, as well as intangible assets such as patents, trademarks, and goodwill.

Assets are recorded on a company's balance sheet and are used to generate revenue and support business operations. They can be categorized as current assets (expected to be converted into cash or used up within one year) or non-current assets (expected to provide benefits over multiple years).

Liabilities:

Liabilities of a company are the obligations or debts that a company owes to external parties.

These can include both short-term liabilities, which are expected to be settled within one year, and long-term liabilities, which are expected to be settled over multiple years.

Examples of liabilities include accounts payable, loans, bonds, and lease obligations. Liabilities are recorded on a company's balance sheet and represent the claims that external parties have on a company's assets.

Managing liabilities is important since they represent the company's debts which need to be paid off and thus it’s an indicator of the company's liquidity, solvency, and overall financial health.

Long-Term Liabilities

Long-term liabilities are the obligations that a company expects to pay after one year. They include bonds payable, mortgages payable, long-term notes payable, lease liabilities, and pension liabilities.

These are debts or obligations that a company owes to external parties, and they typically have longer repayment periods. It's important to consider long-term liabilities when evaluating a company's financial health, as they can impact its ability to generate profits and meet other financial obligations in the long run.

Stockholders' Equity

Stockholders' equity represents the ownership claim on a company's assets. It is the residual interest in the assets of a company after deducting its liabilities. Stockholders' equity is usually reported in the balance sheet and consists of common stock and retained earnings.

Common stock represents the initial investment made by shareholders in the company, while retained earnings are the accumulated profits that the company has retained instead of distributing as dividends. Stockholders' equity reflects the net worth of a company and can be an important indicator of its financial strength and stability.

How to Analyze a Balance Sheet

Liquidity Ratios

Liquidity ratios assess a company's short-term debt-paying ability, or its ability to meet its current obligations. Three common liquidity ratios are the current ratio, quick ratio, and cash ratio.

The current ratio is calculated by dividing current assets by current liabilities, the quick ratio is calculated by dividing cash and cash equivalents plus accounts receivable by current liabilities, and the cash ratio is calculated by dividing cash and cash equivalents by current liabilities.

A ratio between 1-3 is generally considered a good sign, indicating that a company has enough cash to meet its debts. However, a ratio of less than 1 may suggest that a company may struggle to pay its debts and may need to finance or extend payment terms with creditors.

Solvency Ratios

Solvency ratios assess a company's long-term paying ability, or its ability to meet its long-term obligations. Two common solvency ratios are the debt-to-equity ratio and the debt ratio. The debt-to-equity ratio is calculated by dividing total debt by total equity, and the debt ratio is calculated by dividing total debt by total assets.

Efficiency Ratios

Efficiency ratios assess how efficiently a company utilizes its assets to generate sales or cash flow. Three common efficiency ratios are the receivables turnover ratio, inventory turnover ratio, and asset turnover ratio.

1. Receivables Turnover Ratio:

   The receivables turnover ratio measures how efficiently a company manages its accounts receivable, which are the amounts owed to the company by its customers for goods or services sold on credit. The formula for the receivables turnover ratio is:

Receivables Turnover Ratio = Net Sales / Average Accounts Receivable

A higher receivables turnover ratio indicates that the company is able to collect its accounts receivable more quickly, which implies better liquidity and cash flow management. On the other hand, a lower ratio may suggest that the company takes longer to collect its receivables or has issues with credit management.

2. Inventory Turnover Ratio:

   The inventory turnover ratio assesses how effectively a company manages its inventory, which is the goods or products held for sale. The formula for the inventory turnover ratio is:

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

A higher inventory turnover ratio indicates that the company is able to sell its inventory more quickly, which implies efficient inventory management and a faster cash conversion cycle. On the contrary, a lower ratio may suggest slow-moving inventory or overstocking, which could result in higher holding costs and obsolescence risk.

3. Asset Turnover Ratio:

   The asset turnover ratio measures how efficiently a company utilizes its total assets to generate sales. The formula for the asset turnover ratio is:

Asset Turnover Ratio = Net Sales / Average Total Assets

A higher asset turnover ratio indicates that the company is able to generate more sales per unit of assets, which implies effective asset utilization and higher productivity. On the other hand, a lower ratio may suggest the underutilization of assets or inefficiencies in the utilization of resources.