Wednesday, December 11, 2013

What Should the Investor Look for in the Financial Statements? The Balance Sheet.

The first section to tackle when examining the financial statements of any investment enterprise is the Balance Sheet.  The balance sheet shows the company's financial situation on a certain date, and is like a snapshot of a company's financial health.

There are three primary sections of the balance sheet:

1) Assets: what the company owns and has owing to it from others. 
2) Liabilities: what the company owes to others. 
3) Shareholders Equity: the net worth of the company, or the shareholders' interest in the company. It will always equal the Assets minus the Liabilities.  

The reason it is called a "balance" sheet is because both sides of the balance sheet equation must always be the same. 

Assets = Liabilities + Shareholders Equity

Often, the Shareholders Equity will be referred to as the Book Value of the company, and can be thought of theoretically as what the value of the company would be if it sold all of its assets and paid off all of its debts. 

In reality, for a variety of reasons, the business could be worth more or less than its Shareholders Equity or Book Value. This is primarily because the company will either have a certain degree of earning power to generate more assets in the future, or lack earning power, and its assets may decrease in value over time with future losses and depreciation. 

Also, sometimes the real value of a company's assets may be difficult or hard to determine, and an example of this might be the value of a patent on a new technology that a company owns. 

Assets, Liabilities, and Shareholders Equity can be categorized into a wide number of different items, such as: 

Assets: Cash, Temporary Investments, Accounts Receivable, Prepaid Expenses, Inventories. 

Liabilities: Current Liabilities, Future Income Taxes, Non-Controlling Interest in Subsidiary Companies, Long-Term Debt

Shareholder Equity: Share Capital, Contributed Surplus, Retained Earnings

There are additional categories to be explored later, but the crucial thing for the Intelligent Investor to understand is the importance of a "healthy" balance sheet

A healthy balance sheet is one showing ample assets to cover any future liabilities, and no warning signs that would indicate limited amounts of cash or "liquid" assets to fund ongoing operations.

A number of seemingly great businesses, upon further inspection, are buried in liabilities that seriously limit shareholder gains over time, and can pose a serious risk to shareholders during a tough economy or business environment. 

To highlight an example of a poor balance sheet, below is some information on Wynn Resorts Limited, (NASDAQ:WYNN):

The current balance sheet of Wynn highlights $7.3 Billion in Assets and $5.8 Billion in Debt... if all Liabilities are included, the number rises to $7.5 Billion. Therefore, the following is true for Wynn:

Assets ($7.3 Billion) = Liabilities ($7.5 Billion) + Shareholders Equity ($-0.2 Billion). 

As a shareholder, this would not be a positive situation, and for the Intelligent Investor, in general should be avoided. 

In future, we will examine more characteristics of the Balance Sheet, and in particular the Earnings Statement and the Cash Flow Statement.

Cheers, and Happy Investing.