Analyzing The Balance Sheet Of A Company
( Originally Published 1939 )
THE balance sheet of any corporation is of importance to the investor, but still more important is the ability of the investor to determine what the balance sheet reflects.
Every balance sheet has two divisions, namely, that of assets and liabilities. The asset side of a balance sheet lists all of the re+sources of the corporation. The opposite side, known as liabilities, lists the various equities or obligations against these assets, which includes what the company owes its creditors, as well as its stock-holders. For this reason the amount of outstanding stock is always carried on the liability side.
It should be mentioned here that balance sheets, unlike income statements, are often difficult to analyze. For example, the Compass Motor Company might carry among its fixed assets, plant and equipment, representing $250,000, when in dissolution it would be worth only $100,000 or less. The item might be faith-fully set-up, nevertheless it may still remain a matter of individual judgment. This will be more fully discussed under depreciation and depletion.
Two companies of similar capitalization might show a marked degree of difference in the amount of their fixed assets. It depends entirely upon what endeavor the company is engaged in. An advertising agency's fixed assets would necessarily be much smaller than some lithograph company, although they might have the same capitalization, and each were showing the same percent-age of earnings.
Again, a company manufacturing cold cream might need a great deal less machinery and equipment than some company manufacturing stop watches. Hence the ratio of fixed assets depends to a very great extent upon the nature of the business.
As the balance sheet pertains to fixed assets, various companies employ different methods in setting it up. For instance, the Compass Motor Company might show its fixed assets as $250,000 in the asset column, and, directly beneath that figure, show depreciation reserves aggregating $50,000, thus leaving a net in the asset column of $200,000. On the other hand they might show the $250,000 in the asset column and list the depreciation reserves in the liability column.
In the case of the advertising agency, their fixed assets might consist principally of office furniture, typewriters, etc. They may lease the space they occupy, hence there is practically no depreciation of plant and very little of equipment.
The lithograph company, on the other hand, may own the building they occupy. Hence they have to face the problem of upkeep and depreciation, not only on their premises, but on the vast amount of equipment they use.
There is still another side of the picture, however. While it is true that the companies which lease the quarters they occupy do not have the depreciation problem to contend with, nevertheless they may find that during a period when earnings are bad, the rent they pay is a serious difficulty.
The United Cigar Stores, with its hundreds of leases through-out the country, and many of them. long-term leases, were forced into the hands of receivers several years ago, principally due to landlords. Any number of locations were leased during prosperous times, and when earnings slowed down, they found their rent problem impossible.
Appearing on the asset side of the balance sheet, often times you find the item, securities. Whenever it appears, make a herculean effort to ascertain what these securities are.
Suppose for instance, the Compass Motor Company showed on their asset side, 5000 shares of preferred stock at a cost of $25.00 per share, or $125,000. On the face of it, this looks good, and the implication is that the company has 5000 shares of stock which may be quickly converted into cash. But what stock is it? If the treasurer of the company has purchased its own stock, it does not necessarily reflect the true condition. The market may be unable to absorb 5000 shares if the company needed the money in a hurry, and again, in dissolution the 5000 shares would be worth no more than the same proportion of equity accruing to the company's other preferred stock. Hence it is obvious that if the 5000 shares is stock which its treasury has purchased, it should be set-up in the liability column and thus deducted from the total stock outstanding. Hence it is always advisable to ascertain just what are the securities listed in the asset column, and what kind of market they may enjoy under adverse conditions.
One of the principle foundations upon which a business rests is its working capital. This capital which is usually reflected as the difference between the current assets and current liabilities on the balance sheet, is very important. While some enterprises re-quire more working capital than others, nevertheless, a substantial ratio between current assets and liabilities is essential.
To determine what is an essential ratio, is to consider the character of the business, and even this does not always accurately reflect the true status. Mining companies usually reflect a low ratio, ranging from three to five, while tobacco companies some-times average from fifteen to twenty-five.
What do current assets consist of? Theoretically speaking, cur-rent assets consist of cash or its equivalent, that is, anything which can be utilized to meet current liabilities without interferring with the operation of the business. This would quite naturally include cash, the accounts receivable, such securities as they may own, and their inventories.
Current liabilities, on the other hand, represent what the company owes; usually short-term obligations which are not included in the capital structure. Notes payable, wages, salaries, dividends, interest, and the like, constitute the current liability side of the balance sheet.
The thing which interests the investor principally, however, is the determination between current assets and current liabilities, thus giving an assurance that the company has sufficient working capital at all times. Working capital is the tool which every business utilizes to manufacture and carry its wares to the market where they exchange it for the commodity called earnings.