Analyzing a Balance Sheet

How many times have you flipped to the back of a company's annual report or 10K and found yourself blankly
staring at the pages of numbers and tables? You know that these should be important to your investing decision,
but you're not uite sure what they mean or where to begin! "hat is a balance sheet? "hy does it matter? "hy
are professional investors so obsessed with studying it, and even more importantly, how are they able to use it
to reduce their portfolio risk and make better, safer decisions when it comes to putting their own money to
work?
#n this investing lesson, #'m going to help you take your first ma$or step towards changing that by teaching you
about the balance sheet! %mart investors have always known that financial statements are the keys to every
company! &hey can warn of potential problems, and when used correctly, help determine what a business is
really 'worth'! (n investor who understands financial statements will never have to ask 'is this company a
good investment?'!
The Role of the Balance Sheet In the Financial Statements
)or every business, there are three important financial statements you must e*amine+ &he ,alance %heet, the
#ncome %tatement, and the -ash )low %tatement! &he balance sheet tells investors how much money the
company has, how much it owes, and what is left for the stockholders! &he cash flow statement is like the
checking account. it shows you where the money is spent! &he income statement is a record of the company's
profitability! #t tells you how much money a corporation made /or lost0!
#n this lesson, we are going to learn to analy1e a balance sheet! &here are two segments! #n the first, we will go
through a typical balance sheet and e*plain what each of the items means! #n the second, we will actually look
at the balance sheets of several (merican corporations and perform basic financial calculations on them!
2y goal for many of you by the end of this series of financial statement analysis lessons is to give you the basic
skills to pick up the financial statements and use the balance sheet, income statement, and cash flow statement
together to perform calculations that provide an idea of how much debt the business has relative to its euity,
how uickly customers are paying their bills, whether short3term cash is declining or increasing, the percentage
of assets that are tangible 3 factories, plants, machinery 3 and how much comes from accounting transactions,
whether products are being returned at higher3than3average historical rates, how many days it takes, on average,
to sell the inventory the business keeps on hand, whether the research and development budget is producing
good results, whether the interest coverage ratio on the bonds are declining as an early sign of trouble, the
average interest rate a company is paying on its debt, where the retained profits that aren't being sent to owners
in the form of dividends are getting spent or reinvested, and much more! (ccounting is the language of business
and these three financial statements, the balance sheet among them, are the report card!
Let's Get Started on Teaching You Ho to Analyze a Balance Sheet
(re you ready? 4rab a cup of coffee, a nearby calculator and let's begin5 #f you have a few annual reports your
stock broker has sent you, you may want to grab those, too, so you can see how real3world balance sheets
sometimes differ slightly in presentation and formatting!
(s you click through the balance sheet lesson, reali1e that # tried to organi1e each, individual topic on its own
self3contained page so you wouldn't be overwhelmed! # highly recommend you do not move forward until you
fully understand, and have mastered, the page you are reading because # designed the balance sheet tutorial to
be worked through seuentially. topics will be built upon what was discussed earlier, and some e*amples, such
as sample financial ratio calculations, will be pulled from earlier data with which you've already become
familiar!
%ince you can't do your analysis without a balance sheet, you're going to have to get your hands on one! How
do you get a company's financial statements? 4enerally, you should look in one of three places!
1!0 The Annual Re!ort+ &he annual report is a document released by companies at the end of their fiscal year
which includes almost everything an investor needs to know about the business! #t generally contains pictures
of facilities, branch offices, employees, and products, all of which are completely unimportant to making your
investing decision! &hey are normally followed by a letter from the -67 and other senior management which
discusses the past as well as upcoming year! &ucked away in the back of most annual reports is a collection of
financial documents! 2ost of the time you can go onto a company's website and find the #nvestor 8elations
link! )rom there, you should be able to either download the annual report in 9:) form or find information on
how to contact shareholder services and reuest a copy in the mail!
;!0 The "#$+ &his is a document filed with the %6- which contains a detailed e*planation of a business! #t is
reported annually and contains the same financial statements the annual report does, in a more detailed form!
&he benefit of the 10K is that it allows you to find out additional information such as the amount of stock
options awarded to e*ecutives at the company, as well as a more in3depth discussion of the nature of the
business and marketplace! %ometimes you will find that a company has no financial statements in the 10K, but
instead has written, 'incorporated herein by reference' &his means that the financial statements can be found
elsewhere, such as in the annual report or another publication! 6ven if this is the case, it is still worth it to get a
copy! You can find this by contacting the company, visiting their website, or going to )ree6dgar
/freeedgar!com0 or %6-!gov!
<!0 The "#%+ &he is similar to the 10K, but is filed uarterly /four times a year 3 normally the end of =anuary,
=une, %eptember, and :ecember0! #f the company is planning on changing its dividend policy, or something
eually as important, they may bury it in the 10>! &hese documents are critical and can be obtained in the same
way as the annual report and 10K!
You will want to get a copy of all three documents for the past year or two from the company in which you are
interested in making an investment! 2ost of them can be found at http+??finance!yahoo!com 3 type in the ticker
symbol of the company you want to research and then click the ')inancials' link! &his will bring up a copy of
the latest uarterly financial statements! /)or all good purposes, # would recommend you first analy1e the
annual balance sheet, which can be found by clicking 'annual data' in the upper right hand corner!0 (s always,
it is best to get the information directly from the company! You can head to the #nvestor 8elations section on its
corporate website /nearly all of them have one0, and download free copies of the reports, all available for free,
which you can then save for review! &his not only saves paper and keeps your desk from piling up with clutter,
it makes it much easier to review several years of annual reports at once, seeing how management's
e*pectations played out in subseuent periods, helping you gauge how realistic and honest the e*ecutives are
when communicating with the owners!
(nother trick you will want to employ in your own analysis is to reuest and study the balance sheets, income
statements, and cash flow statements of companies in the same industry at the same time! #t can help you
understand an oil company better if, say, you are studying all of the ma$or oil companies at the same time! "ith
the other firms fresh in your mind, differences, both positive and negative, are more likely to stand out and get
your attention when calculating financial ratios or determining whether one corporation has a significant cost
advantage over the other /and, $ust as importantly, why that cost advantage e*ists and whether or not it is
sustainable0! &his is true for every industry in e*istence 3 it doesn't matter if you are reading the annual reports
and 10K filings of chocolate companies, automobile manufacturers, newspapers, banks, gold mine operators,
real estate developers, packaged food giants, soda bottlers, farm euipment suppliers, coffee shops, discount
retailers, or theme parks! #f one business mentions a new accounting rule that is going to influence results
substantially, and another only glosses over it, that would raise red flags for the latter firm in my mind!
@ikewise, one company may point out a compelling opportunity the industry is facing, while other, more
conservative firms don't e*pand on anything more than the results produced during the reporting period!
9retend that you are going to apply for a loan to put a swimming pool into your backyard! You go to the bank
asking to borrow money, and the banker insists that you give him a list of your current finances! (fter going
home and looking over your statements, you pull out a blank sheet of paper and write down everything you
have that is of value /your checking and savings account, mutual funds, house, and cars0! &hen, at the bottom of
the sheet your write down all of your debt /the mortgage, car payments, and your student loan0! You subtract
everything you owe by all the stuff you have and come up with your net worth!
-ongratulations, you $ust created a balance sheet!
Balance Sheets Re&uired 'y the Securities and ()change *ommission
=ust as the bank asked you to put together a balance sheet to evaluate your credit3worthiness, the government
reuires companies to put them together several times a year for their shareholders! &his allows current and
potential investors to get a snapshot of a company's finances! (mong other things, the balance sheet will show
you the value of the stuff the company owns /right down to the telephones sitting on the desk of their
employees0, the amount of debt, how much inventory is in the corporate warehouse, and how much money the
business has to work with in the short term! #t is generally the first report you want to look at when valuing a
company!
,efore you can analy1e a balance sheet, you have to know how it is set3up! &hat is what this lesson aims to
teach you!
"hat makes a corporate, limited liability company, or limited partnership balance sheet different from the
ordinary household balance sheet is that there are a lot of comple* items on the books of an operating
enterprise! -ompanies have to deal with all sorts of difficult uestions that most people do not. how to
depreciate and cost out a $umbo $et, how to account for the construction e*penses of a power plant, dealing with
lease obligations for retail space in a busy shopping mall, valuing large inventory stockpiles that might have
gained or lost value since acuired, establishing reserves for potential future losses on bank loans made to
borrowers, and translating multiple currency assets and liabilities back to a reporting currency are $ust a few
e*amples!
#t might seem overwhelming, but when you break it down into the individual parts, you reali1e that there is
nothing particularly difficult about any of it! &he entire purpose of the balance sheet is to answer three
uestions+
"hat do we have? /(ssets0?
"hat do we owe? /@iabilities0?
"hat is left over for the owners? /,ook value or net euity0?
(ll of these fancy words, advanced terms, and accounting rules e*ist to give you, the investor, a good idea of
how to estimate those three things! #f you make yourself remember that is the ob$ective, you shouldn't get
overwhelmed as you wade into the waters of balance sheet analysis!
Aote+ Bnlike other financial statements, the balance sheet cannot cover a range of dates! #n other words, it may be good 'as of :ecember <1, ;00C', but can't cover from :ecember 1 3
:ecember <1! &his is because a balance sheet lists items such as cash on hand and inventory, which change daily! You'll find that the way to deal with this when calculating many ratios, which
#'ll e*plain later, is to take the 'average weighted' figures of a balance sheet! )or e*ample, if you wanted to know the average inventory value for the year, you would take the inventory value at
the end of last year, add it to the ending inventory value this year, then divide by two! #t's a uick trick that helps you avoid distortions by ending period figures that may or may not reflect what
was going on for most of the year! 7ne illustration+ #f a manufacturing business paid off all of its debt, and showed D0 in liabilities on the balance sheet, yet you saw a line for interest e*pense
on the income statement, you might be confused! ,y weighting the average debt outstanding from the balance sheet for the same period, you'd get a better idea of what was going on and why
there were interest costs!

6very balance sheet is divided into three main parts 3 assets, liabilities, and shareholder euity!
(ssets are anything that have value! Your house, car, checking account, and the antiue china set your
grandma gave you are all assets! -ompanies figure up the dollar value of everything they own and put it
under the asset side of the balance sheet!
@iabilities are the opposite of assets! &hey are anything that costs a company money! @iabilities include
monthly rent payments, utility bills, the mortgage on the building, corporate credit card debt, and any
bonds the company has issued!
%hareholder euity is the difference between assets and liability. it tells you the 'book value', or what is
left for the stockholders after all the debt has been paid!
6very balance sheet must 'balance'! &he total value of all assets must be eual to the combined value of the all
liabilities and shareholder euity /i!e!, if a lemonade stand had D10 in assets and D< in liabilities, the shareholder
euity would be DE! &he assets are D10, the liabilities F shareholder euity G D10 HD< F DEI0!
+hat ,oes a Balance Sheet Loo- Li-e.
,elow is an e*ample of what a typical balance sheet looks like! #'ve taken it from an old -oca3-ola annual
report and, for the sake of space, removed lines that had a D0 value! :on't worry, though, we will still discuss
each line you are likely to encounter when reading a balance sheet, whether for small business or a large
publicly traded corporation!
&he first thing listed under the asset column on the balance sheet is something called 'current assets'! &his is
where companies list all of the stuff that can be converted into cash in a short period of time, usually a year or
less! ,ecause these assets are easily turned into cash, they are sometimes referred to as 'liuid'! -urrent assets
normally consist of cash and cash euivalents, short3term investments, and a few items! @et's take a moment to
e*amine each!
*ash and *ash (&ui/alents
-ash and -ash 6uivalents represent the amount of money the company has in bank accounts, savings bonds,
certificates of deposit, and money market funds! #t tells you how much money is available to the business
immediately! How much should a company keep on the balance sheet? 4enerally speaking, the more cash on
hand the better, though e*cessive amounts are likely to make investors unhappy as they would rather have the
money paid out in the form of a dividend to be reinvested, spent, saved, or given to charity /nobody likes seeing
someone else hoard wealth that rightfully belongs to them, especially if isn't doing anything to earn a good
return0! Aot only does a decent cash hoard give management the ability to pay dividends and repurchase shares,
but it can provide e*tra wiggle3room when times get bad! &ypically, a common stock investor is going to be
happiest when the stock market falls apart if he or she owns a large, profitable business with large cash reserves
and little to no debt! 7ften, these strongly capitali1ed businesses can swoop in and take advantage of the
maelstrom, buying up competitors for a fraction of their true value, or e*panding market share as others in the
industry are busy playing defense!
&here are some cases where cash on the balance sheet isn't necessarily a good thing! #f a company is not able to
generate enough profits internally, they may turn to a bank and borrow money! &he money sitting on the
balance sheet as cash may actually be borrowed money! &o find out, you are going to have to look at the
amount of debt a company has /we will be discussing this later on in the lesson0! &he moral+ You probably
won't be able to tell if a company is weak based on cash alone. the amount of debt is far more important!
Short Term In/estments on the Balance Sheet
&hese are investments that the company plans to sell shortly or can be sold to provide cash! %hort term
investments aren't as readily available as money in a checking account, but they provide added cushion if some
immediate need were to arise! &hese securities and assets become important when a company has so much cash
sitting around that it has no ualms about tying some of it up in slightly longer3term investment vehicles /such
as bonds which have maturities of less than one year0! &his allows the business to earn a higher interest rate
than if they stuck the cash in a corporate savings account!
)rom time to time, companies become known for their legendary cash hoards! ( decade ago, 2icrosoft was
known for its DJ!;J billion in cash and D<;!CE< billion in short term investments! ,erkshire Hathaway has kept
as much as DK0F billion in cash on hand as a strategic maneuver to allow its legendary -hairman of the ,oard
and -hief 6*ecutive 7fficer, "arren ,uffett, the opportunity to pounce on deeply discounted stocks and entire
enterprises during recessions or depressions! (lmost all of these funds are kept in short3term &reasury bills,
representing a claim on the ta*ing power of the Bnited %tates 4overnment!
0ot All *urrent Assets Are (&ual
(s an investor, you need to understand not all current assets on the balance sheet are eual! 2any companies
are now holding things called 'auction rate securities', which they treat as a high uality current asset when
they clearly aren't 3 in a panic, the market for these will dry up and it could take weeks, months, or even longer
to convert back into greenbacks! You need to dig into the 10K or annual report and find out the specific type of
holding in which management has placed your money!
Accounts Recei/a'le as a Balance Sheet Asset
8eceivables are also sometimes known as accounts receivables and represents money that is owed to a
company by its customers!
Ho Accounts Recei/a'le Are Recorded on the Balance Sheet
Here's how it works+ @et's say "al32art wants to order a new :L: which is being released by "arner
,rothers! "al32art orders J00,000 copies for its stores! "arner ,rothers receives the order, and within a week,
ships the :L:s to one of "al32art's warehouses! #ncluded in the shipment is a bill /let's say ", charged "al3
2art DJ per :L: for half a million copies 3 that's D;!J million0! "arner ,rothers has already sent the movies to
"al32art, even though "al32art hasn't paid a penny! #n essence, "al32art is buying on credit and promising
to pay ",'s the D;!J million!
&he D;!J million would go on "arner ,rother's balance sheet as accounts receivables!
Accounts Recei/a'le Terms
4enerally a company that sells a product on credit sets a term for its accounts receivable! &he term is the
number of days customers must pay their bill before they are charged a late fee or turned over to a collection
agency /most terms are, <0, M0 or C0 days0! #f "arner ,rothers sold the :L:s to "al32art on a <0 day term,
"al32art must pay its bill during that time!
"hile accounts receivable are good, they can bring serious problems to a business if they aren't handled
properly! "hat if "al32art went bankrupt or simply didn't pay "arner ,rothers? ", would then be forced to
write down its receivables on the balance sheet by D;!J million! &his is what is called a delinuent account!
Aormally, companies build up something called a reserve to prepare for situations such as this! 8eserves are set
amounts of money that are taken out of the profits each year and put into an account specifically designed to act
as a buffer against possible loses the company may incur! /8eserves are touched on in 9art ;C0! "hen
customers don't pay their bills, companies can take money out of the reserve they had built up to pay back
suppliers! 2ost companies, however, don't actually set aside the money they charge to reserves, but instead $ust
write it off the income statement! #n other words, you can't 'dip into the reserves' in the traditional sense unless
you were dealing with an e*tremely conservative management that actually believed a set percentage of sales
should be put aside in safe cash euivalents!
&he receivable turns or receivable turnover is a great financial ratio to learn when you are analy1ing a business
or a stock because common sense tells you the faster a company collects its accounts receivables, the better!
&he sooner customers pay their bills, the sooner a company can put the cash in the bank, pay down debt, or start
making new products! &here is also a smaller chance of losing money to delinuent accounts! )ortunately, there
is a way to calculate the number of days it takes for a business to collect its receivables! &he formula looks like
this+
Recei/a'le Turns *alculation
-redit %ales
1
N (verage (ccounts 8eceivables
1+ -redit sales are found on the income statement, not the balance sheet

@et's look at an e*ample! #'ve built a table at the bottom of this page that will provide you with the numbers you
need for a fictional company, H!)! ,everages!
An ()am!le of *alculating Recei/a'le Turns
H!)! ,everages is a ma$or manufacturer of soft drinks and $uice beverages! #t sells to supermarkets and
convenience stores across the country on a <0 day term! &o see if customers are paying on time, we need to
look for the income statement! #t is normally found within a page or two of the balance sheet in the annual
report or 10K! "ith the income statement in front of you, look for an item called '-redit %ales' /if you can't
find it, there is an item called '&otal %ales' which is acceptable but not as accurate0!
#n ;00C, H!)! ,everages reported credit sales of D1J,M0O,<00! #f we look at the e*cerpt from its balance sheet
/above0, we will see that in ;00C, it had D1,1O<,<M< in receivables and in ;00O, D1,1EO,K;<! "e need to find out
the average amount of receivables H!)! had in ;00C, so we would take D1,1OE<,<M< F D1,1EO,K;< and divide it
by ;! &he answer is D1,1O0,OC<!
9lug the two numbers into the receivable turn formula!
-redit %ales of D1J,M0O,<00 N (verage 8eceivables G D1,1O0,OC<
&he answer, called receivable turns by financial analysts and professional investors, is 1<!;1E<! &his means that
H!)! ,everages collects its accounts receivable 1<!;1E< times per year! 7nce you calculate this number, finding
out the number of days it takes for customers to pay their bills is simple! %ince there are <MJ days in a year and
the company gets 1<!;1E< turns per year, take <MJ N 1<!;1E<! &he answer is the number of days it takes the
average customer to pay /in H!)!'s case, we come up with ;E!M10!
&his means the company is doing a good $ob managing its accounts receivable because customers aren't
e*ceeding the <0 day policy! Had the answer been greater than <0, you would have been wise to try to find out
why there were so many late payments, which could be a sign of trouble! /Keep in mind you will need to read
through the company's reports to find out what its collection deadline is! Aot all companies reuire their
customers to pay within <0 days0!
In/entory Is (s!ecially Im!ortant to In/estors
"hen looking at a company's current assets, you need to pay special attention to inventory! #nventory consists
of merchandise a business owns but has not sold! #t is classified as a current assets because investors assume
that inventory can be sold in the near future, turning it into cash!
&o come up with a balance sheet amount, companies must estimate the value of their inventory! )or instance, if
Aintendo had J,000 units of its new video game system, the 4ame -ube, sitting in a warehouse in =apan, and
e*pected to sell them to retailers for D<00 each, they would be able to put D1,J00,000 on their balance sheet as
the value of their current inventory /J,000 units * D<00 each G D1!J million0!
The Ris- of Too 1uch In/entory
&his presents an interesting problem! "hen inventory piles up, it faces two ma$or risks! &he first is the risk of
obsolesce! #n another year, few stores will probably be willing to buy the 4ame -ube video game system for
D<00 simply because a newer, faster, and better system may have come along! (lthough the inventory is carried
on the balance sheet at D1!J million, it may actually lose value as time passes! "hen you hear that a company
has taken an inventory write3off charge, it means that management essentially decided the products that were
sitting in storage or on the store shelves weren't worth the values they were stated at on the balance sheet! &o
correct this, the company will reduce the carrying value of its inventory!
#f a year passes and Aintendo still has <,000 of the J,000 units in storage, the e*ecutives may decide to lower
their prices hoping to sell the remaining inventory! #f they lower the 4ame -ube's price to D;00 each, they
would have <,000 units at D;00! ,efore, those <000 units were stated at a value of DC00,000 on the balance
sheet! Aow, because they are selling for less, the same units are only worth DM00,000! &he risk of obsolesce is
especially present in technology companies or manufacturers of heavy machinery!
In/entory S!oilage
(nother inventory risk is spoilage! %poilage occurs when a product actually goes bad! &his is a serious concern
for companies that make or sell perishable goods! #f a grocery store owner overstocks on ice cream, and two
months later, half of the ice cream has gone bad because it has not been purchased, the grocer has no choice but
to throw it out! &he estimated value of the spoiled ice cream must be taken off the grocery store's balance sheet!
&he moral of the story+ the faster a company sells its inventory, the smaller the risk of value loss!
,efore you invest, you are going to have to make an informed decision about how much you think the
inventory on the balance sheet is really worth! ( ma$or part of this decision should be based on how fast the
inventory is 'turned' /or sold0! &wo competing companies may each have D;0 million sitting in inventory, but
if one can sell it all every <0 days, and the other takes K1 days, you have less of a risk of inventory loss with the
<0 day company!
)inding out how fast a company turns its inventory is simple! Here's the formula!
*alculating In/entory Turns 2 In/entory Turno/er Ratio
-ost of 4oods %old
1
N (verage #nventory for the 9eriod
;

1+ &his is found on the income statement, not the balance sheet
;+ (verage inventory is calculated by taking the last period's inventory plus the current period inventory and dividing them by two!

Real +orld ()am!le of In/entory Turns 2 In/entory Turno/er
@et's look at a real world e*ample! (t the bottom on the page, #'ve provided an older e*cerpt from the financial
statements of -oca3-ola! &he cost of goods sold is DM,;0K,000,000! &he average inventory value between 1CCC
and ;000 is D1,0E1,000,000 /average the values from 1CCC and ;0000! 9lug them into the formula for inventory
turn!
-urrent Year's -ost of 4oods %old of DM,;0K,000,000 N (verage #nventories of D1,0E1,000,000
&he answer is the number of inventory turns 3 in -oca3-ola's case, J!EC;E! "hat this means is that -oca -ola
sells all of its inventory J!EC times each year! #s this good? &o answer this uestion, you must find out the
average turn of -oke's competitors and compare! #f you do the research, you find out that the average turnover
of a company in -oke's industry is O!K! "hy is -oca3-ola's turn rate lower? %hould it affect your investing
decision? &he only way you can answer these kinds of uestions is if you truly understand the business you are
analy1ing! &his is why it is important that you read the entire annual report, 10K and 10> of the companies you
have taken an interest in! (lthough -oke's turn rate is lower, further analysis of the balance sheet will reveal
that it is K to J* financially stronger than its industry averages! "ith such outstanding economics, you probably
don't need to worry about inventory losing value!
3sing In/entory Turno/er to *alculate A/erage ,ays to Sell a 4roduct
@et's take the inventory analysis a step further! 7nce you have the inventory turn rate, calculating the number of
days it takes for a business to clear its inventory only takes a few seconds! %ince there <MJ days in a year and
the -oca -ola clears its inventory J!EC;E times per year, take <MJ N J!EC;E! &he answer /M<!0<0 is the number
of days it takes for -oke to go through its inventory! &his is a great trick to use at cocktail parties. grab a copy
of an annual report, scribble the formula down and announce loudly that '"ow5 &his company takes M< days to
sell through its inventory5' 9eople will instantly think you are an investing genius!
+hat Is a 0ormal In/entory Turno/er Ratio.
&he number of days a company should be able to sell through its inventory varies greatly by industry! 8etail
stores and grocery chains are going to have a much higher inventory turn rate since they are selling products
that generally range between D1 and DJ0! -ompanies that manufacture heavy machinery such as airplanes, are
going to have a much lower turn over rate since each of their products may sell for millions of dollars!
Hardware companies may only turn their inventory < or K times a year, while a department store may do twice
that, turning at M or E!
( useful e*ercise is to compare the inventory turnover rate of a potential investment against that of its
competitors to see which management team is more efficient!
In/entory in Relation to *urrent Assets
"hen analy1ing a balance sheet, you also want to look at the percentage of current assets inventory represents!
#f E0P of a company's current assets are tied up in inventory and the business does not have a relatively low
turn rate /less than <0 days0, it may be a signal that something is seriously wrong and an inventory write3down
is unavoidable!
Q #t is acceptable to use the total sales instead of the cost of sales when calculating inventory turnover ratios! &he cost of sales is a more accurate reflection of inventory turn and should be used
for the truest results! "hen comparing the company to others in its industry, make sure you use the same number! You cannot value one company using cost of sales, and another using total
sales or else you will end up with faulty data!

#t's easy to see how a higher inventory turn than competitors translates into superior business performance!
2c:onald's is unuestionably the largest and most successful fast food restaurant in the world! @et's compare it
to one of its main competitors, "endy's!
Bse the inventory turn formula /cost of goods sold divided by the average inventory values0 to come up with
the number of inventory turns for each business! ,etween 1CCC and ;000, 2c:onald's had an inventory turn
rate of CM!1JKC, incredible for even a high3turn industry such as fast food! &his means that every <!EC days,
2c:onald's goes through its entire inventory! "endy's, on the other hand, has a turn rate of K0!0E< and clears
its inventory every C!10 days!
&his difference in efficiency can make a tremendous impact on the bottom line! ,y tying up as little capital as
possible in inventory, 2c:onald's can use the cash on hand to open more stores, increase its advertising
budget, or buy back shares! #t eases the strain on cash flow considerably, allowing management much more
fle*ibility in planning for the long term!
The Final +ord on In/entory
&he bottom line+ #nvestors want as little money as possible tied up in inventory! #t is fine to have a lot of
inventory on the balance sheet if it is being sold at a fast enough rate there is little risk of becoming obsolete or
spoiled! 4reat companies have e*cellent inventory handling systems so they only order products when they are
needed 3 they never buy too much or too little of something! ,usinesses that have too much inventory sitting on
the shelves or in a warehouse are not being as productive as they could be+ had management been wiser, the
money could have been kept as cash and used for something more productive!
#n the course of every day operations, businesses will have to pay for goods or services before they actually
receive the product! #f a $ewelry store moved into your neighborhood mall, it would most likely have to sign a
rent agreement and pay si* to twelve months' rent in advance! #f the monthly rent was D1,000 and the business
prepaid for an entire year, they would put D1;,000 on the balance sheet under 9repaid 6*penses /D1,000
monthly rent * 1; months G D1;,0000! 6ach month, they would deduct 1?1; from the prepaid e*penses until the
end of the year, at which point, the amount would be D0!
%ometimes companies decide to prepay ta*es, salaries, utility bills, rent, or the interest on their debt! &hese
would all be pooled together and put on the balance sheet under this heading!
,y their very nature, 9repaid 6*penses are a small part of the balance sheet! &hey are relatively unimportant in
your analysis and shouldn't be given too much attention!
0otes Recei/a'le
Aotes 8eceivable are debts owed to the company which are payable within one year!
5ther *urrent Assets
7ther current assets are non3cash assets that are owed to the company within one year!
0on Standard Items
%ometimes companies put items on their balance sheet which aren't standard! #f you find yourself analy1ing a
balance sheet and an oddball term shows up, search for it at investorwords or investopedia! #f that still doesn't
work, you can call your broker or a local banker, all of whom should be happy to give you an e*planation of a
term!
# would recommend you get a copy of ,arron's ':ictionary of )inance and #nvesting &erms'! &hey are
relatively ine*pensive /D10 or D110, and define over K,000 terms! &his can be a huge asset regardless of the
financial statement you are looking at! You may also find the ':ictionary of ,usiness &erms' useful as well! #t
has E,J00 entries covering almost every business definition you could possibly ask for! "hile neither is
reuired to do balance sheet analysis, they can be a big help!
-urrent liabilities found on the balance sheet are the debts a company owes which must be paid within one
year! &hey are the opposite of current assets! -urrent liabilities includes things such as short term loans,
accounts payable, dividends and interest payable, bonds payable, consumer deposits, and reserves for )ederal
ta*es!
@et's take a look at some of the most common and important current liabilities on the balance sheet!
Accounts 4aya'le 6 The 1ost 4o!ular *urrent Lia'ility
(ccounts payable is the opposite of accounts receivable! #t arises when a company receives a product or service
before it pays for it! (ccounts payable, or (?9 as it is often shorthanded, is one of the largest current liabilities a
company will face because they are constantly ordering new products or paying vendors for services or
merchandise! 8eally well managed companies attempt to keep accounts payable high enough to cover all
e*isting inventory, meaning that the vendors are paying for the company's shelves to remain stocked, in effect!
&he most effective operators in industries such as discount retailers, &arget and "al32art among them, have
turned this into an art! #n a very real sense, their business growth was funded by vendors such as 9rocter R
4amble and -loro*, both of which shipped products to the store shelves on credit, giving the merchants a
chance to sell the goods before paying the amount owed to these wholesalers! &his meant both "al32art and
&arget could use more of the money they had raised from shareholders, bondholders, and retained profits to
fund new store e*pansion!
Accrued Benefits and 4ayroll as a *urrent Lia'ility
&his item in the current liabilities section of the balance sheet represents money owed to employees as salary
and bonus that the company has not yet paid!
Short Term and *urrent Long Term ,e't
&hese current liabilities are sometimes referred to as notes payable! &hey are the most important item under
current liabilities section of the balance sheet and most of the time, they represent the payments on a company's
bank loans that are due in the ne*t twelve months! ,orrowing money in itself is not necessarily a sign of
financial weakness. an intelligent department store e*ecutive may work out short term loans at -hristmas so she
can stock up on merchandise before the Holiday rush! #f demand is high, the store would sell all of its
inventory, pay back the short term loans, and pocket the difference! &his is known as utili1ing leverage! &he
department store used borrowed money to make a profit!
%o how can you ever hope to tell if a company is wisely borrowing money /such as our department store0, or
recklessly going into debt? @ook at the amount of notes payable on the balance sheet /if they aren't classified
under 'notes payable', combine the company's short term obligations and long term current debt0! #f the amount
of cash and cash euivalents is much larger than the notes payable, you shouldn't have any reason to be
concerned!
#f, on the other hand, the notes payable has a higher value than the cash, short term investments, and accounts
receivable combined, you should be seriously concerned! Bnless the company operates in a business where
inventory can uickly be turned into cash, this is a serious sign of financial weakness!
5ther *urrent Lia'ilities
:epending on the company, you will see various other current liabilities listed! %ometimes they will be lumped
together under the title 'other current liabilities!' Aormally, you can find a detailed listing of what these 'other'
liabilities are buried somewhere in the annual report or 10K! 7ften, you can figure out the meaning of the entry
by its name! #f a business lists '-ommercial 9aper' or ',onds 9ayable' as a current liability, you can be fairly
confident the amount listed is what will be paid out to the company's bond holders in the short term!
*onsumer ,e!osits Are Lia'ilities to Ban-s
#f you are looking at the balance sheet of a bank, you will want to pay close attention to an entry under the
current liabilities called '-onsumer :eposits'! 7ften, they will be will lumped under other current liabilities!
&his is the amount that customers have deposited in the bank! %ince, theoretically, all of the account holders
could withdrawal all of their funds at the same time, the bank must list the deposits as a current liability!
7ne of the main reasons serious investors look at a balance sheet is to find out a company's working capital /or
'current'0 position! "orking capital reveals more about the financial condition of a business than almost any
other calculation because it tells you what would be left if a company took all of its short3term resources, and
used them to pay off its short3term liabilities! &he more working capital a firm has on hand, the less financial
strain a company e*periences! ,y studying a company's position, you can clearly see if it has the resources
necessary to e*pand internally or if it will have to turn to a bank and take on debt!
*alculating +or-ing *a!ital
"orking -apital is the easiest of all the balance sheet calculations! Here's the formula!
-urrent (ssets 3 -urrent @iabilities G "orking -apital
7ne of the main advantages of looking at the working capital position is being able to foresee any financial
difficulties that may arise! 6ven a business that has billions of dollars in fi*ed assets will uickly find itself in
bankruptcy court if it can't pay its monthly bills! Bnder the best circumstances, poor working capital leads to
financial pressure on a company, increased borrowing, and late payments to creditor 3 all of which result in a
lower credit rating! ( lower credit rating means banks charge a higher interest rate, which can cost a
corporation a lot of money over time!
0egati/e +or-ing *a!ital *an Be a Good Thing for High Turn Businesses
-ompanies that have high inventory turns and do business on a cash basis /such as a grocery store0 need very
little working capital! &hese types of businesses raise money every time they open their doors, then turn around
and plow that money back into inventory to increase sales! %ince cash is generated so uickly, managements
can simply stockpile the proceeds from their daily sales for a short period of time if a financial crisis arises!
%ince cash can be raised so uickly, there is no need to have a large amount of working capital available!
( company that makes heavy machinery is a completely different story! ,ecause these types of businesses are
selling e*pensive items on a long3term payment basis, they can't raise cash as uickly! %ince the inventory on
their balance sheet is normally ordered months in advance, it can rarely be sold fast enough to raise money for
short3term financial crises /by the time it is sold, it may be too late0! #t's easy to see why companies such as this
must keep enough working capital on hand to get through any unforeseen difficulties!
&o find the appro*imate amount of working capital a company should have, you should look at 'working
capital per dollar of sales!' #n other words, you are going to have to compare the amount of working capital on
the balance sheet to the total sales, which is found on the income statement, not the balance sheet! ( business
that sells a lot of low3cost items, and cycles through its inventory rapidly /a grocery store0 may only need 103
1JP of working capital per dollar of sales! ( manufacturer of heavy machinery and high3priced items with a
slower inventory turn may reuire ;03;JP working capital per dollar of sales! ( company such as -oca -ola
would probably fall somewhere between the two!
*alculating +or-ing *a!ital 4er ,ollar of Sales
Here's the formula for "orking -apital per :ollar of %ales
"orking -apital N &otal %ales /)ound on the #ncome %tatement0
@et's look at an e*ample taken from an old annual report of 4oodrich!
Sam!le +or-ing *a!ital 4er ,ollar of Sales *alculation
4oodrich provides systems for aircraft as well as manufacturers heavy3duty engines! "orking -apital+
DC<<,000,000 /current assets 3 current liabilities0 &otal %ales /found on the income statement0 G DK,<M<,O00,000
@et's plug the numbers into the formula+
"orking -apital of DC<<,000,000 N &otal %ales of DK,<M<,O00,000
&he answer for 4oodrich is !;1<O, or ;1!<OP! (s a manufacturer of heavy duty machinery, 48 falls within the
;03;JP working capital per dollar of sales range! &his is good and compares favorably to competitors!
%ome companies can generate cash so uickly they actually have a negative working capital! &his is generally
true of companies in the restaurant business /2c:onald's had a negative working capital of DMCO!J million
between 1CCC and ;0000! (ma1on!com is another e*ample! &his happens because customers pay upfront and so
rapidly, the business has no problems raising cash! #n these companies, products are delivered and sold to the
customer before the company ever pays for them!
:on't understand how a company can have a negative working capital? &hink back to our "arner ,rothers ?
"al32art e*ample! "hen "al32art ordered the J00,000 copies of a :L:, they were supposed to pay "arner
,rothers within <0 days! "hat if by the si*th or seventh day, "al32art had already put the :L:s on the
shelves of its stores across the country? ,y the twentieth day, they may have sold all of the :L:s! #n the end,
"al32art received the :L:s, shipped them to its stores, and sold them to the customer /making a profit in the
process0, all before they had paid "arner ,rothers5 #f "al32art can continue to do this with all of its suppliers,
it doesn't really need to have enough cash on hand to pay all of its accounts payable! (s long as the transactions
are timed right, they can pay each bill as it comes due, ma*imi1ing their efficiency!
&he bottom line+ ( negative working capital is a sign of managerial efficiency in a business with low inventory
and accounts receivable /which means they operate on an almost strictly cash basis0! #n any other situation, it is
a sign a company may be facing bankruptcy or serious financial trouble! You can tell if this is the case by
comparing a company's accounts payable to the total inventory on the balance sheet!
Buying a *om!any for Free
#f you can buy a company for the value of its working capital, you essentially pay nothing for the business!
4oing back to our 4oodrich e*ample. the company has DC<< million in working capital! &here are currently
101!C million shares outstanding, which means each share of 4oodrich stock has DC!1M cents worth of working
capital! #f 48's stock was trading for DC!1M, you would basically be purchasing the stock for free /paying D1 for
each D1 the company had in its checking account, inventory, etc!0! You would pay nothing for the company's
fi*ed assets /such as real estate, computers, R buildings0 and earnings!
)or the past ten or twenty years, it has been incredibly rare for a company to trade that low! You can still use
the basic concept to your advantage. if you can find a business that is trading for working capital plus half the
value of the fi*ed assets, you would be paying D0!J0 for every D1!00 of assets!
&he current ratio is another financial ratio that serves as a test of a company's financial strength! #t calculates
how many dollars in assets are likely to be converted to cash within one year in order to pay debts that come
due during the same year! You can find the current ratio by dividing the total current assets by the total current
liabilities! )or e*ample, if a company has D10 million in current assets and DJ million in current liabilities, the
current ratio would be ; /10?J G ;0!
"hat you, as an investor, should consider an acceptable current ratio varies by industry because different types
of enterprises have different cash conversion cycles, economic needs, and funding practices! 4enerally
speaking, the more liuid the current assets, the smaller the current ratio can be without cause for concern! )or
most industrial companies, 1!J is an acceptable current ratio! (s the number approaches or falls below 1 /which
means the company has a negative working capital0, you will need to take a close look at the business and make
sure there are no liuidity issues! -ompanies that have ratios around or below 1 should only be those which
have inventories that can immediately be converted into cash! #f this is not the case and a company's number is
low, you should be seriously concerned! &his is especially true when dealing with a business that relies on
vendors financing much of the cash by providing credit for goods ultimately sold to the end customer! #f the
vendors were to become concerned about the financial health of the corporation, they could send the business
into a scramble, or even a death spiral, by reducing credit lines or refusing to sell without upfront payment,
resulting in a liuidity crisis!
3sing the *urrent Ratio to Gauge Inefficiency
#f you're analy1ing a balance sheet and find a company has a current ratio of < or K, you may want to be
concerned! ( number this high means that management has so much cash on hand, they may be doing a poor
$ob of investing it! &his is one of the reasons it is important to read the annual report, 10K and 10> of a
company! 2ost of the time, the e*ecutives will discuss their plans in these reports! #f you notice a large pile of
cash building up and the debt has not increased at the same rate /meaning the money is not borrowed0, you may
want to try to find out what is going on!
2icrosoft has a current ratio in e*cess of K. a massive number compared to what it reuires for its daily
operations! &he company has no long term debt on the balance sheet! "hat are they planning on doing? Ao one
knew until the company paid its first dividend in history, bought back billions of dollars worth of shares, and
made strategic acuisitions!
(lthough not ideal, too much cash on hand is the kind of problem a smart investor prays to encounter! (
business with too much money has options! &he biggest danger in such a pleasant situation is that management
will begin compensating itself too highly and suander the funds on bad pro$ects, terrible mergers, or high risk
activities! 7ne defense against this, and sign that management is on the side of the long3term owner, is a
progressive dividend payout policy! &he more cash the e*ecutives send out the door and put in your pocket as a
sort of rebate on your purchase price, the less money they have sitting around to tempt them to do something
dumb!
#n fact, it isn't an accident that overwhelming academic evidence studying nearly a century of stock market
returns demonstrates that businesses dedicated to operating efficiently by paying out surplus funds as dividends,
meaning by definition they avoid having what management considers a non3$ustifiably high current ratio, do far
better over the long3run than businesses where the e*ecutive team hoards the cash! &here are always e*ceptions,
but as a general rule, this is one of the big truths too many investors ignore as they think they are only going to
own those outliers!
&he >uick &est 8atio /also called the (cid &est or @iuidity 8atio0 is the most e*cessive and difficult test of a
company's financial strength and liuidity! &o calculate the uick ratio, take the current assets and subtract the
inventory /current assets minus inventory is often referred to as the 'uick assets'0! "hat you are left with are
the items that can be converted into cash immediately! :ivide the result by the current liabilities! &he answer is
the >uick &est ratio, one of the most difficult balance sheet tests!
"hat does this tell you? #t is a reflection of the liuidity of a business! &he >uick &est ratio does not apply to
the handful of companies where inventory is almost immediately convertible into cash /such as 2c:onalds,
"al32art, etc!0 #nstead, it measures the ability of the average company to come up with cold, hard cash literally
in a matter of hours or days! %ince inventory is rarely sold that fast in most businesses, it is e*cluded!
Long Term Assets
6verything we've discussed up until now has been a current asset or current liability! Aow, we are going to take
a look at the long term assets that are found on the balance sheet! &hese are the things that a business owns but
can't be used to fund day3to3day operations!
Long Term In/estments
@ong &erm investments and funds are investments a company intends to hold for more than one year! &hey can
consist of stocks and bonds of other companies, real estate, and cash that has been set aside for a specific
purpose or pro$ect! #n addition to investments a company plans to hold for an e*tended period of time, @ong
&erm #nvestments also consist of the stock in a company's affiliates and subsidiaries!
&he difference between short term and long term investments lie in the company's motive for owning them!
%hort term investments consist of stocks, bonds, etc! a company has bought and will sell shortly! &he
investments made under long term investments may never be sold! (n e*cellent e*ample would be ,erkshire
Hathaway's relationship with -oca3-ola! ,erkshire owns ;00 million shares of the soft3drink giant, and will
most likely continue to hold them forever, regardless of the price they are selling for in the open market!
*arrying 7alues of Stoc- In/estments
(s you now know, when a business purchases common stocks as an investment, they will go into either the
short term or long term investment categories on the balance sheet! &hese are normally carried on the balance
sheet at cost or market value /whichever is less0! &his means that most of the time, the stocks the company
owns are worth far more than they are on the balance sheet /for e*ample, if a business owned J0,000 shares of
%print and they paid D10 per share, they would have DJ00,000 on the balance sheet under either short term or
long term investments! #f %print rose to D<J per share, the value of their holdings would be D1,EJ0,000, yet the
balance sheet would continue to carry DJ00,000! &hus, the difference of D1,;J0,000 would not be included in
the book value of the company! /&his is a prime e*ample of how financial statements are only the beginning of
the valuation process! &hey have their limitations, but without them, we would have no basis to calculate
intrinsic value!0
&hese are referred to as 'fi*ed assets'! #n other words, these are the corporation's real estate, buildings, office
furniture, telephones, cafeteria trays, brooms, factories, etc! &hey are the physical assets the company owns but
can't uickly convert to cash!
:epending on the type of business, these may or may not make up a large percentage of the total assets! 2ost
of the assets of a railroad or airline will fall into this category /these companies must continue to buy railroad
cars and planes to survive 3 both of which are fi*ed assets0! (n advertising agency on the other hand, will have
far fewer fi*ed assets! &hey reuire nothing but their employees, some pencils, and a few computers!
You must be careful not to pay too much attention to this number! %ince companies are often unable to sell their
fi*ed assets within any reasonable amount of time /who would be willing to buy three notebook binders, a
factory, the broom in the broom closet, etc! at a moment's notice?0 they are carried on the balance sheet at cost
regardless of their actual value! #t is possible for companies to grossly inflate this number /which is called
'watering' the stock0, or to write the values down to nothing /some companies have D1 million dollar buildings
carried for D1 on the balance sheet0!
"hen analy1ing a balance sheet, you will want to look at this number with a raised eyebrow! :on't completely
ignore it /that would be foolish0, but certainly don't take it too seriously!
-ompanies often own things of value that cannot be touched, felt, or seen! &hese consist of patents, trademarks,
brand names, franchises, and economic goodwill /which is different than the accounting goodwill we've
discussed! 6conomic goodwill consists of the intangible advantages a company has over its competitors such as
an e*cellent reputation, strategic location, business connections, etc!0 "hile every effort should be made for
businesses to carry them at costs on the balance sheet, they are normally given completely meaningless values!
&o prove the point that the intangible value assigned on the balance sheet can be deceptive, here's an e*cerpt
from 2ichael )! 9rice's introduction to ,en$amin 4raham's '&he #nterpretation of )inancial %tatements' !!!
In the spring of 1975, shortly after I began my career at Mutual Shares Fund, Max Heine ased me to loo at a
small bre!ery " the F#M Schaefer $re!ing %ompany& I'll ne(er forget looing at the balance sheet and seeing
a )*" +,- million net !orth and +,- million in 'intangibles'& I said to Max, 'It loos cheap& It's trading for !ell
belo! its net !orth&&&& . classic (alue stoc/' Max said, '0oo closer&'
I looed in the notes and at the financial statements, but they didn't re(eal !here the intangibles figure came
from& I called Schaefer's treasurer and said, 'I'm looing at your balance sheet& 1ell me, !hat does the +,-
million of intangibles related to2' He replied, '3on't you no! our 4ingle, 'Schaefer is the one beer to ha(e
!hen you're ha(ing more than one&'2'
1hat !as my first analysis of an intangible asset !hich, of course, !as !ay o(erstated, increased boo (alue,
and sho!ed higher earnings than !ere !arranted in 1975& .ll this to eep Schaefer's stoc price higher than it
other!ise !ould ha(e been& 5e didn't buy it&6
"hen analy1ing a balance sheet, you should generally ignore the amount assigned to intangible assets! &hese
intangible assets may be worth a huge amount in real life /-oca3-ola's brand name is priceless0, but it is the
income statement, not the balance sheet, that gives investors insight into the value of these intangible items!
#n the accounting sense, 4oodwill can be thought of as a 'premium' for buying a business! "hen one company
buys another, the amount it pays is called the purchase price! (ccountants take the purchase price and subtract
it by a company's book value! &he difference is called 4oodwill!
)or decades, when a company bought another company, it could use one of two accounting methods+ pooling of
interest or purchase! "hen the pooling of interest method is used, the balance sheets of the two businesses are
combined and no goodwill is created! "hen the purchase method is used, the acuiring company will put the
premium they paid for the other company on their balance sheet under the '4oodwill' category! (ccounting
rules reuire the goodwill be amorti1ed over the course of K0 years!
An ()am!le of Balance Sheet Goodill
"hat does that mean? @et's use 2c:onald's and "endy's as an e*ample since most people are familiar with
them!
1c,onald's
6arnings+ D1,CEE,<00,000
%hares 7utstanding+ 1!;C ,illion
/You don't need 2c:onald's other information for this e*ample0
+endy's
,ook Lalue+ D1,0O;,K;K,000
,ook Lalue per %hare+ D10!<KO;
%hares 7utstanding+ 10K!M 2illion
6arnings+ D1MC,MKO,000
%ay 2c:onald's decided to buy all of "endy's stock using the purchase method! "endy's has a book value of
D10!<KO; per share, yet is trading at D<; per share! #f 2c:onald's were to pay the current market price, they
would spend a total of D<,<KE,;00,000 /10K!M million shares * D<M per share0! &o keep this e*ample simple, we
are going to assume the shareholders of "endy's approved the merger for cash! 2c:onald's would mail a
check to the "endy's shareholders, paying them D<; for each share they owned!
%ince the book value of "endy's is only D1,0O;,K;K,000, and 2c:onald's paid D<,<KE,;00,000, 2c:onald's
paid a premium of D;,;MK,EEM,000! &his is going to go onto their balance sheet as 4oodwill! #t is reuired to be
amorti1ed against earnings for up to K0 years! &his means that each year, 1?K0 of the goodwill amount must be
subtracted from 2c:onald's earnings so that by the K0th year, there is no goodwill left on the balance sheet!
Aow that 2c:onald's and "endy's are one company, their earnings will be combined! (ssuming ne*t year's
results were identical, the company would earn D;,1KM,CKO,000, or D1!MM per share1! 8emember that goodwill
must be amorti1ed, meaning 1?K0 the amount must be deducted from ne*t year's earnings! 2c:onald's must
deduct DJM,M1C,K00 from earnings ne*t year as a charge against goodwill;! Aow, 2c:onald's can only report
earnings of D;,0C0,<;O,M00, or D1!M; per share /compared to the D1!MM they would have been able to report
before the goodwill charge0! 4oodwill reduced earnings by KS per share!
#f the pooling of interest method had been used, no goodwill would have been created, and 2c:onald's would
have reported 69% /earnings per share0 of D1!MM! 2eaning that depending on how the accounting was handled,
the e*act same transaction could have two vastly different impacts on earnings per share!
Goodill on the Balance Sheet Recei/es 0e Accounting Rules
#t is no wonder that managements, in order to avoid this reduction in reportable earnings, freuently opted to
use the pooling of interest method when they complete a merger! %ince no goodwill is created, over3eager
managers are able to pay outrageous prices for acuisitions with little or no accountability on the balance sheet!
%ince it makes no sense to have two different ways for accounting for a merger, the )(%, /the folks in charge
of coming up with these accounting rules0 decided they should eliminate the pooling of interest method and
force all transactions to be done via the purchase method! 6*ecutives and politicians claimed this will
significantly reduce the number of mergers since the new standards would cause reportable earnings to drop as
soon as a company had completed an acuisition! (s a concession, the )(%, will no longer reuire goodwill to
be written off unless the assets became impaired /which means it becomes clear that the goodwill isn't worth
what the company paid for it0!
9ay careful attention to the mergers a company has made in the past few years! 7nce you are able to value a
business, you will want to look at recent acuisitions to determine if they were too e*pensive! #f you find this to
be the case, you will probably want to avoid the stock /why would you want to invest in a company that was
throwing your money around?0!
Aotes+ 1!0 %ince 2c:onald's purchased "endy's, the two companies' profits will be combined! D1,CEE,<00,000 F D1MC,MKO,000 G D;,1KM,CKO,000! &o get the earnings per share, you would
simply divide it by the number of shares outstanding /1!;C billion0! "e're assuming 2c:onald's bought "endy's for cash! #f stock had been used, the number of shares would change, but for
simplicity sake, we are going to assume this not to be the case! ;!0 &ake the premium D;,;MK,EEM,000 and divide it by K0 years G this is the charge against earnings each year <!0 -ompanies
purchased before 1CE0 are not reuired to be amorti1ed off the balance sheet! &hey can stay there forever!
7ther assets are non3cash assets which are owed to the company for a period longer than one year! &he most
common of these other assets is an entry called :eferred @ong &erm (sset -harges!
,eferred Long Term Asset *harges
&hese are e*penses which the company has paid for but not yet subtracted from the assets! &hey are very
similar to 9repaid 6*penses /where rent would be counted as an asset until it came due each month, then would
be subtracted from the balance sheet0! #n fact, 9repaid 6*penses are type of deferred charge! &he difference is,
when companies prepay rent or some other e*pense, they have a legal right to collect the service! :eferred
@ong &erm (sset -harges have no legal rights attached to them!
)or e*ample, if a company prepaid rent on a storage building, and then spent D<0,000 moving all of their
euipment into it, they could set the D<0,000 up on the balance sheet as a deferred charge! &his way, they
wouldn't be forced to take a hit by reducing their earnings D<0,000 the same month they paid for the relocation
costs! &hey could then write this amount down over time!
&hese charges are intangible and should be given very little weight when analy1ing a balance sheet!
&he amount of long term debt on a company's balance sheet is crucial! #t refers to money the company owes
that it doesn't e*pect to pay off in the ne*t year! @ong term debt consists of things such as mortgages on
corporate buildings and ? or land, bank loans, and, the biggest item of them all, bonds issued to fi*ed income
investors from whom the corporation raises money in e*change for the promise to return those funds in the
future, while paying interest in the meantime /in the Bnited %tates, the customary practice is for interest to be
paid twice a year, in si*3month intervals, with the principal balance returned on the maturity date, though many
e*ceptions do e*ist so it is important you read the prospectus if you ever consider acuiring a bond investment0!
( great sign of prosperity is when a balance sheet shows the amount of long term debt has been decreasing for
one or more years! "hen debt shrinks and cash increases, the balance sheet is said to be 'improving'! "hen it's
the other way around, it is said to be 'deteriorating'! -ompanies with too much long term debt will find
themselves overwhelmed with interest payments, a risk of having too little working capital, and ultimately,
bankruptcy! &hankfully, there is a financial tool that can help indicate whether or not a business has borrowed
too much money relative to the amount of capital the owners have invested in the firm!
,e't to (&uity Ratio
&he debt to euity ratio measures how much money a company should be able to borrow, safely, over long
periods of time! #t achieves this by comparing the company's total debt /including short term and long term
obligations0 and dividing it by the amount of shareholder euity! /"e haven't covered shareholder euity yet,
but we will later! )or now, you only need to know that the number can be found at the bottom of the balance
sheet! You'll actually calculate the debt to euity ratio in segment two when we look at real balance sheets!
&he result you get after dividing debt by euity is the percentage of the company that is indebted /or
'leveraged'0! &he normal level of debt to euity has changed over time, and depends on both economic factors
and society's general feeling towards credit! 4enerally, any company that has a debt to euity ratio of over K0P
to J0P should be looked at more carefully to make sure there are no liuidity problems! #f you find the
company's working capital, and current ratio ? uick ratios drastically low, this is is a sign of serious financial
weakness!
Long Term ,e't *an Be 4rofita'le for 1any Firms
#f a business can earn a higher rate of return on capital than the interest rate at which it borrows on its long term
debt, it is profitable for the business to borrow money! /(n e*ample+ #f a corporation earned 1JP on its
investments and borrowed funds at OP, it would make EP on the borrowed money H1JP return 3 OP cost of
money G EP net profitI! &his boosts what analysts call '8eturn on 6uity'! "e will talk about 8eturn on
6uity, or 876, in a future lesson! #t is briefly touched on in the 8etained 6arnings section of this lesson!0
&he trick for management is to know how much debt is too much! @everage can be tricky as it $uices returns on
the upside, but can wipe out the owners much faster if things go south in an economic recession or depression!
&hat's never a situation in which you want to find yourself when it's your family's money on the line! 7ne way
the markets keep corporations in check is by assigning lower interest rates to companies that are perceived as
'safer' due to having less debt or more stable cash flows! (s a business begins to borrow more and more, it's
cost of debt would increase to the point the return calculation changes!
(nother ma$or risk that you, the investor, need to guard against is owning a business with a lot of long3term
debt taken out when interest rates are low, but needing to be refinanced within the ne*t J or 10 years! #f the debt
comes up for repayment, and the company doesn't have the funds to repay the balance, it's going to reuire a
new debt issuance! #n the end, this means interest costs increase, which is going to result in lower profits on the
income statement!
@ike the few other 'other' parts of the balance sheet, '7ther @iabilities' is a catch3all category where
companies can consolidate their miscellaneous debt! You can normally find an e*planation of what makes up
these other liabilities somewhere in the financial reports! 7ften times, they consist of things such as inter3
company borrowings /where one of a company's divisions or subsidiaries borrows from another0, accrued
e*penses, sales ta* payable /in the instance of retail stores0, etc!
4enerally, you should take the time to look at the various other liabilities a company has! 2ost are self
e*planatory and are not as important as the other ma$or liabilities already discussed!
"hen you look at a balance sheet, you will see an entry called '2inority #nterest'! &his refers to the euity of
the minority shareholders in a company's subsidiaries! (n e*ample will help clarify! Beginning in 8##9 and
8##:; the FASB is re&uiring com!anies to classify minority interest under Shareholder (&uity and not
Lia'ilities< This is a ma=or change and means that you ill need to loo- further don the 'alance sheet
for all neer re!orts>
#n 1CO<, Aebraska )urniture 2art was the most successful home furnishings store in the Bnited %tates! #t's
gross annual sales e*ceeded DOO!M million, and the company had no debt! (t the time, "arren ,uffett, the -67
of ,erkshire Hathaway, was searching for great businesses to acuire! (fter noticing how successful the
furniture business appeared to be, he approach the owner, 8ose ,lumpkin, and offered to buy the company!
(lmost immediately, 8ose offered to sell C0P of Aebraska )urniture 2art to ,erkshire for DJJ million! &he
ne*t day, ,uffett walked into the store and handed her a check! &his made A)2 a partially3owned subsidiary of
,erkshire! /( subsidiary is a company controlled by another company through ownership of at least a ma$ority
of the voting stock!0 %ince subsidiaries are controlled by their parent companies, accounting rules allow for
them to be carried on the parent company's balance sheet
1
! "hen ,erkshire bought its C0P stake in )urniture
2art, it was able to add the assets of the furniture giant to its own balance sheet!
&his presents a problem! ,erkshire can now add the assets of Aebraska )urniture 2art to its balance sheet, but
technically, it doesn't own them all! 8emember, 8ose ,lumpkin only sold C0P of her company 3 she kept the
other 10P! ,erkshire will somehow have to show that some of the assets on its balance sheet belong to 8ose,
who has a minority interest in A)2! &o do this, it will calculate the value of 8ose's stake in the subsidiary and
put it under a liability account called '2inority #nterest'! &hese are the assets ,erkshire 'owes' 8ose! (gain, in
all reports following ;00O and ;00C, this account will appear in the %hareholder 6uity section of the balance
sheet and not as a liability! &his is e*tremely important! &he theory behind this shift was that the money owed
to 8ose wasn't really a debt of the company, it represents allocation of ownership!
( company may have several minority partners in many subsidiaries! &he minority interest of all of these
partners is added together and placed on the balance sheet!
1!0 ( company can integrate the balance sheet of its subsidiary if it owns O0P or more! #t can report earnings of the subsidiary if it owns ;0P or more!

%hareholder 6uity is the net worth of a company! #t represents the stockholders' claim to a business' assets
after all creditors and debts have been paid! %hareholder euity is also referred to as 7wner's or %tockholders'
6uity! #t can be calculated by taking the total assets and subtracting the total liabilities!
%hareholder euity usually comes from two places! &he first is cash paid in by investors when the company
sold stock. the second is retained earnings, which are the accumulated profits a business has held on to and not
paid out to its shareholders as dividends! ,ecause these are the two ways a company generally creates
shareholders' euity, the balance sheet is organi1ed to show each parts' contribution!
,ook Lalue and %hareholder 6uity are not uite the same thing! &o find a company's book value, you need to
take the shareholders' euity and e*clude all intangible items! &his leaves you with the theoretical value of all
of the company's tangible assets /those which can be touched, seen, and felt0! )or this reason, book value is
sometimes also called 'Aet &angible (ssets'!
0et Tangi'le Assets ?or Boo- 7alue@
&he amount of net tangible assets a company has is particularly important! %ince you should always analy1e the
balance sheet you get directly from the company /as opposed to the ones you find on Yahoo or other financial
sites0, you may not always have this figure calculated for you! &o calculate it, take the total assets and subtract
all of the intangible assets such as goodwill! "hat you are left with is the nuts and bolts of the company. the
buildings, computers, telephones, pencils, and office chairs!
#n the past, it was generally thought the more assets a company had the better! 7ver the past twenty years, value
investors have come to re$ect this idea in its pure form. it is actually preferable to own a business that generates
earnings on a lower asset base!
"hy? @et's say your company earns D10 million a year and has D<0 million in assets! 2y company earns the
same D10 million but has DJ0 million assets! #t is generally understood that a relationship e*ists between the
amount of assets a company has and the profit it generates for the owners! #f you wanted to double the earnings
of your company, you would probably have to invest another D<0 million into the company! (fter the
reinvestment, the business would have DM0 million in assets and earn D;0 million a year!
7n the other hand, if # wanted to double the earnings of my company, # would have to invest another DJ0
million into the business /which would double the assets0! (fter the reinvestment, my business would have
D100 million in assets and generate D;0 million a year!
"hat does that mean?
You would have to retain D<0 million in earnings to double your profits! # would have to retain DJ0 million to
get the same profit5 &hat means that you could have paid out the difference /in this case D;0 million0 as
dividends, reinvested it in the business, paid down debt, or bought back shares5 "e will talk more about this in
the future!
You'll normally see an entry for such things as 'common' or 'preferred' stock on the balance sheet under the
shareholder's euity section of a balance sheet! &his does not refer to the current price of all of the company's
shares! #nstead, these entries reflect the par value of the company's stock, and ? or, when there is no par value
assigned to the stock, the amount investors paid when the company issued shares!
The ,efinition of 4ar 7alue
"hat is par value? 9ar was originally created as a way to protect creditors and shareholders by providing a
'cushion' of assets that could not be damaged or impaired! #n time, it proved to be completely unsuccessful at
protecting either party! &his is important because companies would take the total shares outstanding, multiply
them by the par value, and put them on the balance sheet as 'paid in capital'! (n e*ample+ #f a business had
100,000 shares of stock outstanding and each had a par value of D1, the company would put D100,000 under
'common stock' on the shareholder euity part of the balance sheet!
6ventually, state governments no longer reuired companies to establish a par value on their stock! #n cases
where no par e*ists, a corporation must put the amount raised when the company issued stock! #f the same
business had 100,000 shares and no par, but it initially sold stock at D;J per share, it would put D;,J00,000
under the common stock section of shareholder euity on the balance sheet!
7n most balance sheets, there is a list of such entries! &hey consist of all of the capital that has been paid in by
shareholders who have purchased either the common stock, preferred stock, warrants, etc!
*a!ital Sur!lus
&o understand what -apital %urplus is, you must first understand the concept of %urplus! )rom an accounting
standpoint, surplus is the difference between the total par value of the stock outstanding and the shareholder
euity and 9roprietorship 8eserves! /:on't panic5 #t's not as complicated as it sounds50 You already know what
par value and shareholder euity are! &he only thing you haven't learned about is 9roprietorship 8eserves,
which we will discuss in a minute!
(lmost always part of the surplus is a result of retained earnings /which would increase the shareholder euity0!
&here is a specific part of the surplus that comes from other sources /such as increasing the value of fi*ed assets
carried on the balance sheet, the sale of stock at a premium, or the lowering of the par value on common stock0!
&hese 'other' sources are freuently called '-apital %urplus' and placed on the balance sheet! #n other words,
-apital %urplus tells you how much of the company's shareholder euity is not due to retained earnings!
Reser/es A 4ro!rietorshi! Reser/es
8eserves deserve special attention when analy1ing a company! (lthough we aren't going to discuss them in
depth until a later lesson, it would be wise to lightly touch on them so you have a general understanding of their
purpose! "hen a business creates a '8eserve', they are essentially setting aside a certain amount of money for a
specific purpose! 7ften times, reserves are monies set aside to act as a buffer against future losses! @et's look at
a few e*amples+
#f a company had a substantial amount of their current assets in accounts receivables, they would set
charge off a percentage of the total amount they were owed in case some of the customers didn't pay
their bills! &his is a reserve for doubtful and bad accounts!
#f a business had a build up of inventories that risked losing their value, management would create a
reserve to offset losses!
#f a manufacturing corporation decided to save money to build a new widget plant, they would put
money in a reserve until they had saved enough to pay for it! #n this case, there would be no accounting
entry, $ust a pile of cash growing on the balance sheet!
9roprietorship 8eserves are set up to alert investors that a certain part of the shareholder euity cannot be paid
out as cash dividends since they have another purpose!
"hen analy1ing a balance sheet, you're apt to run across an entry under %hareholder 6uity called '&reasury
%tock'! &his refers to the shares a company has issued and somehow reacuired either through share repurchase
programs or donations!
-ompanies sometimes buy back their shares for a variety of reasons! #n most cases, it is a sign management
believes the stock is undervalued! :epending upon its ob$ectives, a company can either retire the shares it
purchases, or hold them with the intention of reselling them to raise cash when the stock price rises!
"hen a corporation purchases its own stock, the cash on hand is reduced! &his lowers the total shareholder
euity! #n order for investors to know the reduced cash and euity was a result of share repurchases and not
debt or losses, management puts the cost of the reacuired stock under '&reasury %tock' in order to clarify!
&his is why you will often see a negative number besides the treasury stock entry! /You may be wondering why
the current market price of the company's treasury stock isn't listed as an asset since the shares can be sold at
any time to raise cash! &here is a debate about this in the accounting world! &he premise is that all unissued
stock can also be sold for cash yet it isn't listed as an assets 3 treasury stock should be treated the same way!0
2any states limit the amount of treasury stock a corporation can own at any given time since it is way of taking
resources out of the business by the owners ? shareholders, which in turn, may $eopardi1e the legal rights of the
creditors!
Treasury Stoc- 0ot 4ermitted In Some States
%ome states don't allow companies to carry treasury stock on the balance sheet, instead reuiring them to retire
shares!
"hen a company generates a profit, management has one of two choices+ &hey can either pay it out to
shareholders as a cash dividend, or retain the earnings and reinvest them in the business! &hat reinvestment may
be used to fund acuisitions, build new factories, increase inventory levels, establish larger cash reserves,
reduce long3term debt, hire more employees, start a new division, research and develop new products, buy
common stock in other businesses, purchase euipment to increase productivity, or a host of other potential
uses!
"hen the e*ecutives decide that earnings should be retained, they have to account for them on the balance
sheet under shareholder euity! &his allows investors to see how much money has been put into the business
over the years! 7nce you learn to read the income statement, you can use the retained earnings figure to make a
decision on how wisely management is deploying and investing the shareholders' money! #f you notice a
company is plowing all of its earnings back into itself and isn't e*periencing e*ceptionally high growth, you can
be sure that the stock holders would be better served if the board of directors declared a dividend!
Bltimately, the goal for any successful management is to create D1 in market value for every D1 of retained
earnings! (ny business that insisted upon keeping the profit that belonged to you, the owner, without ever
sending funds to you in the form of a dividend or increasing your own wealth through higher capital gains is not
going to have much utility! #nvesting is about putting out money today for more money in the future! Ao
rational personal would continue to hold a stake in a corporation that never permitted any of the rewards to flow
through to the stockholder!
Retained (arnings ()am!les from Real *om!anies
@et's look at an e*ample of retained earnings on the balance sheet+
2icrosoft has retained D1O!C billion in earning over the years! #t has over ;!J times that amount in
stockholder euity /DKE!;C billion0, no debt, and earned over 1;!JEP on its euity last year! 7bviously,
the company is using the shareholder's money very effectively! "ith a market cap of D<1K billion, the
software giant has done an ama1ing $ob!
@ear -orporation is a company that creates automotive interiors and electrical components for everyone
from 4eneral 2otors to ,"2! (s of ;001, the company had retained over D1 billion in earnings and
had a negative tangible asset value of D1!ME billion dollars5 #t had a return on euity of ;!1MP, which is
less than a passbook savings account! &he company is astronomically priced at EC!01 times earnings and
has a market cap of D;!ME billion! #n other words+ %hareholders have reinvested a billion dollars of their
money back into the company and what have they gotten? &hey owe D1!ME billion!
1
&hat is a bad
investment!
&he @ear e*ample deserves a closer look! #t is immediately apparent that shareholders would have been better
off had the company paid out its earnings as dividends! Bnfortunately, the economics of the company are so
bad had the profits been paid out, the business probably would have gone bankrupt! &he earnings are reinvested
at a sub par rate of return! (n investor would earn more on the earnings by putting them in a -: or money
market fund then by reinvesting them into the business!
1!0 You may be wondering how the company has a supposed book value of D;<!EE per share, and yet the shareholders owe a billion and a half dollars! #f you look at @ear's balance sheet, you
will notice it shows shareholder euity of D1!M billion and tangible assets of 31!MMJ billion! &his doesn't look as horrible as it is until you discover D<!;E billion of the assets on the company's
balance sheet consist of goodwill! &he shareholders' euity is being inflated by the goodwill figure 3 without it, the shareholders are left owing money to the company's creditors!

You've learned how to analy1e a balance sheet5 #n %egment ; we are going to work through the balance sheets
of a few (merican companies! Here is a reference guide for all of the calculations you've learned so far! You
should memori1e these as soon as possible. they are priceless investment tools for the rest of your life!
Tests of a *om!any's Financial Strength and Li&uidityB
+or-ing *a!italB -urrent (ssets 3 -urrent @iabilities
+or-ing *a!ital !er ,ollar of SalesB "orking -apital N &otal %ales
1

*urrent RatioB -urrent (ssets N -urrent @iabilities
%uic- 2 Acid Test 2 *urrent RatioB -urrent (ssets minus inventory /called '>uick (ssets0 N -urrent
@iabilities
,e't to (&uity RatioB &otal @iabilities N %hareholders' 6uity
Tests of a *om!any's (fficiencyB
Recei/a'le Turno/erB Aet -redit %ales
1
N (verage Aet 8eceivables for the 9eriod
A/erage Age of Recei/a'lesB Aumbers of days in period N 8eceivable &urnover
In/entory Turno/erB -ost of 4oods %old
1
N (verage #nventory for the 9eriod
0um'er of ,ays for In/entory to TurnB Aumber of days in 9eriod N #nventory &urnover
1!0 &hese can be found on the income statement, not the balance sheet!

+hat the Balance Sheet *an and *annot Tell You
7nce again, congratulations! You now have the tools necessary to analy1e a balance sheet! ,efore you go
running out wielding your new3found power of fundamental analysis, you have to understand the limitations of
the balance sheet! #f # were going to sell you the local grocery store or corner gas station, you would not make
an offer based solely on the balance sheet! #nstead, you would take into consideration the profit the business
generated, the future prospects for the business, the local competition, etc! &hat is precisely what you are doing
when you look at a publicly traded company. you must make a decision $ust as if you were purchasing a private
business! &he balance sheet is $ust one key in making that decision. it is the theoretical value of the enterprise if
you were to purchase it, liuidate the assets, and shut its doors! &he liuidation value is not the true value of a
business 3 what is important is how much cash it can generate for the owners in the future! 7nly in
e*ceptionally rare cases /where a company is trading for less than its working capital, for instance0 could you
make an investment decision based solely on the balance sheet!
7ften times, the information you find on the balance sheet isn't valuable in and of itself. it must be compared
with something else! &here were a few calculations we looked at that reuired the use of the income statement,
which is the focus of @esson K! (s you progress through these lessons, you will find that by using the three
financial statements together, you can garner nearly all of the secrets of any business!
Aow, get ready to put your skills to the test! "e're going to analy1e a few balance sheets together!
&he main purpose of balance sheet analysis is to determine if a company is financially strong and economically
efficient! &he first balance sheet we are going to look at is a perfect e*ample of both! #t can be found in
2icrosoft's ;001 10K statement!
A %uic- 0ote on 1icrosoft's Balance Sheet
,efore we begin analy1ing, notice that unlike most balance sheets, the most recent year is on the right hand side
in bold! # highlighted the column so you would be sure to look at the correct figures!
(n additional point+ when companies put together their balance sheet, they tend to omit the 000's at the end of
long numbers to save space! #f you see on the top of a balance sheet that numbers are stated 'in thousands', add
'000' to find the actual amount /i!e!, D10 stated in thousands would be D10,0000! #f a balance sheet is stated in
millions, you will need to add '000,000' /i!e!, D10 stated in millions would be D10,000,0000!
Keep in mind we are analy1ing the fiscal balance sheet as of =une, ;001! &his information may be different
when you go to search on 2oneycentral, Yahoo5, or &he%treet since they will use the most recent data
available! &he purpose of this analysis is not to advice you on what to buy, but rather to show you the process
of analy1ing a balance sheet!
@et's ,egin (naly1ing5
*ash 4osition
&he first thing you will notice is that 2icrosoft has D<1!M billion in cash and short term investments! &his
doesn't mean much unless you compare it to the company's debt to find out if it is borrowed money! 4lance
down the balance sheet and look for any long3term debt! You'll notice there isn't an entry for it! &his isn't a
mistake. 2icrosoft has no long term debt!
:on't get too e*cited yet! 8emember that some businesses fund day3to3day operations with short3term loans
/think back to our department store e*ecutive at -hristmas in 9art 100! &o see if 2icrosoft is using short term
debt to survive, look at the current liabilities! #n ;001, the entire value of 2icrosoft's current liabilities was
D11,1<;! -ompare that to the D<1!M billion in cash the company has! :oes it have enough money to pay off its
debt? (bsolutely! 2icrosoft's balance sheet has <* the cash necessary to pay off current liabilities and long
term debt! &his is without calculating in receivables and other assets! You can be sure the company is not in any
danger of going bankrupt!
+or-ing *a!ital
@et's calculate the company's working capital! &ake the current assets /D<C,M<E0 and subtract the current
liabilities /D11,1<;0! &he answer is D;O,J0J! 2icrosoft has D;O!J billion in working capital! &o find the working
capital per share, look at the bottom of the balance sheet! You'll see there are J!<O< billion shares outstanding!
&ake the working capital of D;O!J billion and divide it by the J!<O< billion shares outstanding! &he answer,
DJ!;C, is the amount of working capital per3share!
#f you could buy 2icrosoft's stock at DJ!;C per share, you would be getting all of the company's fi*ed assets
/real estate, computers, long term investments, etc!0 plus its earnings ? profit each year from now until eternity
for free5 &he company will probably never trade that low. but you should always keep this in mind when
analy1ing a business! %ometimes, especially during serious economic downturns, you will find companies
selling close to working capital! /Aote+ "e will discuss stock option dilution and other advanced concepts in
later lessons!0
+or-ing *a!ital 4er ,ollar of Sales
"e calculated working capital at D;O!J0J billion! (ccording to 2icrosoft's income statement, total revenue /the
same thing as total sales0 came to D;J!;CM billion! )ollowing the formula for "orking -apital per :ollar of
%ales, we come up with 1!1; /or 11;P0! &his means 2icrosoft has more working capital than its sales last year.
if you remember from the lesson, manufacturers of heavy machinery reuire the most working capital and
range from ;03;JP! &he 11;P figure is e*cessive by anyone's standard! &he main concern should not be
financial safety, but efficiency! "hy isn't 2icrosoft putting this money to work?
*urrent Ratio
&he current ratio should be at least 1!J but probably not over < or K! &aking 2icrosoft's current assets and
dividing them by the current liabilities, we find the software company has a current ratio of <!JM! Bnless the
business is saving resources to launch new products, build new production facilities, pay down debt, or pay a
dividend to shareholders, a current ratio this high usually signals that management is not using cash very
efficiently!
%uic- Ratio
&o calculate the uick ratio, we have to take the uick assets and divide them by current liabilities! #f you've
studied 2icrosoft's current assets, you will notice there is no entry for inventory! You know that 2icrosoft sells
software. meaning its products consist of information #t doesn't need to carry inventory! (s soon as a customer
places an order, the company can load its program onto a -:3872 or :L: and ship it out the same day!
,ecause there is no inventory, there is no risk of spoilage or obsolesce!
#nventory is what causes the biggest difference between the current and uick ratio! &he uick ratio was
designed to measure the immediate resources of a company against its current liabilities! (lmost all of
2icrosoft's resources are already liuid! &he only things that aren't are the D1!CKC billion in deferred income
ta*es /how are you going to use it to raise cash?0 and the D;!K1E billion attributed to 'other' current assets!
%ubtract these from the D<C,M<E billion in current assets and you get D<J!;E1 billion! &his D<J billion in uick
assets represents the things the company can turn in to cash almost immediately! :ivide it by the current
liabilities /D<J!;E1 divided by D11,1<;0 and you get <!1MO! 6ven under the most stringent test of financial
strength, 2icrosoft has D<!1MO in current assets for every D1 in liabilities!
In/entory Turn A A/erage Age of In/entory
"e already discovered that 2icrosoft carries no inventory! #t is absolutely efficient! #ts products are already
sold before they are manufactured!
Recei/a'le Turn and Age of Recei/a'les
You'll notice that on the income statement e*cerpt, credit sales is not listed as a separate item! #nstead, we have
to use the less accurate total sales or revenue figure to calculate receivable turn! &ake the D;J!;CM billion in
revenues and divide it by the average receivables, D<!KM0J billion /D<;J0 F <ME1 divided by ;0! You will end
up with E!<0 turns! &o calculate the number of days this translate into, take <MJ divided by E!<! #n 2icrosoft's
case, the answer is J0 days!Q
,e't to (&uity Ratio
2icrosoft is debt free! #t has no long or short term debt! #f you take D0 /the amount of the company's debt0 and
divide it by the shareholder euity /DKE!;OC billion0 you will get 0! &his means that 0P of the company's euity
consists of debt. the shareholders own it all!
Final Thoughts
(ll of our calculations have shown one thing. the company has virtually no risk of bankruptcy! 2icrosoft has
<* the cash it needs to survive, no long term debt, no inventory to worry about, and e*tremely strong current
and uick ratios! #ts working capital per dollar of sales is 11;P, e*cessive by any standard /especially
compared to its competitors! (dobe %oftware had a ratio of <MP, while 7racle %ystems came in at KM!JP0! &he
main uestion an investor should ask when looking at the balance sheet is, 'why so much cash?'! Aone of the
company's top management has given any clues as to the plans for the growing pile of greenbacks!
QYou should generally calculate turns for the past several years, as well as between uarters! &he numbers will almost always fluctuate during the normal course of business. regardless, a
superior company will tend to have superior ratios over the long term!

Aow that we've looked at an outstanding balance sheet, let's look at one that signals the company may be
running into trouble! %imon &ransportation is a trucking company that speciali1es in temperature3controlled
transportation for ma$or corporations such as (nheuser ,usch, -ampbell's %oup, -oors, Kraft, 2R2 2ars,
Aestle, 9illsbury, and "al32art! #f you look closely, you will start to see problems develop in ;000 that foretell
of future financial difficulties!
%imon &ransportation %ervices filed for -hapter 11 bankruptcy in the early part of ;00;! &he company's
balance sheet showed signs of strain almost two years prior! "e are going to focus most of our attention on the
;000 part of the balance sheet to demonstrate that an intelligent investor could have seen warning signs before
the company went under! Aote+ %ince we are going to be focusing on ;000's numbers, we will not average in
;001's numbers to calculate inventory and receivable turn!
*ash 4osition
%imon had D<,<<1,11C in cash in %eptember of ;000! #t also had D<,K<E,1;0 in short term loans! &his is the first
sign the company was using borrowed money to operate! (lmost all of the company's current assets are tied up
in receivables, which is a real concern that customers may not be paying on time!
+or-ing *a!ital
#n ;000, the company had working capital of D1J,CE0,10K!
+or-ing *a!ital !er ,ollar of Sales
#n ;000, the company had total sales ? revenues of D;<1,<CM,OCK! "ith working capital of D1J,CE0,10K, the
company had a total "orking -apital per :ollar of %ales percentage of M!CP! %imon operates in the trucking
industry, so most of its assets are fi*ed /in the form of diesels, trucks, semis, etc!0
*urrent Ratio
&he current ratio should be at least 1!J but probably not over < or K! %imon had a current ratio of 1!M<1 in ;000!
&his is mediocre! &he uick ratio will be a much better indication of the company's financial health!
%uic- Ratio
&he company's uick assets come out to around 1!KOE!
In/entory Turn A A/erage Age of In/entory
&he company's inventory turn for ;000 only is 1;;!CE /meaning the company clears its inventory around every
< days0! #n most situations, this would mean the company would have smaller working capital needs! However,
if you look at the current assets, you notice they consist almost entirely of accounts receivable! (lthough the
business sells its inventory freuently, it isn't converting those sales into cash immediately! &hus, the receivable
turn is going to be very important to the success of this business!
Recei/a'le Turn and Age of Recei/a'les
-redit %ales are not carried individually! &hus, we will have to use the total sales ? revenues of D;<1,<CM,OCK
with receivables of D<K,;MJ,0EJ in ;000! &he receivable turn comes out to M!EJ times per year, or once every JK
days! %o, although the company is clearing its inventory every < days, it is only getting paid every JK days!
%ince the inventory turns aren't being converted to cash, the business needs more working capital! &he MP of
working capital per dollar of sales we calculated earlier is dangerously low!
,e't to (&uity Ratio
-ombine %imon's short and long term debt, and you'll come up with D1C,O1<,C11! :ivide the DKK,OKK,1<; in
shareholder euity by this amount and you'll see that KK!1OP of the company's euity is made up of debt! &his
would be acceptable if %imon en$oyed high enough return on euity to $ustify such a high borrowing level! (
glance at the company's income statement shows that this is not the case. %imon lost money in ;000! Aot only
is the company not making money, it is losing money altogether! -ommon sense tells you that a business that is
heavily in debt and is losing money probably isn't financially secure!
( uick look into the company's 10k and 10 statements reveals that the short term loans are secured by the
receivables! #n plain 6nglish, if %imon &ransportation fails to pay its short term loans on time, the bank can go
to court and take control of the receivables! #f this were to happen, the business may not have enough cash on
hand to pay its long term debt, which makes up a si1able part of the balance sheet! #f %imon ran into a bump in
the road, it probably wouldn't be able to survive because of cash flow issues!
Final Thoughts
Here's what we've observed+ #n ;000, a full year before declaring bankruptcy, %imon &ransportation had very
little working capital, barely acceptable current and uick ratios, a high percentage of debt to euity, and
inventory that was uickly sold but slowly collected for! &he company may be able to survive as long as it
doesn't run into any problems! (n increase in fuel prices, a driver strike, or some other unfavorable event that
increased losses would uicken the company's financial demise! (n item of particular concern is found in the
company's 10k, '&he -ompany's top J, 10, and ;J customers accounted for ;KP, <CP, and JEP of revenue,
respectively, during fiscal ;000! Ao single customer accounted for more than 10P of revenue during the fiscal
year!'
(ccording to these numbers, each of the top five customers accounted for nearly JP of %imon's business! #f $ust
one of these switched to another trucking company, five percent of the business' revenues would have been lost!
#f the company had profitable with little or no debt, this would not be a concern! "hen you're counting on
things going smoothly and you're playing with money that's not your own, you're almost always headed for
disaster!
&he bottom line+ &his is not a company you would invest in if you were looking for something long term and
considerably safe!
7n :ecember 1K, ;000, %imon issued a press release! #t had run into a bump in the road! Here's an e*cerpt+
'#n addition to the change in accounting method, during the uarter, %imon e*perienced the highest driver
turnover in its history! &urnover e*acerbated recruiting costs and contributed to increased claims and repair
e*pense, and low tractor utili1ation! #n addition, high fuel prices continued to affect the truckload industry,
including %imon!'
&o correct this problem, %imon's management increased driver pay by ;S per mile, an increased cost the
company could hardly afford! 9erhaps most disturbing of all, the company openly acknowledged in its 10k
around the same time that it was in violation of its long term debt agreements!
'&he -ompany's secured line of credit agreement contains various restrictive covenants including a minimum
tangible net worth reuirement and a fi*ed charge coverage covenant! (s of %eptember <0, ;000, the -ompany
was in violation of the minimum tangible net worth reuirement! &he -ompany obtained a waiver of the
violation and as discussed in Aote 10 has amended the covenant subseuent to %eptember <0, ;000!'
#n )ebruary of ;00;, the company filed for -hapter 11 bankruptcy protection! Had an investor been able to
analy1e a balance sheet, they would have been warned in advance of the company's problems and possibly
avoided huge losses to their portfolio!