Once you have chosen a stock you think you might like to purchase, the next step is to thoroughly analyze the financial position of the business – a process referred to as fundamental analysis. There are three documents analyzed in conducting a fundamental analysis of a stock that represents the business: the Income Statement (Step One), the Balance Sheet (Step Two),and the Cash Flow Statement (Step Three). Here we discuss the analysis of the Balance Sheet.
Recommended Reading
Jordan Belfort, “The Wolf of Investing: My Insider’s Playbook for Making a Fortune on Wall Street”, (2023).
The purpose of the balance sheet is to provide a financial snapshot of the business at a particular point in time. There are several reasons to analyze a balance sheet– to determine the ability of the business to pay its liabilities, whether the business has too much debt, and whether the business can afford to pay dividends.
The balance sheet first lists all the assets of the business and then lists all of the liabilities. In this fashion, the balance sheet makes it possible to simply do a quick subtraction of the liabilities from the assets to see if the business can pay their obligations. If liabilities exceed assets, the company is on an unstable footing in that the business has already exceeded its ability to pay its liabilities. This would indicate that the investor should move on to another stock.
The balance sheet also allows the investor to determine whether the business has too much debt. The balance sheet lists both the amount of debt (short and long term) and the amount of equity, which is the amount of money the owners and the stockholders have put into the business, (plus retained earnings). This allows an investor to identify a debt to equity ratio, allowing an investor to make a reasonable estimate as to whether the business has too much debt to safely take on more debt and cause of collapse of financial stability. The debt/equity ratio should be roughly in the range of 2:1, meaning that a company should have no more than twice the amount of debt as equity in the business. As stated more fully by Investopedia, this means that no more than two thirds of the business should get financial support from borrowing, while at least one third is coming should be coming from equity in the company.
Finally, the balance sheet lists how much cash the business has at a specific time. This is especially valuable information because it is very difficult to manipulate the amount of cash on hand. This figure is thus an accurate guage of whether the business could handle an immediate emergency.
If an analysis of the balance sheet shows that assets generously exceed liabilities, has a debt/equity ratio roughly in the range of 2:1, and has sufficient cash to handle an emergency, then the investor can feel confident that the stock they have chosen to analyze represents a business that is worth further research for purchase.
Recommended Reading
Jordan Belfort, “The Wolf of Investing: My Insider’s Playbook for Making a Fortune on Wall Street”, (2023).
