Introduction: How to Read a Balance Sheet

"Cash Is King?" Sure, you have heard the cliche. You will be talking to another investor about the latest addition to your portfolio and the conversation will turn to how each of you picks stocks. The other investor will smile at you and wink, cryptically saying, "Cash is king." Although somewhat perplexed, you don't dare ask for clarification for fear of looking like a fool. But what the heck does that really mean?

Publicly traded companies are designed to make money. The conventional way of scoring this pursuit is by looking at the company's ability to grow various flavors of earnings -- operating earnings, pretax earnings, net income and earnings per share are all common measures. However, this is not the only way to determine if there is real value in a company's stock. A company's real earnings are the earnings that make it from the Consolidated Statement of Earnings to the Balance Sheet as a liquid asset.

Shareholder value ultimately derives from liquid assets, the assets that can easily be converted into cash. A company's value is determined by how much in the way of liquid assets it can amass. There are two ways to think about this. The first is to look at terminal value, which assumes for the sake of calculating potential return that at some future point a company will close down its operations and turn everything into cash, giving the money to shareholders. The second is to look at where tangible shareholder value comes from -- returns on invested capital generated by the company's operations. If a company has excess liquid assets that it does not need, it can deploy those assets in two ways to benefit shareholders -- dividends and stock buybacks.

Knowing what is on the balance sheet is crucial to understanding whether or not the company you are investing in is capable of generating real value for shareholders. Most investors who look at annual reports, 10-Ks and 10-Qs spend far too much time worrying about earnings and far too little time worrying about the balance sheet and its cousin, the Statement of Cash Flows. It is the balance sheet that can tell you if a company has enough money to continue to fund its own growth or whether it is going to have to take on debt, issue debt, or issue more stock in order to keep on keeping on. Does a company have too much inventory? Is a company collecting money from its customers in a reasonable amount of time? It is the balance sheet -- the listing of all of the assets and liabilities of a company -- that can tell you all of this.

Where do you find all this information about the balance sheet? Would you believe that you can get it for free? The documents that the Securities and Exchange Commission (SEC) makes available to you online at the Edgar website give you all sorts of balance sheet information in the 10-Ks and 10-Qs. The 10-K is a toned-down version of the annual report with more text and fewer pretty pictures that comes out once a year, containing the company's annual balance sheet. The 10-Q is a quarterly filing that a company makes with the SEC three times a year (with the fourth filing being the 10-K in the fourth quarter) that also tracks the balance sheet through the course of the year. The advantage of the annual balance sheet over the quarterlies is that the annual balance sheet has been double-checked by accountants before it was filed with the SEC.

Armed with this information, you are ready to begin your journey through the balance sheet.