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Decoding a Balance Sheet
It's not as complex as you might think

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By Selena Maranjian (TMF Selena)
May 21, 2002

Q. How should I begin to evaluate information on a balance sheet? Can you take me through an example?

A. Let's examine the increasingly ubiquitous coffee purveyor Starbucks (Nasdaq: SBUX). To make this a little bit more of a learning exercise, we'll review the results for its fiscal year that ended on September 30, 2001. Then you can dig up the company's most recent balance sheet and see whether the company has improved.

Glancing at the balance sheet, we see $113.2 million in cash and cash equivalents, up 60% from the previous year. A growing pile of cash is generally promising.

You usually want to see little or no debt. Between 2000 and 2001, Starbucks' long-term debt dropped from $6.5 million to $5.8 million. That's good. If debt were substantial, we might peek at the footnotes to check out the interest rates. Low rates would indicate that the firm is financing operations effectively.

Next up: inventory. Valued at $202 million in 2000, it ended 2001 at $221 million, up about 9%. Rising inventories can indicate unsold products languishing on shelves, but since sales rose 22% year-over-year (as is shown on the income statement), the rise in inventory appears well under control. (Ideally, inventory growth should not outpace sales growth.)

It's also good to measure inventory turnover, which reflects how many times per year the firm sells out its inventory. Take 2001's cost of goods sold (sometimes abbreviated COGS and appearing on the income statement) of $1.1 billion, and divide it by the average of 2000 and 2001 inventory ($202 million and $221 million averaged is $211.5 million). This gives us a turnover of 5.3, up a smidgen from last year's 5. The higher, the better.

Accounts receivable are also worth examining. This line item represents money owed to a company by customers who have purchased goods and/or services on credit. For 2001, accounts receivable at Starbucks rose 18% over year-ago levels, keeping pace with sales growth. Cool beans. If receivables were outpacing sales growth, that would be a red flag, requiring further investigation.

Finally, look at the "quick ratio." Subtract inventory from current assets and then divide by current liabilities. Starbucks' result is 0.84, below 1.0. That means there isn't quite enough cash (and assets readily convertible to cash) on hand to cover bills. This could be worth keeping an eye on. It's also instructive to look at past years' numbers, to see if there are any patterns. Quick ratios above 1.0 are desirable.

Many investors focus only on sales and earnings growth. While that's important, long-term investors should also study the balance sheet, to see how sturdy the underlying business is.

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This question and answer is adapted from The Motley Fool Money Guide: Answers to Your Questions About Saving, Spending and Investing. For answers to this and 499 other common money questions, check it out -- it's a handy resource.