Foolish Fundamentals: The Balance Sheet

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Balance sheets are a good snapshot of a company's assets and liabilities at a given point in time. They can be intimidating -- until you take a little time to understand how they're set up, and what they can tell you.

Let's examine clothing retailer Gap (NYSE: GPS). To make this a bit more of a learning exercise, we'll review the results for its fiscal second quarter, which ended Aug. 4. We'll compare that quarter with its counterpart from the previous year -- a useful exercise, since companies receive payment from creditors and pay their vendors at around the same time each year.

Glancing at the balance sheet for the 2007 quarter, we see $2.7 billion in cash and cash equivalents (which usually includes short-term investments), down 1.1% from the previous year. A growing pile of cash would generally be promising, while a trend of declining cash could signal trouble.

You generally want to see a manageable amount of debt. Between the second quarters of 2006 and 2007, Gap's long-term debt has dropped considerably, from $513 million to $188 million -- a good sign. It's also substantially down from the nearly $1.9 billion in long-term debt the company had at the end of January 2005. And we can always peek at the footnotes in the financial statements to check out the interest rates and the company's interest coverage ratio (earnings before interest and taxes divided by interest expense). A higher ratio would indicate that the company is financing operations effectively, in which case the absolute debt level is not a concern. If the ratio is less than 1, it indicates that the company is not generating enough money to satisfy its interest obligations.

Next up is inventory.

Accounts receivable are also worth examining. Gap doesn't actually have accounts receivable, but if it did, you'd want to see them keeping pace with sales growth. If receivables were outpacing sales growth, that would be a red flag, requiring a little further investigation.

Finally, look at the "quick ratio." Subtract inventory from current assets, then divide by current liabilities. Gap's result is 1.35, a figure that shows there's enough cash (and assets readily convertible into cash) on hand to cover obligations.

Many investors focus only on sales and earnings growth, calculated from the income statement. While that's an important metric, long-term investors should also study the balance sheet to gauge the sturdiness of the underlying business.