Understanding the Balance Sheet

Balance sheets 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 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 Sept. 29, 2002. 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 $174.6 million in cash and cash equivalents, up 54% from the previous year (which was up 60% over the year before). A growing pile of cash is generally promising.

You usually want to see little or no debt. Between 2001 and 2002, Starbucks' long-term debt dropped from $5.8 million to $5.1 million. That's good. If debt was 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 $221 million in 2001, it ended 2002 at $263 million, up about 19%. Rising inventories can indicate unsold products languishing on shelves, but since sales rose 24% year-over-year (as is shown on the income statement), the rise in inventory appears 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 2002's cost of goods sold (sometimes abbreviated COGS and appearing on the income statement) of $1.35 billion, and divide it by the average of 2001 and 2002 inventory ($221 million and $263 million averaged is $242 million). This gives us a turnover of 5.6, up from last year's 5.3. The higher, the better -- so this is a good trend.

Accounts receivable are also worth examining. For 2002, they rose 8% over year-earlier levels, keeping pace with sales growth. Cool beans. If receivables were outpacing sales growth, that would be a red flag, requiring a little further investigation.

Finally, look at the "quick ratio," which measures a company's ability to pay a years' worth of obligations. Subtract inventory from current assets and then divide by current liabilities. Starbucks' result is 1.09, which shows that there's enough cash (and assets readily convertible into cash) on hand to cover obligations. Quick ratios above 1.0 are desirable. It's also instructive to look at past years' numbers, to see if there are any patterns. A year earlier, Starbucks' quick ratio was 0.84, which might have warranted keeping an eye on.

Many investors focus only on sales and earnings growth, calculated from the income statement. 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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