Foolish Fundamentals: The Balance Sheet

Balance sheets are a good snapshot of a company's assets and liabilities at a given point in time. But 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 Gap (NYSE: GPS), the youth-focused clothing retailer. To make this a little bit more of a learning exercise, we'll review the results for its fiscal third quarter that ended Oct. 29, 2005, and we'll compare it with the same one 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 period ending in October '05, we see $2.2 billion in cash and cash equivalents (which usually includes short-term investments), down 19% from the previous year (which was up 34% over the year before). A growing pile of cash would generally be promising, while a trend of declining cash could signal trouble.

You usually want to see a manageable amount of debt. Between the third quarters of 2004 and 2005, Gap's long-term debt dropped from $1.9 billion to $513 million (down from $2.6 billion in 2003). That's good. 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 of concern. If the ratio is below 1, it indicates that the company is not generating enough money to satisfy its interest obligations.

Next up is inventory, which we already discussed in a previous Foolish Fundamental.

Accounts receivable are also worth examining. Gap actually does not 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 and then divide by current liabilities. Gap's result is 1, a figure that shows there's enough cash (and assets readily convertible into cash) on hand to cover obligations. It's also instructive to look at past years' numbers, to see whether there have been any patterns. In 2004, Gap's quick ratio was 1.1. It was 0.8 in 2003, which might have warranted keeping an eye on, since a quick ratio above 1 is desirable.

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 see how sturdy the underlying business is.

Learn more about how to make sense of financial statements by trying out our "Crack the Code: Read Financial Statements Like a Pro" how-to guide -- a Foolish online seminar. Or give any of our how-to guides a whirl . more than 90% of those who've taken one have consistently given them high marks -- and besides, we offer a satisfaction guarantee, or you get your money back.

Gap is a recommendation of The Motley Fool's Stock Advisor and Inside Value newsletter services.

Selena Maranjian, Shruti Basavaraj, and Adrian Rush contributed to this article.