Source: Flickr user lendingmemo.com.
Digging into the balance sheet isn't as exciting as considering new market-moving products or fast-growing services, but the balance sheet can be an investor's best friend because it gives investors important insight into a company's health.
What's a balance sheet?
A balance sheet is broken into three parts: assets, liabilities, and shareholder equity, and therefore, balance sheets tell you how able a company is to pay its debt.
In the assets section of a balance sheet, a company lists both short- and long-term assets. Short-term assets are assets such as cash or inventory that can be tapped in a year or less, while long-term assets are things such as property that are less liquid and harder to access.
The liabilities section of a balance sheet is similarly broken out by short- and long-term liabilities. In the short-term section, items listed include things like accounts payable and any portion of long-term debt that needs to be paid off in the coming year. Long-term liabilities include obligations that are due in more than a year, such as long-term debt that doesn't have to be paid within one year.
Finally, the shareholder equity portion of a balance sheet shows investors how much equity they have in the company, with that equity reflecting things such as net income that's left over after dividends are paid, any stock that's been bought back and is being held in treasury, and how much capital investors have invested in the company.
Best ways for investors to use the balance sheet
Balance sheets provide a static snapshot of a company's financial health at the end of a specific period, and investors can benefit from considering how much cash and cash equivalents a company has at their disposal and whether its cash stockpile is big enough to pay money borrowed back to bankers.
One of the simplest ways to determine whether a company is financially healthy is to calculate the current ratio, which shows investors how likely it is that a company can make good on its short-term financial obligations if debtors come knocking. The ratio is calculated by dividing short-term assets by short-term liabilities. A ratio above 1 is good because it can indicate that a company isn't likely to become insolvent in the coming year. Conversely, a ratio below 1 can indicate that a company could struggle to pay its debts if creditors are unwilling to negotiate or the company's cash flow slips.
For example, cancer-drug maker Celgene Corp. (CELG +0.00%) boasts $10.1 billion in current assets, including $7.5 billion in cash and short-term investments, and $3.14 billion in short-term liabilities, which gives it a current ratio of 3.23. Since Celgene's current ratio is north of 3, there's little short-term risk that it can pay its bills.
Investors may also benefit from calculating a company's debt-to-equity ratio, which shows how leveraged a company is relative to the amount of money that investors have in equity. To calculate the debt-to-equity ratio, simply divide total liabilities by total shareholder equity.
A high ratio can mean that a company is more risky than a company that has a low ratio. A high debt-to-equity ratio can indicate that companies will have to pay more in interest if they want to borrow more money or that lenders may balk at lending money to the company at all. It can also indicate that a company may struggle to pay its obligations if its business slows.
Typically, investors ought to view debt-to-equity ratios north of 100% as concerning, but investors should also recognize that some large companies with robust cash flow purposefully borrow at favorable terms to fuel M&A, buybacks, and other shareholder friendly actions. Additionally, some industries naturally have higher debt-to-equity ratios; particularly capital intensive industries such as utilities.
For example, International Business Systems (IBM +0.00%) has a debt-to-equity ratio of 298% and Coca-Cola (KO +0.00%) has a debt-to-equity ratio of 177%. Those ratios are high, but they don't necessarily mean that IBM and Coca-Cola, which have current ratios of 1.25 and 1.16, respectively, are in trouble.
KO Debt to Equity Ratio (Quarterly) data by YCharts
Therefore, investors need to consider a company's size and its business model before determining if a high debt-to-equity level is worrisome. It can also be helpful to compare debt-to-equity ratios against peers to determine if levels are too high.
Regardless, the current ratio and the debt-to-equity ratio are valuable calculations that offer greater insight into the financial health of a company and whether it should be owned in portfolios.
Trending balance sheet items
Viewing trends in specific items on a balance sheet over time can also help shape an investor's opinion of a company as an investment. Charting cash and long-term debt, for example, can show you if a company is borrowing to finance its debt and if investments in M&A and products or services are paying off.
Let's take a closer look at how trending these measures may influence an investment decision by considering Celgene again. Celgene's total long-term debt is skyrocketing, and its cash and equivalents stockpile has more than quadrupled since 2012. By looking at these two trends together, we can see that the long-term debt growth isn't nearly as worrisome to investors as it would be if Celgene wasn't also stockpiling cash:
CELG Cash and Equivalents (Quarterly) data by YCharts
Alternatively, let's look at how trending these items may prompt concern. Valeant Pharmaceuticals' (VRX +0.35%) M&A-heavy approach to growth has caused its debt to soar without a corresponding increase (yet) in cash. Since Valeant Pharmaceuticals' business is expanding rapidly via acquisition, it's not certain how its spending will translate into cash on its balance sheet in the future, but these trends suggest that investors ought to spend a fair amount of time considering how much value Valeant Pharmaceuticals will be able to reap from its deal-making.
VRX Cash and Equivalents (Quarterly) data by YCharts
Tying it together
Investors shouldn't rely solely on a balance sheet to make their investment decision, but a balance sheet can highlight potential weaknesses in a business that investors need to investigate further. For that reason, balance sheet analysis is an important part of finding winning investments.
