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
Glancing at the balance sheet, we see $299 million in cash and cash equivalents, up 49% from the previous year (which was up 102% over the year before). A growing pile of cash is generally promising.
You usually want to see little or no debt. Between 2003 and 2004, Starbucks' long-term debt dropped from $4.4 million to $3.6 million (down from $5.8 million in 2001). 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 $343 million in 2003, it ended 2004 at $423 million, up about 23%. Rising inventories can indicate unsold products languishing on shelves, but since sales rose 30% 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 2004's cost of goods sold (sometimes abbreviated COGS and appearing on the income statement) of $2.2 billion, and divide it by the average of 2003 and 2004 inventory ($343 million and $423 million averaged is $383 million). This gives us a turnover of 5.7, up from 2002's 5.6 and 2001's 5.3. The higher the better, so this is a good trend.
Accounts receivable are also worth examining. For 2004, they rose 14.5% 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." Subtract inventory from current assets and then divide by current liabilities. Starbucks' result is 1.21, 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. In 2002, Starbucks' quick ratio was 1.09. It was 0.84 in 2001, 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.
Learn more about how to make sense of financial statements in our "Crack the Code: Read Financial Statements Like a Pro" how-to guide (also known as an online seminar). Give any of our how-to guides a whirl. More than 90% of those who've taken them have consistently given them high marks -- and besides, we offer a satisfaction guarantee, or your money back.