If you want to understand a company's financial health, it's important to be able to make sense of its balance sheet. Let's go through an example to get your feet wet.
Consider the ubiquitous coffee purveyor Starbucks
Glancing at the balance sheet, we see $113.2 million in cash and cash equivalents, up 60% from the previous year. A growing pile of cash is generally promising.
You usually want to see little or no debt. Between 2000 and 2001, Starbucks' long-term debt dropped from $6.5 million to $5.8 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 $202 million in 2000, it ended 2001 at $221 million, up about 9%. Rising inventories can indicate unsold products languishing on shelves, but since sales rose 22% year over year (as is shown on the income statement), the rise in inventory appears well 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 2001's cost of goods sold (sometimes abbreviated COGS and appearing on the income statement) of $1.1 billion, and divide it by the average of 2000 and 2001 inventory ($202 million and $221 million averaged is $211.5 million). This gives us a turnover of 5.3, up a smidgen from last year's 5. The higher the better.
Accounts receivable are also worth examining. For 2001, they rose 18% over year-ago 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 0.84, below 1. That means there isn't quite enough cash (and assets readily convertible to cash) on hand to cover the bills. This could be worth keeping an eye on. It's also instructive to look at past years' numbers to see whether there are any patterns. Quick ratios above 1 are desirable.
Many investors focus only on sales and earnings growth. While that's important, long-term investors should also study the balance sheet to see how sturdy the underlying business is.