Understanding Financial Statements Part 1: Balance Sheet (Balance Sheet)

About the article series “Understanding Financial Statements”

Understanding or analyzing financial statements (BCTC) is a very important part in stock selection and making buy/sell decisions. Understanding BCTC is the first step in fundamental analysis to determine the intrinsic value of a business / stock. Through this, investors can evaluate the financial situation, current business performance, as well as the future prospects of the business.

However, understanding and analyzing BCTC is not easy for new investors or those without a background in finance and accounting. Understanding this, Việt Hustler brings to readers a series of articles about “Understanding Financial Statements”, helping readers approach and understand BCTC from the simplest steps.

Financial statements are divided into 3 separate parts:

1. Balance Sheet (Balance Sheet): shows the company's financial position at a specific point in time → how many assets the company has and how much it owes.

2. Income Statement (Income Statement): shows the company's revenue and expenses over a specific period of time.

3. Statement of Cash Flows (Statement of Cash flow): tracks cash inflows and outflows of the business.

   … but these 3 types of reports are closely related to each other.

In this week's article, Việt Hustler will describe in detail the Balance Sheet and apply practical analysis with the example of Apple.

Introduction to the Balance Sheet (Balance Sheet)

One of the first things Warren Buffet does when trying to determine if a company has a sustainable competitive advantage is to see how many assets - in cash and land - the company has and how much money it owes to suppliers, banks, and bondholders. To do this, he looks at the company's balance sheet.

The Balance Sheet shows the scale and structure of assets of the business at a specific point in time (usually at the end of the quarter and year).

• This is different from the income statement or cash flow statement: these 2 types show the financial situation of the business over a period, e.g. from the beginning to the end of a quarter or fiscal year.

The structure of the Balance Sheet consists of 2 balancing parts: Assets and Sources of capital (from debt or owners' equity).

• The balance equation of the balance sheet:

We can understand simply:

• Assets: Anything the company owns

• Liabilities: Any debts the company has not yet paid

• Equity: The value of the company after all debts are paid off (the remainder after subtracting liabilities from assets)

Apple's Balance Sheet shows:

• Total assets = 352.8 billion USD

• Total liabilities = 302.1 billion USD + Equity = 50.7 billion USD

→ Total assets = Liabilities + Equity. The Balance Sheet is balanced!

Structure of a standard balance sheet

1. Assets (Asset)

Assets are things owned by the business that can generate economic benefits for the business.

• Assets can be tangible or intangible,

• … divided into 2 types in the balance sheet: Current Assets and Long-term Assets.

(1) Current Assets: assets that can be easily converted into cash within less than 1 year or 1 operating cycle, including:

• Cash and cash equivalents: cash + bank deposits.

  • is the type of asset with the highest liquidity.

• Accounts Receivable: The amount that customers have not yet paid to the business.

• Inventory: The value of the business's stored goods.

  • For example, raw materials, work-in-progress, finished goods,…

• Prepaid Expenses: Expenses that the company has paid in advance to suppliers for future periods

  • For example: rent (usually paid annually), insurance,…

From Apple's balance sheet, we can see:

• Inventory is always very low and only accounts for 3-5% of current assets.

• This is explained because Apple applies the inventory management model "Just In Time" (JIT).

FYI: Apple's JIT model differs from the traditional model of producing first and then finding consumers. Instead, JIT requires purchasing just enough raw materials according to consumer demand, then ensuring smooth logistics, and delivering to customers only after producing the goods. => Thereby, minimizing inventory in stock.

(2) Long-term Assets: are assets that will have a useful life (or be held on the balance sheet) for more than 1 year.

• Fixed Assets: Assets used in the company's operations for a long period, such as property, plant, and equipment.

  • —> depreciated over time (depreciation expense is shown in the income statement).

• Long-term Investments: investments that the company intends to hold for a long time, such as stocks and bonds (less liquid than cash).

• Intangible Assets: Non-physical assets, (For example: patents, trademarks, or goodwill).

  • They are also amortized over time.

2. Liabilities (Liability)

Liabilities and Owners' Equity will be in the sources of capital, reflecting the sources of the business's assets.

Liabilities represent the financial obligations of the business to external parties such as: creditors, government, suppliers, employees…

Similar to assets, Liabilities are also divided into 2 types: Current Liabilities and Long-term debt.

• Current Liabilities: debts and financial obligations that must be paid within 1 year.

  • Accounts Payable : Money owed to suppliers for goods or services received but not yet paid.

  • Accrued expenses : Expenses that have been incurred but not yet paid, such as salaries and taxes.

  • Current liabilities (Account payable) : Loans and debts generally due for payment within the next year.

• Long-term debt :

  • Long-term debt (Term debt) : Loans and debts due after 1 year.

  • Unearned revenue (Unrealized turnover) : Money customers pay in advance for goods and services that the company has not yet provided

  • Pension fund liability (pension fund liability) : The amount that the company is required to pay into employees' pension accounts.

  • Other long-term liabilities (Other non-current liabilities) : Tax obligations and other obligations that the company expects to pay in the future.

• Most of Apple's current liabilities are accounts payable to suppliers. With such high accounts payable, Apple has strong trade credit → Apple must be an important customer to suppliers to have such strong trade credit

• Apple's liabilities are mainly long-term debt.

3. Equity (Equity)

Equity represents the portion of the company's assets owned by shareholders. It is the remainder after subtracting all liabilities.

Equity is composed of many sources:

• Share capital : Direct investment capital, capital from issuing shares

• Retained earnings : Profits that the company retains (not distributing dividends to shareholders).

Financial ratios from the Balance Sheet

Important financial ratios used to analyze the company's balance sheet and understand the overall financial situation include:

• Working capital (Working capital) : measures short-term liquidity and financial health of the business

• Current ratio (Current ratio) : measures the company's liquidity by comparing current assets to current liabilities.

• Quick ratio (Quick ratio) : measures the company's liquidity by considering only the most liquid current assets.

  • A threshold around 1 is considered healthy, the higher the better.

• Debt-to-Equity ratio (Debt-to-Equity ratio) : measures the company's solvency by comparing total liabilities to total equity.

  • A ratio below 1 indicates the company has less leverage and greater debt repayment ability.

• Total asset turnover : measures the efficiency of the company's asset utilization.

  • A high ratio shows the company uses its assets efficiently to generate revenue.

  • However, the comparison benchmark also depends on the industry. For example, retail companies have higher asset turnover ratios than utility companies.

• Interest coverage ratio : calculated by dividing earnings before interest and taxes (EBIT) by interest expense.

  • A high ratio indicates that a company generates enough income to cover interest expenses and has low default risk.

Ways to analyze data

From the data calculated above, investors can apply the following analysis methods:

• Trend analysis: How have the indicators changed over time?

  • Look for changes in recent years and the reasons behind them.

• Comparative analysis: Compare with peer companies in the same industry and industry averages.

  • Each industry will have different characteristics, leading to indicators that also fluctuate according to the nature of that industry.

• Proportional analysis: Express the items in the balance sheet as percentages of total assets, comparing between different companies.

  • This approach can identify which type of asset occupies the largest proportion in the company's asset structure, and how it differs from industry peers

Applying the analysis of Apple's ratios

Looking at Apple's 2022 balance sheet:

• Quick ratio 0.7 (weak and trending downward).

• Current ratio is 0.879 (average and also trending downward).

• Debt-to-equity ratio is 2.4 (high and strongly trending upward) —> details below.

  • Facts: Apple ($AAPL) has repurchased $604 billion in stock over the past 10 years, significantly reducing AAPL shares available in the free market.

    • This figure is larger than the market cap of 492 companies in the S&P 500.

    

Looking at the factors affecting these ratios by observing long-term debt, cash and cash equivalents, as well as shareholders' equity over the past decade:

• Apple's debt-to-equity ratio has continuously increased over the past decade because:

  • The company borrowed more debt from 2014 to 2018 when interest rates were favorable, for the purpose of share buybacks, increasing dividends, and reinvesting in the company. However, this is not the main reason; long-term debt has been relatively stable over the past 5 years.

  • The main reason is that Apple's shareholders' equity has significantly decreased as the company continuously buys back shares (chart above).

CONCLUSION

In summary, balance sheet analysis is very important to understand the company's financial situation. It provides valuable insights into liquidity, solvency, and the company's asset types.

However, balance sheet analysis is only one aspect of conducting a comprehensive financial analysis of a company. Investors should also use other analysis tools, such as income statement, cash flow statement, and financial ratio analysis. These are also the next contents in the series ““Reading and Understanding Financial Statements” in the coming weeks from Viet Hustler.