How To Read A Balance Sheet Like An Expert

The purpose of the balance sheet is to report the way the resources to run the operations of the business were acquired. The Balance Sheet helps us to assess the risk of the business.

By looking at it, you will be able to answer questions, such as: What is the leverage? Is the company liquid enough?

Remember, leverage is the proportion between equity and debt, while liquidity is the capacity of the business to repay for its short-term obligations, to run the operations.

Why the balance sheet is important

It has been my experience that competency in mathematics, both in numerical manipulations and in understanding its conceptual foundations (accounting), enhances a person’s ability to handle the more ambiguous and qualitative relationships that dominate our day-to-day financial decision- making by Alan Greenspan former FED Governor 

Understanding the balance sheet is critical to be able to dissect any business. We’ll start from the ten commandments of the GAAP accounting system.

A quick introduction to the main GAAP principles

Although the fundamental accounting system hasn’t changed, the principle and rules applying today have been updated in the last century.

The generally accepted accounting principles are the standards and procedures used by organizations to submit their financial statements. Today we have two main accepted frameworks, globally: GAAP and IFRS.

Indeed, after the 1929 market crash, the American government felt the necessity to create a set of rules to discipline and to harmonize the accounting system, and avoid what had happened. In the decade after the 1929 market crash institutions such as the Securities and Exchange Commission were created.

In 1934, the SEC, assisted by the American Institute of Accountants (AIA), started to work on the GAAP. The AIA subsequently instituted an organism to specifically create these principles, The Committee on Accounting Procedure (CAP).

Finally, the first set of GAAP was created, and in 1973 and the CAP board was substituted by the Financial Accounting Standards Board (FASB). From this work came out ten basic principles, that are the foundation of the modern accounting system in the US:

  • Economic entity assumption: If you have a business, even if you are a sole proprietor, the accountant will consider yourself separately from your business.
  • Monetary Unit Assumption: The Business activity you undertake is considered in US Dollars.
  • Time Period Assumption: a Business activity you undertake can be reported in separated time intervals, such as weeks, months, quarters or fiscal years.
  • Cost Principle: If you buy an item in 1980 at $100, it will be reported on your balance sheet as worth $100 today, independently on inflation or appreciation of the asset.
  • Full Disclosure Principle: You have to report all the relevant information of the business in the financial statements or the footnotes.
  • Going Concern: The accountant assumes that your business will continue its operations in the foreseeable future.
  • Matching Principle: If you incur an expense, it should be matched with the revenues, according to the accrual principle. If you decide to pay your employees a bonus related to 2015 but you pay it in 2016, you still will report it as 2015. You will report the expense when it was recognized and not when actual cash disbursed (accrual principle).
  • Revenue Recognition Principle: if you sold a product on January 2015, but you will receive the money from the customer in April 2015, you will report the sale in January since it was the period when the actual sale was realizable.
  • Materiality Principle: when you report the financials, it will be allowed to round them, since if an amount is insignificant can be neglected by your accountant.
  • Conservatism Principle: When in doubt between $80 or $100 loss, your accountant has to choose the most conservative alternative, report $100.

These principles are the “ten commandments” of the accountant. Keep them in mind. They will guide you throughout the book.

Also, the accrual principle in practical terms states: “Revenues and expenses are recognized when occurred, independently from cash disbursement.”

This principle is crucial to building our primary financial statements, in particular, the Income Statement and Balance Sheet.

A quick glance at the main accounts of a financial statement

An account is an item on the financial statements that has certain characteristics. Usually, the accountant groups them in five main types. Each of those types has subtypes.

For now, it is critical to understand each main type to have a better understanding of how financial statements work. The main accounts are:

Assets

Resources owned by an organization. They will produce future benefits for the company. For example, you own a bakery that has to produce biscuits. For you to produce them, you have to buy a machine. The machine will be an asset to your organization.

Liabilities

Obligations (Debt) contracted by an organization. Your bakery bought $100 of raw material from the supplier, and you will pay in 60 days. Until the payment will be made the $100 will show as a liability (future debt) on your balance sheet.

Owner’s Equity

Amount of money or resources you endowed to your organization. The accounting definition is Owner’s Equity = Assets – Liabilities.

Revenue or Income

The $ amount of sales occurred in a certain period. According to the accrual principle, income is recognized independently from cash receipt.

Expenses

The $ amount of costs occurred in a certain period. According to the accrual principle, expenses are recognized independently from cash disbursement. 

While assets, liabilities, and equity will be shown on the balance sheet. Revenue and expenses will be shown on the income statement.

A snapshot of the primary financial statements

“Unless you are willing to put in the effort to learn accounting – how to read and interpret financial statements – you really shouldn’t select stocks yourself” Warren Buffet

The primary financial statements are Balance Sheet, Income Statement and Cash Flow Statement. Each of these statements has a different purpose, and together they give us specific information in regard to: “Return, Risk and Cash.”

First, if you look at the income statement, there is no way you would make any assessment about the risk of the organization in that particular point in time or the cash produced in a certain period. Instead, the Income Statement (or Profit & Loss) will show you the return generated by the business.

Second, if you want to understand how an organization acquired the resources to operate the business, you have to look at the Balance Sheet.

How does the balance sheet assess the risk of an organization? Simple: there are two ways a company can acquire resources, either through Equity or Debt.

As you can imagine, too much debt can be dangerous. What would occur if you run a business, and suddenly your creditors ask for the money you owe them?

You would go bankrupt. Instead, when debt in proportion to the equity is dismal, this makes your organization creditworthy and safer.

Third, it is highly probable seeing an organization which makes profits but out of cash. The cash flow statement helps you to answer questions such as: How much cash did we make?

Where this cash came from? An organization can find cash through three main activities: Operating, Investing and Financing.

What is the income statement?

The primary purpose of the income statement is to show the return of the business in a certain period: Quarterly, Biannually or Yearly. The income statement is built around the bottom line, the “net profit.”

Do not be surprised to notice your eyes unexplainably falling on the net income. Accountants make it as visible as a fluorescent fish ready to mate. This distracts you by other metrics on the Income Statement that are as important as the Net Income.

What is the balance sheet?

The primary purpose of the Balance Sheet is to show the risk of the business in the particular moment you are looking at it. If you look the balance sheet on January 1st, it won’t be the same on January 2nd. Of course, this is true for the P&L and CFS (Cash Flow Statement) as well, but the balance sheet

is an instant snapshot of the business more than a collage of pictures taken in different moments, like the Income Statement.

What is the cash flow statement?

The primary purpose of the CFS is to show the cash generated by an organization in a certain period: Quarterly, Biannually or Yearly. It doesn’t matter how much profits a business is making, one way to know whether the business will survive in the next future is to look at the cash.

Generating cash is not an easy task, and the organizations who can keep their profits stable and make enough cash to sustain their operations and invest for future growth are the ones who thrive.

Sample of a balance sheet

The purpose of the balance sheet is to report the way the resources to run the operations of the business were acquired. The Balance Sheet helps us to assess the risk of the business.

By looking at it, you will be able to answer questions, such as: What is the leverage? Is the company liquid enough?

Remember, leverage means the proportion between equity and debt, while liquidity is the capacity of the business to repay for its short-term obligations, to run the operations.

Imagine you have to open a restaurant. The overhead costs, plus the costs of running the business are $200,000. There are two ways for you to find the money needed to open the business, assuming you don’t have the resources to do it your own.

Either you find a partner that would put personal money, or you ask for a loan. Therefore, Equity and Debt are the two ways to finance your business. This is how a typical balance sheet looks like:

example-of-balance-sheet

Let’s look now at some practical case studies.

Alphabet (Google) Balance Sheet

google-balance-sheet

Source: Google 10K, 2018

It is important to notice that while the balance sheet will keep its structure. It might vary based on the kind of business we’re analyzing.

In Google‘s case, I’m focusing the analysis on a few key items:

  • Cash and cash equivalents and Marketable securities
  • Accounts receivable
  • Inventory
  • Non-marketable securities
  • Property and equipment

Cash equivalents and marketable securities

For instance, for a company like Google, you’ll notice how the top sections with items like cash and cash equivalents and marketable securities are the ones that bring most resources to the company.

These comprise assets that can be easily turned into cash.

As the company explains in its 10K those are primarily composed of “time deposits, money market funds, highly liquid government bonds, corporate debt securities, mortgage-backed and asset-backed securities.”

In short, the company keeps part of its cash reserves as short and longer terms investments where it can earn interest income.

google-interest-income

Some of those marketable securities are also represented by companies in which Googe might be investing from time to time.

These resources are extremely important as they are liquid. Thus, the company can turn to them as a buffer in case of emergencies. But also to keep them as a strategic asset when it is time to make strategic acquisitions.

For instance, the company invests in other bets, which while today don’t contribute much to the overall revenue of the business, they might become important sources of income in the coming decade.

Accounts receivables

In Google‘s case, as the company specifies “accounts receivable are typically unsecured and are derived from revenues earned from customers located around the world.”

More precisely the company’s income recorded but not received yet, it will be reported as accounts receivable. In Google‘s case, as it sells advertising to businesses, we can imagine those sums is money to get from some of those businesses.

Some of the money turned into the accounts receivable might become uncollectible over time, as the customer who owes them might become insolvent. That is why it is critical to check the age of those accounts.

Google, indeed, keeps together reserves in case those accounts won’t be collected anymore.

Inventory

If you’re wondering what kind of inventory a company like Google might hold. A small chunk of Google‘s revenues (as of 2019) come from Hardware. In short, the company sells phones (the Pixel), and other voice devices (Google Home and Google Mini), and other devices.

Thus the inventory is primarily comprised of these devices. And as you’ll see this number is extremely low compared to companies like Amazon which instead focused more over the years in selling physical goods.

Non-marketable investments

While in the marketable securities we see lumped those investments that can be easily liquidated. In the non-marketable investments, we’ll find those investments which can be hardly sold for several reasons.

For instance, those might be long-term bonds or private companies which as they are not yet traded publicly can’t be considered as highly liquid.

And limited partnerships, which once again are not as easy to liquidate (at least from the accounting standpoint) as those that we find under the marketable securities.

That is why we find the non-marketable securities under the long-term assets of the organization.

Property and equipment

One thing you might be surprised about businesses which seem to be primarily digital like Google is the fact that they have billions and billions of dollars in physical assets.

In Google‘s case, you don’t see them under inventories, or other intangible assets. But you do see them under property and equipment. As specified by Google those include:

  • Land and buildings
  • Information technology assets
  • Construction in progress
  • Leasehold improvements
  • Furniture and fixtures

Things like land and building and IT assets are critical resources that make the Google business model sustainable over time. The former to host the human resources that keep the company going. The latter, to enable the company to have enough data centers to host billions of sites of Google‘s index and the billions of queries that each day go through the search engine.

So if you’re surprised to see almost sixty billion dollars under this item, you might ignore the fact that also digital businesses that scaled up require massive resources.

While it is possible to be extremely lean when growing. It becomes hard to keep that kind of organizational structure. Thus culture becomes a key element that holds the company together. As of December 31, 2018, Google reported over 98 thousand full-time employees.

Which seems a huge number. But if compared to Microsoft‘s reported 144 thousand employees, considering the Microsoft made about $110 billion in revenues in 2018 (Google reported over $130 billion in revenues in 2018), you can appreciate how so far the company is leaner.

The interesting part is as the company transition more to its mission to be AI-first it also consumes more computer power, which requires more data centers.

Let’s look now how Amazon balance sheet looks.

Amazon Balance Sheet

I’ve covered the Amazon business model at great length. For the sake of this article, we’ll look though at its balance sheet to make also some comparison with Google‘s balance sheet.

amazon-balance-sheet

Source: Amazon 10K, 2018

In Amazon‘s balance sheet you might notice right away a few differences with Google‘s balance sheet. For instance, Amazon carries less marketable securities, more inventories and more accounts payable.

This can be explained by the fact that Google and Amazon are fundamentally different businesses. I want to highlight that while Amazon and Google have wholly different business models.

If we look at the competitive landscape, we can use several lenses. But if we use a simple heuristic and look at the overlapping of users that use both platforms.

While those two companies have wholly different business models they still might be considered as competitors.

For instance, in the race to dominate voice search Amazon and Google are (fierce) competitors. And while this is not yet showing on the bottom line it might in the coming years.

Thus, it’s hard sometimes to assess the nature of strategy and when doing a financial assessment starting from hard numbers is good. But you need to make sure to look also at things that don’t have yet a tangible return today but they might in five, ten years.

For the sake of understanding Amazon balance sheet and compare it to Google, we’ll focus on:

  • Cash and cash equivalents and Marketable securities
  • Inventories
  • Accounts receivable
  • Accounts payable
  • Property and equipment

I want to show you how the Amazon cash machine works.

Cash equivalents and marketable securities

When it comes to cash and cash equivalents Amazon specifies those are “highly liquid instruments with an original maturity of three months or less as cash equivalents.”

The company also explains to “hold cash equivalents and/or marketable securities in foreign currencies including British Pounds, Euros, and Japanese Yen.”

That might be used as a hedging strategy designed to offset potential loss due to currency fluctuations. But also simply as revenues which are not necessarily turned into US dollars.

Inventories

When we look at platform business models one key element is that they don’t necessarily own assets but control the so-called network effects.

However, when a platform identifies a key strategic asset, owning and controlling it is crucial for its business model.

In Amazon‘s case, when the company transitioned more and more to become a platform (that happened when Amazon third-party sellers made up for more than 50% of Amazon e-commerce revenue).

The company had to make sure its fulfillment centers would be as efficient as possible, thus becoming one of the most important strategic assets for the company.

Indeed, while third-party sellers might stock their inventories or part of it with Amazon. Amazon can still guarantee a fast delivery experience (a key element of Amazon’s customer obsession). And the key to maintaining control over the overall customer experience!

That is why among its business risks Amazon mentions “If We Do Not Successfully Optimize and Operate Our Fulfillment Network and Data Centers, Our Business Could Be Harmed.”

In addition, Amazon highlights how “because of our model we are able to turn our inventory quickly and have a cash-generating operating cycle.”

In short, the company is able to quickly sell its inventory, thus making short term cash which is and has been a bonanza for the company in the past decades.

The inventory management strategy that Amazon uses also enables us to understand how the company generates a lot of cash from its operations.

As Amazon explains “on average, our high inventory velocity means we generally collect from consumers before our payments to suppliers come due.” In other words, Amazon is able to collect money right away from customers, which thanks to Amazon fast delivery pay right away.

In the meanwhile, Amazon collects the cash but (as we’ll see in the accounts payable) the company doesn’t have to pay its suppliers right away. Thus, generating extra short-term cash which can be easily invested in the operations of the business and to fuel growth.

Accounts receivable

Another element of Amazon cash machine is the ability to keep its accounts receivable under control while turning inventory quickly, and having advantageous payout agreements with suppliers and third-party sellers.

Indeed, even though Amazon is a company which sells hundreds of billions of goods and services on its platform. Yet its accounts receivable are lower than Google.

That might also be due to how the company reports them. But as Amazon clarifies in its financial statements “because consumers primarily use credit cards to buy from us, our receivables from consumers settle quickly.”

Accounts payables

Just to close the puzzle of Amazon cash machine, its accounts payable are kept relatively higher to its inventories and receivables as they enable the company to stretch short term cash resources for the liquidity of the business.

The difference between Accounts receivable, inventories and accounts payable make up the so-called working capital, which again is the set of short-term liquidity of the organization.

Indeed, paradoxically when a company lacks short term liquidity (not enough cash or assets easily convertible in cash) it might go bankruptcy nonetheless the business might be solid in the long-run (long-term assets are higher than long-term liabilities).

Case study: Imagine the case of a company which owns a beautiful building which is worth millions. But it can’t sell right away. And creditors call up the company to return a couple of hundred thousand dollars in a month. While the company seems viable in the long-run. The complete lack of short-term available resources might jeopardize the overall organization! 

Property and equipment

As the company highlights “property includes buildings and land that we own, along with property we have acquired under build-to-suit, finance, and capital lease arrangements. Equipment includes assets such as servers and networking equipment, heavy equipment, and other fulfillment equipment.”

amazon-property-and-equipment

Key takeaways

The balance sheet is a very important financial statement as it enables us to understand the assets that the company built over time.

It also enables to see the short and long-term liabilities the company owes.

At the same time from a balance sheet, we can appreciate the differences among several businesses and also understand some of the key elements of their business models.

That is why looking at the balance sheet should be an exercise to practice to dissect and understand any business.

Case studies:

Other business resources:

Published by

Gennaro Cuofano

Gennaro is the creator of FourWeekMBA which he brought to reach about a million business students, professionals, and entrepreneurs in 2019 alone | Gennaro is also Head of Business Development for a high-tech startup, which he helped grow at double-digit rate and become profitable | Gennaro is an International MBA with emphasis on Corporate Finance | Subscribe to the FourWeekMBA Newsletter | Or Get in touch with Gennaro here

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