How to Read a Balance Sheet

How to Read a Balance Sheet

The first thing that’s important to know is how a balance sheet works. A balance sheet, by definition, must balance out. The formula is assets must equal liabilities plus shareholder equity. In our example, this $24 billion number must equal total liabilities plus total stockholder equity. Also note that I said $24 billion instead of $24 million because although this number says $24 million, I can see that these numbers are all in thousands. This asset section here is broken into two sub-sections; Current assets and long-term assets.

Assets

Current Assets

Current assets and current liabilities for that matter are items that are expected to be converted to cash within the next year. Within the next year is the key point here. If you see current before other assets or liabilities, you’ll know it’s expected over the next 12 months. Long-term, on the other hand, is when it’s greater than 12 months. Now, that could be 13 months away or it could be years and years and years. So on this first line item, there’s cash and cash equivalents. Cash is either cash they have in the bank or perhaps in a money market fund. Anything that can be converted into cash immediately.

The next one; short-term investments. These investments meet two primary criteria; they can be converted into cash quickly and the company plans on converting it into cash within the next year. This goes back to the one year current assets.

Next is net receivables. Receivables are what are owed to the company. So in the case of Nike, if Nike sold a bunch of shoes to a shoe store, and that shoe store has 60 days to pay for it, during that 60 days, that revenue will be classified as a receivable. The reason they call it net receivables is because it needs to account for the possibility that Nike never gets paid. Maybe the shoe store goes out of business or some reason. Using Nike’s $3.6 billion receivables number, maybe that was $3.8 billion but they think $200 million will never be paid.

Moving on to inventory. Once again, this is exactly what it sounds like. This is inventory that Nike holds that are expected to sell in the next 12 months. It’s important to note that inventory in this case is not just a bunch of shoes or clothing or something that Nike is ready to sell, but it could also be all the raw material they have, all of the work in progress shoes or clothing whatever it is. Other current assets refer to current assets that don’t fall neatly into one of these categories. This seems like a large number relative to other categories so I was curious. I went over to the last quarterly filing where I got these numbers from, and I found out that according to their footnotes, they classified prepaid expenses in other current assets. Let’s imagine that you prepay for some service in advance and that would fall into prepaid expenses. Total all of these up and you get total current assets.

Long-term Assets

The next line item is long-term investments; Nike isn’t showing anything here but a good example of what this would be, if the company owned shares or real estate or something like that that the company is holding as an investment and they expect to hold it for more than one year or maybe they expect to hold it forever. Property plant and equipment on the other hand is often called PP&E and these are tangible fixed assets that they are using in business operations versus just an investment. This includes land buildings machines, vehicles things like that. For Nike, this is a $4.1-billion number and its reasonable size relative to the size of their business. You can see it’s gradually moving higher here but it’s not excessively high. If on the other hand PP&E was a huge number, they would call that a capital intensive business. The capital intensive business is when the assets needed to run the business are excessively large compared to labor costs. Airlines would be a good example of that.

Onto Goodwill; Goodwill is generated when a company acquires another company. So let’s imagine that Nike was going to acquire another business. That business has assets, they have liabilities and let’s pretend that Nike is going to pay a billion dollars for the business. The company that Nike is buying has $900 million assets and $100 million in liabilities. So in theory, they should be worth $800 million but Nikes paid a billion; why? Because the business they’re buying has a brand and that’s worth something. Since the brand is very difficult to quantify, accounting rules say that you just look at the purchase price and take away net assets and what’s remaining will be considered Goodwill. Another important point here is Nike’s brand. People sometimes make the mistake of thinking that Goodwill is the value of Nike’s brand and that’s not true. In fact, it’s against the rules for Nike to assign a value to their brand and list it on the balance sheet. That is why when a company gets acquired, it’s almost always for a premium compared to the current stock price. Because although Nike can’t list a value of their brand, if another firm wants to buy them out, they’re going to have to pay for that brand.

The next is intangible assets. Intangible assets are assets that don’t actually exist but still help with revenue. This would include patents or trademarks, copyrights etc. Now, this is similar to Goodwill because Nike cannot generally count the value of their own intangible assets. So if Nike files for patent, the cost of that patent would be expensed and go right to the income statement. But if they were to go out and acquire a trademark as an example, then that could be added to intangible asset. But let’s imagine for a second that this number went down by $10 million every year. It’s likely that it would be a patent or something that expired, and as time passes the company must reduce the value of that asset. They call that amortization; amortization is similar to depreciation except you amortize intangible assets and you depreciate tangible assets. This next line here supports our point. If there was an intangible asset that expired, then we would have amortization building up right here.

Onto other assets. Nike doesn’t appear to have anything here, but the same is true here as it was before. When things don’t neatly fall into one of the categories, they put them in other assets.

The last item in the assets section is deferred long-term assets. These are deferred tax assets and tax benefits. You can look at these as credits for taxes when they can be used at some future year. Now you know won’t be over the next 12 months because otherwise would be a short term asset. Then we have total assets which adds all of these up.

Liabilities

Current Liabilities

Now we are at the liability section. Liabilities are what the company owes. Accounts payable, which is a liabilities version of accounts receivable, is accounts payable of bills that Nike has that they need to pay. So same example before they have a supplier and they have 60 days to pay during that 60 days, this would be an account payable. We also know that they expect to pay within the next year because this number falls under current liabilities. We can see that this number has been fairly consistent for Nike. Imagine this number jumped from $5.5-$10 billion. That would raise a red flag as I would suddenly start to worry about what happened that Nike isn’t paying their bills, what is going on? But in our case, it’s been consistent and seems to be manageable.

Short/current long-term debt still falls into the current liability section so we know it’s due over the next year. They also point out that it’s also tied to long term debt. This means that this $1.239 billion is the portion of long-term debt that is due in the next 12 months; simple enough.

Other Current Liabilities: once again it’s another category so you really got to look up in the footnotes. They have nothing here so I’m not too worried about it. Add all these up and you get total current liabilities. It’s also good to compare total current liabilities to total current assets. Ideally, you want total current assets to be higher. And we could see that Nike has this well covered.

Long-term Liabilities

The first line item that belongs to long-term liabilities is long-term debt. Long-term debt can be bonds that the company has issued or other long term debt that the company has taken up. It looks a bit unusual that the debt hasn’t changed much in each period. So I went over to the annual filings to see what that looked like and we could see the debt has risen each of the past three years, but not terribly so relative to the rest of their balance sheet. I’m not too concerned about it.

Other liabilities: once again, something that doesn’t fit into one of these categories, nothing there so it doesn’t seem to be terribly interesting right now.

Deferred long term liability charges: This is the flip side of deferred long-term liability assets, most likely tied to future tax expenses. Now, its long-term so we know that it’s greater than 12 months away before they can take advantage of it or before they have to pay.

Okay, on to minority interest. Minority interest refers to the portion of the business that in this case Nike doesn’t own. So if Nike bought 80% of a business, 100% of that company’s financials are reported on Nike’s financial statements. That’s why they call them consolidated statements. However, they don’t own 20% of it, and this is where that 20% would fall. It’s a minority interest. If you come across a company with minority interest, I’d recommend you read the footnotes because there are many ways to get to minority interest. Based on how much of the company you own or how much influence you have over the company, and there’s all sorts of rules and nuances around it, so I’d recommend you look at the footnotes for that.

Negative Goodwill: here, negative Goodwill is sort of the other side of Goodwill. If Nike acquires a company for less than the net tangible assets, then you end up with negative Goodwill. This would in theory mean that they’ve bought them for a great deal. Total all of these up and you end up with total liabilities. You can compare total liabilities to total assets and try to compare the health of the company. And it seems that they have a decent balance sheet so far.

Shareholder Equity

Coming down to the home stretch, let’s have a look at shareholder equity. Once we get to equity, if Nike had any warrants or preferred shares, they would list those here as well. But since they don’t, they just list common stock. For common stock, they have 3 million. This is tied to shares issued by the company at par value. So if you ever set up a corporation or have the option to set up what par value is for your company, usually it’s about $0.01. Let’s pretend that Nike’s par value is $0.01. If they issue a thousand new shares, then common stock will rise up by 10 which is 1000 shares times 1 penny. But Nike is currently trading at about $65 a share, so if they issue 1000 new shares, it would actually receive $65,000, which is the 1,000 shares times $65 per share. So for the sake of understanding the balance sheet, cash has risen by $65,000 when they issue the thousand new shares, and we know that $10 went over to the common stocks section. The rest goes here to capital surplus.

Retained earnings: Retained earnings shows the profit of the company that was not paid out as a dividend. Now, this is a cumulative number so in theory it should keep rising as long as the company remains profitable. And it doesn’t pay any dividends that is too much higher than profits. Well, you can see that Nikes fell a bit; why? Well, included in Nike’s retained earnings is any stock buybacks that the company did. And they have done buybacks every quarter, so each quarter it falls; simple enough.

On to Treasury stock. They show nothing here, but Treasury stock comes from when the company buys back stock and saves it in their own Treasury. These shares don’t have any voting rights and they don’t get dividends, but technically they do count as share ownership of the company. So we already covered capital surplus, we’ll just leave that.

Other stockholder equity. Once again, this is that other category. I went to the footnotes to see what this was since it could be a lot of different things if falling in the other category. It looks like they are losses that they have related to currency translations back to the US dollar.

This next item; total stockholder equity. It is the sum of all of these.

And finally, net tangible assets; this is just like it sounds, this is the tangible assets of the firm minus the intangible assets of the firm.

This just about wraps it up. Every company is different and the rules are different for different companies in the United States or using US GAAP or countries outside of the United States that generally follow IFRS or International Financial Reporting Standards. If you’re ever not sure about the number, the footnotes will probably explain it to you. Be careful when you’re researching a company and comparing it to competitors and be sure that they’re both reporting things in a similar fashion. Otherwise, you might have to make adjustments to them.

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