A Blanket View of Balance Sheets

And while you're reading the footnotes, check out the accounting-policy footnote for any changes in inventory valuation. Most companies use FIFO, first-in-first-out. That means the first item that was manufactured is the first item sold and taken out of inventory. LIFO is another method. Here, it's last-in-first-out, so the item that was most recently produced is accounted for in the sale.

A switch in valuation methods may be a flag. Many times, a switch happens for economic or tax reasons. But it shouldn't occur very often. Be concerned if the company switches back and forth.

Again, depending on the industry, inventory may be a nonissue. A service company will barely have any inventory on hand, whereas a car dealership will have plenty.

Debt

On the liabilities side, excessive debt is clearly a concern.

A big swing in long-term debt means the company has taken on new loans. That should be explained somewhere. So read the debt footnote and make sure you're comfortable with what the company is doing with this newly borrowed money.

And while you're reading that footnote, pay attention to the lease obligations. Some nonsensical, arcane accounting rule says that companies do not have to report many of their lease obligations on the balance sheet, reminds Noll. But anyone who signs a lease on a Manhattan apartment knows that the amount of money that will come due should not be ignored.

Although these lease obligations may not be on the balance sheet, they are detailed in the debt footnote, so read it.

While looking at debt, analyze the company's leverage. Leverage is the amount of liabilities compared to the company's net worth. Basically, if the company had to liquidate today, could it pay all its bills? Divide total long-term liabilities by the total stockholders' equity (total net worth). You're looking for a number of one or lower.

Granted, this is heavy stuff -- and we really only hit the surface -- but you should understand what management is doing with your money.

Now hold on to your seats -- the income statement is coming soon!

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