Getting Started: The Balance Sheet

The Balance Sheet: Stockholders' Equity

One of the trickier portions of the balance sheet is the stockholders' equity section. It's affected by the more advanced topics, such as multiple stock classes, share-based employee compensation, equity-based financing, market valued investments and subsidiaries. And while stockholders' equity might be a little more complex, this portion of the balance sheet is worth becoming familiar with over time. After all, it is the spot where the company recognizes your ownership.

Balance Sheet Limitations

Depending on what you're hoping to get out of it, you may find that there can be some limitations to the balance sheet. Because the balance sheet is a financial statement, it's governed by accounting guidelines set forth by GAAP and the Financial Accounting Standards Board . Primarily, it's important to note that the values of most items on the balance sheet aren't recorded at fair value . That's because the accounting industry uses a rule of thumb known as lower of cost or market (LCM).

LCM is a practice whereby the accountant takes an asset's fair value and its cost, and records the asset at the lower of the two values. This is to make sure that the assets recorded by companies aren't over-inflated. For example, revisit that kid's lemonade stand. Let's say that the lemonade is in such demand that the savvy kid started producing it on a large scale. The kid might have a lemonade inventory that cost $100. However, the kid knows that it can be sold at a 500% profit, so the market value of the drink inventory is now $500. However, even though the kid's inventory is worth $500, the balance sheet will only show inventory at the kid's $100 cost.

If a company were to sell all of the assets on its balance sheet, would the resulting cash be equal to the book values of the assets on the balance sheet? No, probably not. Very few items on the balance sheet are reported at their market value.

Keeping the Balance

Financial statements aren't universally looked at by individual investors, but there's no need to feel intimidated by them. Despite a couple of investing shortcomings, the balance sheet is an exceedingly powerful tool for fundamental analysis ("Getting Started: Fundamental Analysis"). While weaving through assets, liabilities and the like can take a couple of attempts (the "practice makes perfect" rule of fundamental analysis applies), your skills can help ensure that you don't invest in a company that has blarney on its balance sheet.

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