A Blanket View of Balance Sheets

These statements can help you give your company a mini-audit. We tell you what to zoom in on.
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Still have your company's 10-Q handy?

Hopefully, you do. (If you don't, go to the

SEC's site and pull it up again because we've got more investigating to do.)

Our last story

introduced the 10-Q and gave you a good idea of how to navigate it. But we're going to delve deeper into each of the three big financial statements -- balance sheet, income and cash flow statements -- and help you perform your ownmini-audit.

So, without further ado, I give you ... the balance sheet.

The balance sheet is a summary of a company's financial condition at a specific point in time.So, at the end of the first quarter, the statement would be calculated as of March 31. If thecompany's year mirrors the calendar year, the annual report's balance sheet would be as ofDec. 31.

The balance sheet shows the company's assets, liabilities and overall net worth. Assets are thethings the company possesses -- like its cash account or investments, any money it's owed and the inventory in its warehouse. A company's liabilities are what it owes to people. So if it bought items on credit, that payable balance is a liability. Same goes for any debt the company took on to buy a building or more equipment.

A company's total assets minus its total liabilities is its net worth, aka owner's equity orshareholders' equity. And that's a pretty important determinant of the value of the company.

So you can learn a lot from a balance sheet. "It gives me a breakdown of what the company is made of. It's a picture in time of the financial state of the company," says Eric Heyman, senior vice president, director of research, for the

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Olstein Financial Alert fund.

There are definitely a couple of "hot spots" on balance sheets that you shouldn't miss, butfirst, a big caveat: Certain line items are much more important in certain industries. For example, the inventory number is very important if you're looking at a homebuilder's stock because you can tell if the company is buying equipment, land to build on, etc. But the accounts-receivable line is more of a biggie for a company that sells a product because you want to know about any additional revenue that might be coming to the company.

To view Tracy Byrnes' video take of this column, click here

So get to know your company's industry by reading analysts' reports and good news stories on your company because you'll start to get a feel for what the pros are looking at in their analysis.

A Quick Cheat

Before we dive into the nitty-gritty, here's a quick cheat that gives you a cursory feel foryour company's overall standing.

Calculate its book value per share, suggests Dan Noll, director of accounting standards at theAmerican Institute of Certified Public Accountants. First, subtract liabilities from assets. Then divide that number by the number of shares outstanding (this can be found in the 10-Q), and you've got the book value per share.

"It's a fundamental age-old measure," says Noll, and it could be an indictor that stock is either overvalued or undervalued.

In very simple terms, if the book value is higher than the stock price, the stock might be undervalued, and you just might have a buying opportunity. If the book value is less than the current stock price, it could mean the market has overvalued the stock, and you should wait for it to settle before you dive in.

But compare this number to your company's peers before you jump the gun.

OK. Now it's time to put on your auditor's hat while we walkthrough some line items to find out if things are fishy.

Accounts Receivable

Go to the accounts receivable (A/R) number in the asset section of the balance sheet. Remember, if a sale is made on credit, a corresponding "receivable" account will be created on the day of that sale. The accounts receivable balance is the total money owed to the company by the customer as a result of a sale.

If the company had a bad quarter and sales were down (you'd have read that in Management'sDiscussion and Analysis), the receivable account should be down, too. If it's not, that could be a red flag. So flip to the footnotes and look for an explanation, suggests Heyman.

Maybe the company extended its payment terms. Or maybe it's not writing off older receivables. Remember, receivables are an asset on the balance sheet, so they're a good thing. That's why companies are very hesitant to write them off (essentially, a write-off is a charge taken to eliminate an asset's value). But if a customer bought an item on credit over six months ago and still hasn't paid for it, it may be time admit that the money just ain't coming.

A big A/R balance can also mean that the company is having problems collecting the money it's owed. That's a management issue, and you have a right to be concerned. Just be sure to compare this number to a company's peers before you panic.

Inventory

The same logic you used to analyze the receivable accounts can be applied to the inventory account. Inventories are the goods that are held for sale in the ordinary course of business, but they also include raw materials, factory supplies and any works in process.

If sales have grown a lot, that would mean the company sold a ton of merchandise. So inventory should be pretty low. But if the number is still relatively high compared to last year, something could be up. The company may be holding on to useless inventory and not writing off obsolete items. Or it could just mean that the company is coming out with a new product and stocking up on raw materials, notes Heyman.

An abnormally high inventory number may mean that the company is accumulating too much inventory before an actual sale is made. Either way, there may be very good reasons for this high balance. Reread the MD&A and check out the inventory footnote for an explanation.

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!

Tracy Byrnes is an award-winning writer specializing in tax and accounting issues. As a freelancer, she has written columns for wsj.com and the New York Post, and her work has appeared in SmartMoney and on MarketWatch. Prior to freelancing, she spent four years as a senior writer for TheStreet.com. Before that, she was an accountant with Ernst & Young. She has a B.A. in English and economics from Lehigh University and an M.B.A. in accounting from Rutgers University. Byrnes appreciates your feedback;

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