How to analyze an earnings report — Part 2: The balance sheet

Published Tue, Oct 4 202210:12 AM EDTUpdated Mon, Oct 10 20221:45 PM EDT

One thing that separates fledgling investors from the pros is reading financial statements. For amateurs, comparing the so-called headline numbers — sales and earnings — to estimates is the full extent of research into a company, whereas in more experienced hands, they are just a starting point. If you want to become a better investor, make like a pro and digest the financials. It's the best way to truly understand a company's performance. In the lead up to the start of earnings season later this month, we've put together a five-part series to help Club members better understand all the tables and charts and how to analyze them. Here's Part 2: the balance sheet. Part 2: Balance sheet If the income statement, which we covered in Part 1 , is akin to a report card, the balance sheet is most like a physical exam: Here we discover just how healthy — or sick — a company is at the end of each quarter. This check-up includes the good (assets and equity) along with potential risk factors (liabilities). It's one of three main sections — the other two are the income sheet and the cash flow statement — included in the earnings reports companies file with the U.S. Securities and Exchange Commission on a quarterly and annual basis. Let's run through what's in most balance sheets and, more importantly, how understanding how to read one can help make you a better investor. First, some basics: All balance sheets are divided into three main parts: assets, liabilities and equity (assets minus liabilities). Additionally, assets and liabilities are segmented into short term (referred to as "current") and long term (referred to as "non-current"): Short term refers to those assets or liabilities intended to be held for a year or less, while long term refers to assets or liabilities with a lifespan greater than a year. As with our discussion on reading an income statement , we'll use Club holding Apple (AAPL) as our example. Here's what we see in Apple's most recent quarterly report. Current assets Cash and cash equivalents : Nothing to unpack here. This first line is cash and other things treated as cash — like short-term Treasurys. Apple puts "highly liquid investments with maturities of three months or less" here, considering bonds of longer maturities as marketable securities. Why you should care : Cash is the ultimate form of liquidity and allows companies to invest in growth and innovation without the need to raise funds by some other means, such as taking on additional debt or issuing additional shares. Marketable securities : These are extremely liquid securities that can quickly be converted to cash if needed. Examples of marketable securities include stocks, longer maturity bonds, derivatives, and other similar investments. But while they may be viewed as similar to cash, they're also more susceptible to market volatility so should be considered a shorter-term investment. Why you should care: Many analysts will include the marketable securities alongside cash and cash equivalents when thinking about how much readily available funds are on the balance sheet. Accounts receivable : This represents sales made on credit. When you buy an iPhone with a credit card, the company doesn't actually receive any cash at the time of purchase. As a result, Apple can't list the proceeds of that sale as cash on the balance sheet. Think of this as an IOU. Eventually, this moves over to the cash line once payment is actually collected. But until then, there is going to be some credit risk. Why you should care: In theory this represents cash to come in the future. That said, it is important to monitor fluctuations here. A rapid increase in receivables indicates that more sales are being made on credit and, if so, an investor must ensure that the company has not reduced the quality of credit it demands to sell goods or services, as this increases the risk that the cash is never actually received and the receivables are written down. Inventories : Apple can't sell you what they don't have. That's why the company keeps an inventory of its products. This line represents the total dollar value of that inventory. Since it isn't broken down by product, we don't have any detail on the mix. While that's normal, you might learn a bit more detail on the earnings call. Why you should care: Comparing inventory levels against history can tell us a bit about management's demand expectations. If management is bullish on demand, they may seek to build up inventory (such as before a holiday selling season). On the other hand, if inventory is trending lower, it may speak to concerns about near-term demand. For all companies — but especially Apple and other names that need to keep innovating with products — managing inventory appropriately is absolutely crucial to financial performance. If there isn't enough product to meet demand, the company misses out on sales. If there's too much inventory, management will be forced to cut prices to clear the shelves and make way for the next product iteration. Vendor non-trade receivables : This is a line item a bit more unique to Apple and a good reminder to Club members: When there is a line item on a financial statement that is unusual, the best thing to do is look for an explanation in the company's 10-K, the annual report all companies must file with the SEC. A quick search of Apple's 10-K informs us that this line item represents components that Apple purchases directly from suppliers and then sells to its manufacturing vendors for assembling into the final products for the company. Why you should care: This line item is a bit more opaque, but similar to inventories can provide some insight into future expectations of demand since it is a gauge of manufacturing activity. Given that this speaks to supplies provided to manufacturers to assemble products, like the inventory line, it may indicate future sales expectations or product ramps. Other current assets : This is a catch-all for anything considered to be an asset that falls outside the other major categories. Why you should care: On its own this isn't the most informative line item. However, it adds to the total current assets value — and as we will see later in our analysis of important financial ratios, the level of total current assets plays into crucial ratios that signal liquidity levels. Non-current assets Marketable securities : These are no different than the marketable securities listed under current assets, except that Apple plans to hold these as investments for more than one year. Once the status of these holdings change — Apple plans to hold for less than a year — the value moves to current assets. Why you should care: When Apple discusses the amount of cash, cash equivalents and marketable securities on the balance sheet during earnings calls, the team usually adds this non-current portion to the value of "cash" on the balance sheet. Property, plant and equipment (PP & E) : This represents the total value of hard assets such as land, buildings, machinery, equipment and internal-use software. Why you should care: In a vacuum, the the value of this line item offers little information. But by analyzing the value against past releases, we can get a sense of how much money Apple spends on hard assets. This is especially important from a cash flow perspective as many companies define free cash flow (a non-GAAP metric) as "operating cash flow less expenditures on property, plant and equipment." So if the company doesn't provide the cost of PP & E explicitly (Apple does not provide a spend amount on PP & E in a given quarter, nor does it provide a free cash flow line since that is not a GAAP metric), we can calculate the difference in value between one period and the next (after adjusting from any depreciation realized during the period) to determine capital expenditures in the period. GAAP stands for generally accepted accounting principles. Other Non-Current Assets : Another catch-all, but adds to total value of non-current assets. Current liabilities Accounts Payable : Whereas receivables represent money owed to Apple, payables represent money Apple owes to others. Why you should care: A company must be able to meet its financial obligations, or risk litigation or, even worse, bankruptcy. Payables represent those obligations that are most front and center. However, unlike commercial paper or term debt (below), which represent debt taken on in exchange for cash, payables represent a liability due to purchases made on credit. Other Current Liabilities : Similar to "other current assets," this is a catch-all for anything considered to be a liability that falls outside the other major categories. Why you should care: While it may not provide much detail on these liabilities, they are earmarked as current and, therefore, represent an obligation that must be met within the next year. Deferred Revenue : This represents money that has been collected for sales, but the product or service hasn't been delivered yet. For example, when a service is sold, the money is collected up front but the product (think music streaming) is delivered over the course of a month. That revenue is only realized as the service is delivered. Consider: Apple collects $15 for 30 days of access to Apple Music; it may index $15 to deferred revenue at the time of collection and then realize $0.50 per day as the service delivered, thereby realizing the full $15 over the 30-day period. Why you should care: This represents the value of sales that Apple can realize over time (the timing is generally available within the company's 10-Q or 10-K). As a result, deferred revenue provides some indication of sales — depending on cancelation policies — that have been locked in. They rely solely on Apple delivering the associated product or service. Importantly, seeing as this is an obligation to deliver goods/services, it is important to keep in mind that it does not require a cash outlay. So if deferred revenue is a high percentage of liabilities, it may determine which financial ratios — such as cash versus liabilities without the deferred revenue included — are best for valuing the company. Commercial Paper : This refers to debt taken on with a payback period of less than one year. Why you should care: This is a line worth taking note of, especially in relation to liquid assets on the balance sheet, as it speaks to an upcoming need for cash — and therefore, the company's liquidity. We'll discuss these relationships between assets and liabilities when we review financial ratios every investor should be familiar with. Term Debt : This refers to debt with a payback period of greater than a year, but when listed under current liabilities represents the portion of longer-term debt that is coming to maturity within the next year. In this way, it is similar to commercial paper; the difference is that when initially issued, this debt has a payback period greater than one year. Why you should care: This can pretty much be grouped in with commercial paper as far as an investor is concerned because, like commercial paper, it represents an upcoming need for cash and further highlights the company's liquidity. Non-current liabilities Term Debt : As noted above, this refers to debt with a payback period of greater than a year. The difference between term debt listed as non-current versus current is that the former still has greater than a year remaining before the maturity date is reached. Why you should care: This provides an indication of what must eventually be paid back to borrowers and, shedding light on the company's future cash requirements. Importantly, this line item does not indicate when the debt must actually be paid back. If the number is high versus the company's liquid assets — indicating that more cash is ultimately needed to pay it back, either via cash flow or additional borrowing and equity offers — further investigation is required. To do this, hop over to the company's 10-K annual report. On the first page of the report you will find all registered securities associated with the company, including the equity shares (and any associated classes) and all debt notes outstanding. A little more digging and you can find a better description of the outstanding debt securities, which will provide an indication of how much money — and when — the company is required to payback. For exact amounts, one must go even deeper and look for the financial statement schedule, where you'll find links to the 8-K "current report" associated with each issue and the exact amounts and terms. Other Non-Current Liabilities : Once again, this is a catch-all for anything considered to be a liability that falls out of the other major categories with an expected holding period longer than one year. Equity Equity is equal to total assets less total liabilities. Here we can find a count of the total shares outstanding, which are used in the calculation of earnings-per-share, which is simply net income divided by shares outstanding. Retained earnings: This represents net income minus money paid out to investors via dividends and stock buybacks. It is important to note that this is a running calculation. We start with the prior period's ending retained earnings value, add net income for the period, and then subtract dividend and share purchases done during the reported period. Why you should care: This isn't the most telling number in terms of how a company is doing in the here and now, but it can provide some insight into a company's history of generating profits and losses. There is also an argument to be made that in the earlier stages of a company, the more importance one should place on this number. For example, when a company decides to go public, we may get a few years of financial data, but it's this line item that gives us a grand total of how much money may have been lost to get to this point, indirectly indicating how efficient management is when it comes to allocating capital. Accumulated other comprehensive income/(loss) : This represents unrealized gains or losses unrelated to daily operations. For example, Apple may utilize currency hedges to protect against swings in foreign exchange rates. The value of those hedges will fluctuate and the unrealized gain or loss will be recorded here. Eventually, when the gain or loss is realized, they will be reclassified into earnings and be reflected on the income statement under other income/(expense). Why you should care: In general, there won't be enough information here for an investor to work off, however, it is worth a look because if the number is out of whack versus historical norms, it may be worth looking for an explanation in the 10-Q or 10-K, which are filings required by the government. Total shareholders' equity : As noted previously, this is simply the result of total assets less total liabilities. Right underneath this we will always see "total liabilities and shareholders' equity," which is simply a double check of the accounting. It should always be equal to total assets. If it isn't, we know something went wrong somewhere in the calculation of either assets or liabilities. (This should never be the case, as management should catch this blatant error before ever publishing their financials.) Bottom line While it may not be the most exciting thing in the world, knowing how to read a balance sheet is one of the most important skills an investor can have. Whereas the income and cash flow statements provide insight into performance over a three-month period, the balance sheet is like something of a "financial physical." It provides insight into both a company's ability to invest in growth and innovation in the future, as well as its ability to weather any potential storms on the horizon. Here's Part 3 in our financial statement series for the Investing Playbook where we will go over Apple's cash flow statement . (Jim Cramer's Charitable Trust is long AAPL. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. 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