The balance sheet shows investors the value of a company's assets, liabilities (debt) and owners' equity. It is called a balance sheet because total assets will always equal or balance with liabilities plus owners' equity. The balance sheet helps investors understand how well the company is using its assets and how it is financing operations. Some of the most important fundamental metrics investors use to gauge the overall health of an organization, such as Return on Equity and liquidity ratios, are built using the data from the balance sheet. Understanding how this report works can help investors because it makes it easier to compare one company to another within the same industry.

The Balance Sheet: Understanding its Parts

1. Current and long-term assets. A current asset is usually defined as cash or anything that will be turned into cash within a year. (Accounts receivable is a non-cash example of a current asset.)

Sometimes the current assets portion of the balance sheet can tell us important things about how management feels about the economy and their business confidence. For example, in the third quarter of 2010, the stocks in the S&P 500 reported cash balances of over $1 trillion, an all time record, which indicates that management teams are still very concerned about the future prospects of the economy and are saving their cash to prepare for contingencies.

Long-term assets include property, plants and equipment, and some kinds of investments. The assets portion of the balance sheet is affected by changes to the cash flow statement as money is invested in long-term assets or as customers run up receivables with the firm. Many analysts would consider a shift of assets from the short-term category to the long-term category as a good sign that businesses are investing in long-term assets that will help the company grow.

2. Liabilities. Liabilities, or debt, are those obligations that the firm owes to other parties, employees or to the government. Like the assets portion of the balance sheet, there are both short-term (current) and long-term liabilities included in this section.

Short-term liabilities include anything that must be paid within a year, such as accounts payable or short-term notes. Comparing the ratio between short-term liabilities and short-term assets (cash) is called the current ratio and is a measure of the firm's ability to pay its bills.

Long-term liabilities include debts that will be paid over a term longer than a year. Financing that was used to acquire property, plants and equipment may fall into this category. (Note that the principle portion of debt payments in the long-term and short-term liabilities category are actually shown on the statement of cash flows, which we will be discussing in a later article.)

The liabilities section of the balance sheet shows investors how management is using debt to finance the firm's operations. It might be natural to assume that lower debt is better for a firm. However, having too little debt can actually be a bad thing. If a firm can manage debt that costs them less than they can make by having access to that capital, then using too little debt shows that the management team is not optimizing the firm's capitalization potential.

The right amount of debt compared to assets will vary from one firm and industry group to another. It is almost meaningless to compare debt or liquidity ratios from very debt-heavy industries like utilities to an industry such as retail clothing. The way those firms can utilize capital is just much too different; however, comparisons within industry groups can be very helpful, and investors often use these comparisons to understand how one firm compares to another within a group.

3. Owners' equity. When owners' equity is added to liabilities, the sum will be equal to assets. Therefore, owners' equity is the "net asset value" or the firm's book value. Owners' equity can be reduced through dividend payments and losses.

Finding the Balance Sheet in Your Scottrade Account

To access a company's balance sheet, first type the symbol into the Detailed Quote file in the top right corner of your screen to bring up company-specific performance data. Click the Financials tab, and along the top of the Financials area, you can choose Income Statement, Balance Sheet or Cash Flow. Select Balance Sheet, and current and historical balance sheet information will appear.

Using the Balance Sheet as an Investor

There are a few things to keep in mind about the balance sheet as you begin using it in your investing analysis.

1. The relative size of owners' equity compared to debt can give you some insight about how a company is financing its operations. Very large debt balances can increase a firm's sensitivity to interest rate changes and credit availability.

2. Retained earnings within owners' equity can be reduced by losses during the quarter. The company's performance as a function of its equity is therefore a critical fundamental measure. The fundamental ratio Return on Equity (ROE) is a common way to measure this kind of performance.

3. The assets portion of the balance sheet can contain large amounts of intangible assets. Usually these assets (such as goodwill) are not an issue. But investors grow concerned when they become disproportionately large compared to other current and long-term assets. This was a major warning sign, for example, that the so-called "roll-ups" in the technology sector of the early 2000's were no more than a shell game.

Once you understand some of these issues, it is easier to see why the information on the balance sheet is best when used with the information on the other financial statements. In this series of articles, beginning with last month's Navigating the Income Statement, we will be covering each financial statement and will help you understand how to use them to improve your searching and analysis.

John Jagerson contributes educational videos and articles about the stock, options and forex markets that can be seen daily at www.learningmarkets.com. This article was written exclusively for Scottrade. Scottrade and Learning Markets are separate companies and the information provided by Learning Markets, or its employees, should not be attributed to Scottrade.