How to Analyze a Balance Sheet Like a Hedge Fund Analyst

Summary

This video offers an in-depth guide on analyzing a company's balance sheet, focusing on assets, liabilities, and equity. It uses Apple as an example to explain key terms like cash equivalents, accounts receivable, and inventory. The presenter also discusses debt analysis, net debt calculation, and the importance of comparing a company's financial ratios with industry peers.

Takeaways

• 📊 Understanding a company's balance sheet is crucial for investors as it can indicate the financial health and potential for bankruptcy.
• 💼 The balance sheet is divided into three main sections: assets, liabilities, and stockholders' equity, reflecting a company's resources, obligations, and ownership interest.
• 🏦 Assets are categorized as current (easily convertible to cash within a year) and non-current (long-term resources), with liquidity being the key to their order in the balance sheet.
• 📋 Liabilities are also divided into current (due within a year) and non-current (longer than a year), indicating the company's short-term and long-term obligations.
• 💰 The basic accounting equation is Assets = Liabilities + Stockholders' Equity, showing how a company's assets are financed.
• 💹 Cash and cash equivalents, including marketable securities, are important to assess a company's liquidity and financial flexibility.
• 📈 Accounts receivable represent money owed to the company, while inventories are products ready for sale but not yet sold, indicating potential sales performance.
• 🏭 Property, plant, and equipment (PPE) are long-term physical assets that can indicate the capital intensity of an industry.
• 💳 Accounts payable and deferred revenue are part of the liability section, showing the money owed to suppliers and the revenue received in advance for services.
• 📉 Commercial paper represents short-term debt used for daily operations, while term debt is longer-term and can affect a company's financial stability.
• 🔢 Net debt is calculated by subtracting a company's cash from its total debt, providing a clearer picture of its financial obligations and ability to meet them.

Q & A

What is the primary focus of the video script?

The primary focus of the video script is to teach viewers how to analyze a company's balance sheet using the experience of an investment analyst, with the aim of helping investors understand what to look for when investing.

Why is understanding a company's balance sheet critical for investors?

Understanding a company's balance sheet is critical for investors because it can indicate the financial health of a company, the presence of excessive debt, and the risk of bankruptcy, which directly affects the potential return on investment.

What are the three main sections of a balance sheet?

The three main sections of a balance sheet are assets, liabilities, and stockholders' equity.

How does the basic accounting equation relate to the balance sheet?

The basic accounting equation, assets = liabilities + stockholders' equity, shows how the assets of a company are financed, which is the core concept of a balance sheet.

What are current assets and how do they differ from non-current assets?

Current assets are assets that can be converted into cash within one year, such as short-term investments and accounts receivable. Non-current assets are longer-term assets that cannot be recognized until after one year, like property and machinery.

What is the significance of liquidity in the context of a company's assets?

Liquidity refers to how quickly assets can be turned into cash. Assets are listed in order of their liquidity on a balance sheet, with the most liquid assets at the top, indicating their ease of conversion to cash.

How does the script use Apple Inc. as an example to explain balance sheet analysis?

The script uses Apple Inc.'s balance sheet to illustrate key concepts, such as cash and cash equivalents, marketable securities, accounts receivable, inventories, and property, plant, and equipment (PPE), providing a line-by-line breakdown.

What is the importance of accounts receivable on a company's balance sheet?

Accounts receivable represents the money owed to the company by customers for purchases made on credit. It's important for investors to understand the company's credit sales and collection efficiency.

Why is inventory analysis important for investors?

Inventory analysis is important for investors to assess whether a company is having difficulty selling its products, as growing inventory levels can signal overproduction or weak demand.

How does the script explain the concept of net debt?

The script explains net debt as the calculation of a company's debt minus its cash, which gives an investor a clearer picture of the company's actual debt position, considering its liquid assets.

What is the significance of the net debt to EBITDA ratio in evaluating a company's financial health?

The net debt to EBITDA ratio is significant as it shows how well a company can support its debt through the cash it generates, providing insight into the company's financial stability and efficiency in using capital.

Why is return on equity (ROE) an important metric for investors?

Return on equity (ROE) is important because it measures how efficiently a company uses its capital to generate profit, providing a comparison of profitability relative to the shareholders' investment.

How does the script use Coca-Cola as an example to illustrate net debt calculation?

The script uses Coca-Cola's financial figures to demonstrate the calculation of net debt by subtracting the company's cash from its debt, resulting in a net debt figure that can be further analyzed in the context of the company's operations and industry.

Outlines

00:00

📊 Introduction to Analyzing a Company's Balance Sheet

This paragraph introduces the video's focus on teaching viewers how to analyze a company's balance sheet, leveraging the presenter's experience as an investment analyst. It emphasizes the importance of a good balance sheet for successful investing and avoiding bankruptcy. The balance sheet's organization into assets, liabilities, and stockholders' equity is explained, along with the basic accounting equation that relates these elements. The paragraph also differentiates between current and non-current assets and liabilities, highlighting the significance of liquidity in asset valuation.

05:01

💼 Deep Dive into Apple's Balance Sheet Components

The second paragraph delves into a detailed analysis of Apple's balance sheet, starting with its cash and cash equivalents, and how to calculate the company's 'true cash' position by including marketable securities. It explains accounts receivable as money owed to the company and inventories as finished products yet to be sold. The discussion then moves to property, plant, and equipment (PPE) as indicators of a capital-intensive industry. The paragraph also covers accounts payable, deferred revenue, and commercial paper, concluding with an explanation of how to calculate a company's true debt and net debt, using Apple's financial figures as an example.

10:01

🏦 Understanding Debt and Equity Through Apple and Coca-Cola Examples

The final paragraph discusses the importance of evaluating a company's debt in relation to its cash holdings, as demonstrated by Apple's lack of net debt due to substantial cash reserves. It introduces the concept of net debt to EBITDA ratio as a measure of a company's debt sustainability relative to its earnings. The paragraph uses Coca-Cola's financial figures to illustrate how to calculate this ratio and emphasizes comparing it with industry peers. It concludes with an explanation of Return on Equity (ROE), showcasing Apple's high ROE compared to Samsung's, thereby highlighting Apple's capital efficiency and profitability.

Keywords

💡Balance Sheet

A balance sheet is a financial statement that provides a snapshot of a company's financial position, including its assets, liabilities, and shareholders' equity at a specific point in time. It is central to the video's theme as it is the main focus of the analysis. The script explains that a good balance sheet can indicate a successful investment, while a poor one could signal bankruptcy.

💡Asset

An asset is any resource owned by a business that has monetary value, such as cash in the bank or a factory. In the video, assets are discussed in the context of their liquidity and their role in financing a company's operations, with examples like cash and marketable securities.

💡Liability

A liability is an obligation or debt that a company owes to others, such as bank loans or payments to suppliers. The video emphasizes the importance of understanding liabilities in relation to assets, as they represent how a company's assets are financed.

💡Stockholders Equity

Stockholders' equity, also known as shareholders' equity, represents the residual interest in the assets of a company after deducting liabilities. It is part of the basic accounting equation mentioned in the script and is a key component of the balance sheet analysis.

💡Current Assets

Current assets are assets that can be converted into cash within one year, such as short-term investments and accounts receivable. The script uses current assets to illustrate the liquidity of a company's assets and their importance in the balance sheet.

💡Non-Current Assets

Non-current assets are long-term assets that cannot be converted into cash within one year, such as property and machinery. The video discusses these in the context of their placement in the asset section of the balance sheet and their significance in indicating a company's capital intensity.

💡Liquidity

Liquidity refers to the ability of an asset to be quickly converted into cash. The script explains that assets are listed in the balance sheet in order of their liquidity, with the most liquid assets at the top, which is crucial for understanding a company's financial health.

💡Accounts Receivable

Accounts receivable is the money owed to a company by customers for goods or services provided on credit. The video uses the concept to explain the timing of revenue recognition and its impact on the balance sheet.

💡Inventories

Inventories are products that are completed and ready to be sold but have not yet been sold. The script warns investors about the potential risks associated with growing inventory levels, as it could indicate difficulty in selling products.

💡Property, Plant, and Equipment (PPE)

Property, plant, and equipment (PPE) are physical assets that a company owns and uses in its operations, with a life longer than one year. The video discusses PPE in the context of capital intensity and provides an example of Apple's headquarters, Apple Park.

💡Net Debt

Net debt is calculated by subtracting a company's cash and cash equivalents from its total debt. The script explains that net debt provides a clearer picture of a company's financial obligations and its ability to meet them, using Apple's financial figures as an example.

💡Net Debt to EBITDA Ratio

The net debt to EBITDA ratio is a financial metric used to evaluate a company's ability to manage its debt with its operating profits. The video script discusses this ratio in the context of assessing a company's financial health and compares it across different companies in the same industry.

💡Return on Equity (ROE)

Return on equity (ROE) is a measure of the return on investment relative to the shareholders' equity. The video explains that ROE indicates how efficiently a company uses its capital to generate profit, using Apple's high ROE as an example of a well-performing business.

Highlights

The video provides an in-depth analysis of a company's balance sheet using the presenter's experience as an investment analyst.

A good balance sheet is critical for successful investing and can indicate a company's financial health or bankruptcy risk.

The balance sheet is divided into assets, liabilities, and stockholders' equity, with each having current and non-current subcategories.

Assets are resources with monetary value, while liabilities are obligations the company owes, such as bank loans or supplier payments.

The basic accounting equation is assets = liabilities + stockholders' equity, illustrating how a company's assets are financed.

Liquidity refers to how quickly assets can be turned into cash, with cash being the most liquid and property, plant, and equipment the least.

Apple's balance sheet is used as an example to explain various line items, including cash and cash equivalents, marketable securities, and accounts receivable.

Inventories represent completed products ready for sale but not yet sold, and high inventory levels can signal sales difficulties.

Property, plant, and equipment (PPE) are long-term physical assets, and a high PPE to revenue ratio indicates a capital-intensive industry.

Accounts payable represent money owed to suppliers, and deferred revenue is money received in advance for services not yet provided.

Commercial paper is a short-term debt used for funding daily operations, differing from term debt which is longer-term.

Net debt is calculated by subtracting a company's cash from its total debt, indicating the company's actual debt burden.

Apple's net debt is negative, meaning it has more cash than debt, a financially healthy position.

Coca-Cola's net debt and its net debt to EBITDA ratio are used to illustrate how debt is evaluated relative to a company's earnings.

Return on Equity (ROE) measures how efficiently a company uses its capital to generate profit, with a higher percentage being better.

Apple's ROE is significantly higher than its competitor Samsung's, demonstrating its superior business efficiency.

The video concludes with the importance of understanding a company's balance sheet for informed investment decisions.

Transcripts

in this video we are going to go over

how to analyze a company's balance sheet

i'm going to use my experience as an

investment analyst at a large investment

firm to help you guys better understand

what to look for when investing whether

you are a new investor just buying your

first stock or if you've been investing

for years i guarantee if you stick

around till the end of this video you

will learn something new and useful that

you can begin applying to your own

investment research process today now

let's get into the video

understanding the inner workings of a

company's balance sheet is absolutely

critical when investing a good balance

sheet can mean the difference between

losing all of your money when investing

or having a successful investment if a

company has too much debt or runs out of

cash and can't fund its operations that

means the company could be heading for

bankruptcy if that happens there is a

solid chance that your investment in the

company is going to zero

the first thing you need to know about a

balance sheet is that is organized into

three sections assets liabilities and

stockholders equity put simply an asset

is any item or resource with the

monetary value that a business owns cash

that the company has in its bank account

or the factory where the company

manufactures its products would both be

examples of assets the opposite of an

asset is a liability put simply a

liability is something that the company

owes things such as a loan from a bank

or payment that the company owes to one

of its suppliers are both examples of

liabilities the basic accounting

equation is assets equals liabilities

plus stockholders equity this equation

pretty much means that liabilities plus

stockholders equity represents how the

assets of a company are financed now i

don't want to get too deep into

accounting in this video but just keep

this equation in mind as we go

throughout the rest of this video

both the asset section and the liability

section are further broken up into two

subcategories current and non-current

current assets are those that you can

convert into cash within one year such

as short-term investments and accounts

receivable non-current assets are

longer-term assets with a full value

that you cannot recognize until after

one year such as property and machinery

for liabilities current liabilities are

liabilities that are expected to be paid

off within one year while non-current

liabilities are liabilities the company

expects to have for longer than one year

it's also interesting to note that

assets appear in the order of their

liquidity liquidity is just a fancy word

for how quickly assets can be turned

into cash cash is the most liquid asset

because well it's already cash the most

liquid assets are at the top and the

least liquid assets like property plant

and equipment for example are at the

bottom of the asset section so now that

we have that background and why the

balance sheet is so important let's go

line by line of a company's balance

sheet and talk about what you need to

know in this example we are going to be

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now back to apple's balance sheet the

first line that i want to talk about is

cash and cash equivalents the first part

of this line is pretty self-explanatory

cash is just the money that you have

sitting in a checking or savings account

the part that needs some explaining is

cash equivalents cash equivalents are

short-term and super safe investments

that can easily be turned into cash the

reason companies put their money into

these short term but extremely low risk

investments is to earn a little extra

money think about it if you're apple and

you have tens of billions of dollars of

cash if you're able to get even a very

small return on your money that is

millions of dollars of extra cash you

are generating moving down the balance

sheet we have marketable securities this

is where the analysis really starts to

take place these marketable securities

are already low risk and can be turned

into cash relatively easily marketable

securities consists of things like

government bonds when i'm trying to

calculate a company's true cash i always

like to add the marketable securities

into the cash and cash equivalence line

so we can see at the end of 2021 apple

had 34

cash and cash equivalents twenty seven

thousand six hundred and ninety nine

dollars in marketable securities and one

hundred and twenty seven thousand eight

hundred and seventy seven dollars and

non-current marketable securities if we

add these three numbers together we get

thousand 190

hundred and sixteen dollars the reason i

add these numbers together is because i

want to determine how much true cash the

company has relative to its debt as well

as how much cash the company can use to

do things such as buy other companies

pay dividends or repurchase stock

next up we have accounts receivable

accounts receivable is the amount of

money owed to the company by customers

for purchases made on credit let's say

you own a lemonade stand one of your

customers asks you to supply lemonade to

a party he's hosting let's say you

supply 20 worth of lemonade to the party

and the customer says to send him over

the bill for 20 and he will pay you next

week this is an example of an accounts

receivable from the time you provided

the lemonade to the customer but have

yet to receive payment you have a 20

account receivable from the customer so

in the case of apple if they are selling

their iphones to a large corporate

customer but are awaiting payment this

would show up on the balance sheet as an

accounts receivable the next line i want

to cover is inventories these are

products that are completed and ready to

be sold but have yet to be sold to a

customer so in the case of apple it

would be the iphones ipads and macbooks

that have been manufactured but have not

yet been sold to customers as an

investor you want to make sure that

these inventory levels aren't growing

significantly as it can be a sign that

the company is having a difficult time

selling its products for example one of

apple's rivals microsoft had this

problem a while back back in 2013

microsoft took a loss of nearly 1

billion dollars on one of its products

because the company simply overestimated

demand they made way too much of the

product because the company thought

demand from customers was going to be

higher than it turned out to be

microsoft investors were left footing

the bill of nearly 1 billion

now microsoft has since recovered and

made that money back in a week or two

however for a company such as a retailer

or department store this inventory line

is extremely important because if a

retailer or department store misplans

their inventory it can have devastating

consequences i now want to jump to the

line titled property plant and equipment

property plant and equipment or pp e for

short are physical assets that a company

owns that typically have a life of

longer than one year this can include

things like vehicles furniture computers

machinery buildings or land for apple an

example of this would be its 5 billion

headquarters that it built called apple

park the larger this pp e number is the

more capital intensive an industry is

examples of capital intensive industries

include railroads oil companies and auto

manufacturers a good way to see how

capital intensive an industry is is to

divide pp e by the company's annual

revenue this shows you how much property

plant and equipment it took a company to

generate a certain amount of revenue for

example if we do this analysis with

apple we see that property plant and

equipment is 11 of annual revenue this

is a relatively capital light industry

the opposite of a capital intensive

industry

however let's try this with a railroad

let's use union pacific which is a

railroad covering the western part of

the united states if we do the same

calculation we get a value of 277

percent this shows just how much more

capital intensive union pacific is

compared to apple

now i want to jump to the liability

section of the balance sheet the first

line i want to touch on is counts

payable think of this line as the

opposite of accounts receivable accounts

payable is money that apple owes to its

suppliers for products and services

apple has received but has not yet paid

for

so for example let's say the company

that makes a glass for the front of the

iphone sent apple 100 million dollars of

glass during the month apple has

received the glass from its supplier but

until apple pays the supplier for that

material the amount apple owes in this

case 100 million dollars shows up in the

line titled accounts payable the next

line item i want to touch on is deferred

revenue this is an important line item

for software companies and many tech

companies the easiest way to explain

this is with netflix so when you sign up

for netflix the company bills you up

front let's say 15

you pay 15 at the beginning of the month

and that allows you to access netflix

for the entire month however because of

accounting rules the company cannot

classify that 15 you pay them as revenue

until they provide the service to you so

in this example provide you with a month

of access to netflix so that 15 will

show up in deferred revenue until after

the company has provided you with the

promise service this is very common in

subscription-based software businesses

like netflix microsoft adobe and

salesforce in the case of apple this

deferred revenue would come from their

services business like apple music and

icloud storage

next up is commercial paper this is

simply very short-term debt around only

30 days until the company has to pay it

off companies use commercial paper to

fund the daily operations of their

business such as payroll paying

suppliers and things like that the

biggest difference between commercial

paper and the next line term debt is

that commercial paper is just super

short-term loans

this brings me to the most important

part of analyzing a company's balance

sheet understanding the company's debt

in the case of apple their data is

listed as three separate lines

commercial paper the current portion of

term debt and the non-current portion of

term dot just a reminder that current

means the debt is due within 12 months

while non-current means due at a time

longer than 12 months in order to

calculate what i refer to as apple's

true debt we have to add these three

lines together adding together the six

thousand dollars of commercial paper the

nine thousand six hundred and thirteen

dollars current portion of debt and the

one hundred and nine thousand one

hundred and six dollars non-current

portion of debt we see that apple's true

debt is 124

719

however i want to take this analysis one

step further so now that we have apple's

true cash that we calculated earlier and

the company's true debt we now want to

calculate what in the investing industry

is referred to as net debt it's a super

easy calculation just take the company's

debt and subtract out the cash the

company has this leaves you with a net

amount of debt if we do this with apple

we get

seven negative 65

ninety seven dollars this means that the

company in theory does not have any debt

on its balance sheet because its cash

exceeds its debt it's important to

subtract out the cash a company has from

its debt amount in order to see how much

net debt the company has that it can't

pay right away in the case of apple even

though the company technically has 124

billion dollars of debt they really

don't because they have far more cash on

the balance sheet than debt at first

glance you as an investor might be

worried about that large set amount of

124 billion dollars but once you

understand that apple has cash of 190

billion dollars you suddenly aren't so

worried about that number at all anymore

in order to illustrate my point let's

use another company as an example

coca-cola coca-cola has

seven hundred and ninety three dollars

in debt and ten thousand nine hundred

and fourteen dollars in cash in order to

calculate coca-cola's net debt we take

the debt amount and subtract out the

cash amount this leaves us with a net

debt amount of thirty one thousand eight

hundred and seventy nine dollars so this

leaves an important question for us as

an investor is this a large nut debt

figure or not that completely depends on

how much money the company makes if the

company makes 10 billion dollars a year

in profits one billion dollars in debts

would be a relatively small amount of

debt however if a company only makes 100

million dollars in profits a year that

same one billion dollars in debt would

probably crush it and cause it to go

bankrupt a helpful analysis to do in

order to determine whether a company can

support its debt through the cash it

generates is to calculate its net debt

to ebitda ratio this is a pretty

straightforward calculation you take the

company's net debt and divide it by its

annual ebitda which is what we usually

use as a proxy for cash flow

if you want to learn more about ebitda

and how to analyze an income statement

check out the video i did on it here

coca-cola had an ebitda of 10 533

dollars in 2020. by taking coca-cola's

net debt and dividing it by this ebitda

amount we get a net debt to ebitda ratio

of

3.03 the best way to analyze this number

is to compare it to that of the

company's competitors in the same

industry this is because different

industries use varying amounts of debt

to fund the operations of the company it

wouldn't make sense to compare

coca-cola's net debt to ebitda to a

high-growth software company but it

would make sense to compare it to other

consumer package good companies like

nestle or procter gamble now i'm not

going to spend a ton of time talking

about the shareholder equity section

because pretty much all of your time as

an investor should be spent better

understanding the assets and the

liabilities of a company however there

is one investment metric that i do want

to bring your attention to that metric

is return on equity and it is calculated

by taking a company's net income from

the income statement and dividing it by

the company's total shareholders equity

return on equity tells you how much net

income a company generates per dollar of

invested capital this percentage is key

because it helps investors understand

how efficiently a firm uses its capital

to generate profit so for apple we take

the company's net income for 2021 of

thousand six hundred and forty dollars

and divided by the total shareholders

equity of sixty three thousand ninety

dollars this leaves us with a return on

equity of one hundred and fifty percent

generally speaking the higher this

number is the better the most useful

thing to do for this number is to

compare to that of the company's

competitors in the same industry samsung

is one of apple's competitors want to

take a guess on what their return on

equity is

seriously take a guess

well samsung's roe is 17

this demonstrates just how great of a

business apple is it is able to generate

a ton of money in profits with

relatively little shareholders capital

no wonder apple is the most valuable

company in the world so there you have

it make sure to give this video a like

and subscribe to the investor center and

if you want to check out the other

videos in this series including how to

analyze an income statement and a cash

flow statement check it out here talk to

you guys soon