How to Analyze a Balance Sheet Like a Hedge Fund Analyst

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 it is organized into three sections: assets, liabilities, and stockholders' equity. Put simply, an asset is any item or resource with a 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 a 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, while 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 using Apple. But first, a quick word from our sponsor, Masterworks. If you follow my channel, you probably know how turbulent the market has been, with inflation hitting a 30-year high. Many professional investors are either trying to find ways to significantly outperform the market over the long term or hedge against inflation. Regardless, if you want to understand what the sharpest minds in investing are doing right now, you need to check out Masterworks.

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Okay, 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 consist 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 equivalents line. So we can see at the end of 2021, Apple had $34,900 in cash and cash equivalents, $7,695 in marketable securities, and $127,800.

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 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 1 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 automobile 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%. 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 accounts 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 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, 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 upfront. 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, providing you with a month of access to Netflix, that $15 will show up in deferred revenue until after the company has provided you with the promised 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 3 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 debt is listed as three separate lines: commercial paper, the current portion of term debt, and the non-current portion of term debt. 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 $6,000 of commercial paper, the $9,600 current portion of debt, and the $9,160 non-current portion of debt, we see that Apple's true debt is $124,700.

Earlier, in 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 $65,719. 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 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 debt amount of $124 billion, but once you understand that Apple has cash of $190 billion, 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 $42,715 in debt and $1,914 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 $31,801. This leaves an important question for us as investors: is this a large net debt figure or not? That completely depends on how much money the company makes. If a company makes $10 billion a year in profits, $1 billion in debt would be a relatively small amount of debt. However, if a company only makes $100 million in profits a year, that same $1 billion 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 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 packaged good companies like Nestle or Procter and 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 $94,400 and divide it by the total shareholders' equity of $63,900. This leaves us with a return on equity of 150%. Generally speaking, the higher this number is, the better.

The most useful thing to do for this number is to compare it 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 the 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 and profits with relatively little shareholders' capital. No wonder Apple is the most valuable company in the world.

So there we have it! Make sure to give this video a like and subscribe to the Investor Center. 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.