HOW TO VALUE A COMPANY

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I.Business Valau�on

1. What Is a Business Valua�on?

A business valuation, also known as a company valuation, is the process of determining
the economic value of a business. During the valuation process, all areas of a business are
analyzed to determine its worth and the worth of its departments or units.

A company valuation can be used to determine the fair value of a business for a variety of
reasons, including sale value, establishing partner ownership, taxation, and even divorce
proceedings. Owners will often turn to professional business evaluators for an objective estimate
of the value of the business.

KEY TAKEAWAYS

• Business valuation determines the economic value of a business or business unit.

• Business valuation can be used to determine the fair value of a business for a variety of
reasons, including sale value, establishing partner ownership, taxation, and even divorce
proceedings.
• Several methods of valuing a business exist, such as looking at its market cap, earnings
multipliers, or book value, among others.

2.The Basics of Business Valua�on

The topic of business valuation is frequently discussed in corporate finance. Business
valuation is typically conducted when a company is looking to sell all or a portion of its operations
or looking to merge with or acquire another company. The valuation of a business is the process
of determining the current worth of a business, using objective measures, and evaluating all aspects
of the business.
A business valuation might include an analysis of the company's management, its capital
structure, its future earnings prospects or the market value of its assets. The tools used for valuation
can vary among evaluators, businesses, and industries. Common approaches to business valuation
include a review of financial statements, discounting cash flow models and similar company
comparisons.

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 Valuation is also important for tax reporting. The Internal Revenue Service (IRS)
requires that a business is valued based on its fair market value. Some tax-related events
such as sale, purchase or gifting of shares of a company will be taxed depending on
valuation.1
Estimating the fair value of a business is an art and a science; there are several formal
models that can be used, but choosing the right one and then the appropriate inputs can be
somewhat subjective.

3.Methods of Valua�on

There are numerous ways a company can be valued. You'll learn about several of these
methods below.
1. Market Capitalization
Market capitalization is the simplest method of business valuation. It is calculated by
multiplying the company’s share price by its total number of shares outstanding. For example, as
of January 3, 2018, Microsoft Inc. traded at $86.35.2 With a total number of shares outstanding of
7.715 billion, the company could then be valued at $86.35 x 7.715 billion = $666.19 billion.
2. Times Revenue Method
Under the times revenue business valuation method, a stream of revenues generated over
a certain period of time is applied to a multiplier which depends on the industry and economic
environment. For example, a tech company may be valued at 3x revenue, while a service firm may
be valued at 0.5x revenue.
3. Earnings Multiplier
Instead of the times revenue method, the earnings multiplier may be used to get a more
accurate picture of the real value of a company, since a company’s profits are a more reliable
indicator of its financial success than sales revenue is. The earnings multiplier adjusts future profits
against cash flow that could be invested at the current interest rate over the same period of time.
In other words, it adjusts the current P/E ratio to account for current interest rates.
4. Discounted Cash Flow (DCF) Method
The DCF method of business valuation is similar to the earnings multiplier. This method
is based on projections of future cash flows, which are adjusted to get the current market value of
the company. The main difference between the discounted cash flow method and the profit
multiplier method is that it takes inflation into consideration to calculate the present value.
5. Book Value
This is the value of shareholders’ equity of a business as shown on the balance sheet
statement. The book value is derived by subtracting the total liabilities of a company from its total
assets.

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 Liquidation value is the net cash that a business will receive if its assets were liquidated
and liabilities were paid off today.
This is by no means an exhaustive list of the business valuation methods in use today. Other
methods include replacement value, breakup value, asset-based valuation and still many more.

4.Accredita�on in Business Valua�on

In the U.S., Accredited in Business Valuation (ABV) is a professional designation awarded

to accountants such as CPAs who specialize in calculating the value of businesses. The ABV
certification is overseen by the American Institute of Certified Public Accountants (AICPA) and
requires candidates to complete an application process, pass an exam, meet minimum Business
Experience and Education requirements,3 and pay a credential fee (as of Mar. 11, 2022, the annual
fee for the ABV Credential was $380).4
Maintaining the ABV credential also requires those who hold the certification to meet
minimum standards for work experience and lifelong learning. Successful applicants earn the right
to use the ABV designation with their names, which can improve job opportunities, professional
reputation and pay. In Canada, Chartered Business Valuator (CBV) is a professional designation
for business valuation specialists. It is offered by the Canadian Institute of Chartered Business
Valuators (CICBV).

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II. What Is Valuation?

1.What Is Valua�on?

Valuation is the analytical process of determining the current (or projected) worth of an
asset or a company. There are many techniques used for doing a valuation. An analyst placing a
value on a company looks at the business's management, the composition of its capital structure,
the prospect of future earnings, and the market value of its assets, among other metrics.
Fundamental analysis is often employed in valuation, although several other methods may
be employed such as the capital asset pricing model (CAPM) or the dividend discount
model (DDM).

KEY TAKEAWAYS
• Valuation is a quantitative process of determining the fair value of an asset,
investment, or firm.
• In general, a company can be valued on its own on an absolute basis, or else
on a relative basis compared to other similar companies or assets.
• There are several methods and techniques for arriving at a valuation—each of
which may produce a different value.
• Valuations can be quickly impacted by corporate earnings or economic events
that force analysts to retool their valuation models.
• While quantitative in nature, valuation often involves some degree of
subjective input or assumptions.

2.Understanding Valua�on

A valuation can be useful when trying to determine the fair value of a security, which is
determined by what a buyer is willing to pay a seller, assuming both parties enter the transaction
willingly. When a security trades on an exchange, buyers and sellers determine the market value of
a stock or bond.
The concept of intrinsic value, however, refers to the perceived value of a security based
on future earnings or some other company attribute unrelated to the market price of a security.

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That's where valuation comes into play. Analysts do a valuation to determine whether a company
or asset is overvalued or undervalued by the market.

3.Types of Valua�on Models

• Absolute valuation models attempt to find the intrinsic or "true" value of an investment
based only on fundamentals. Looking at fundamentals simply means you would only focus
on such things as dividends, cash flow, and the growth rate for a single company, and not
worry about any other companies. Valuation models that fall into this category include the
dividend discount model, discounted cash flow model, residual income model, and asset-
based model.
• Relative valuation models, in contrast, operate by comparing the company in question to
other similar companies. These methods involve calculating multiples and ratios, such as
the price-to-earnings multiple, and comparing them to the multiples of similar companies.
For example, if the P/E of a company is lower than the P/E multiple of a comparable company,
the original company might be considered undervalued. Typically, the relative valuation model is
a lot easier and quicker to calculate than the absolute valuation model, which is why many
investors and analysts begin their analysis with this model.

3.1Types of Valua�on Methods

There are various ways to do a valuation.
Comparables Method
The comparable company analysis is a method that looks at similar companies, in size and
industry, and how they trade to determine a fair value for a company or asset. The past transaction
method looks at past transactions of similar companies to determine an appropriate value. There's
also the asset-based valuation method, which adds up all the company's asset values, assuming
they were sold at fair market value, to get the intrinsic value.
In investments, a comparables approach is often synonymous with relative valuation.
Sometimes doing all of these and then weighing each is appropriate to calculate intrinsic
value. Meanwhile, some methods are more appropriate for certain industries and not others. For
example, you wouldn't use an asset-based valuation approach to valuing a consulting company that
has few assets; instead, an earnings-based approach like the DCF would be more appropriate.
Discounted Cash Flow Method
Analysts also place a value on an asset or investment using the cash inflows and outflows
generated by the asset, called a discounted cash flow (DCF) analysis. These cash flows are

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discounted into a current value using a discount rate, which is an assumption about interest rates
or a minimum rate of return assumed by the investor.
DCF approaches to valuation are used in pricing stocks, such as with dividend discount
models like the Gordon growth model.
If a company is buying a piece of machinery, the firm analyzes the cash outflow for the
purchase and the additional cash inflows generated by the new asset. All the cash flows are
discounted to a present value, and the business determines the net present value (NPV). If the NPV
is a positive number, the company should make the investment and buy the asset.
Precedent Transactions Method

The precedent transaction method compares the company being valued to other similar
companies that have recently been sold. The comparison works best if the companies are in the
same industry. The precedent transaction method is often employed in mergers and acquisition
transactions.

4.How Earnings Affect Valua�on

The earnings per share (EPS) formula is stated as earnings available to common
shareholders divided by the number of common stock shares outstanding. EPS is an indicator of
company profit because the more earnings a company can generate per share, the more valuable
each share is to investors.
Analysts also use the price-to-earnings (P/E) ratio for stock valuation, which is calculated
as the market price per share divided by EPS. The P/E ratio calculates how expensive a stock price
is relative to the earnings produced per share.
For example, if the P/E ratio of a stock is 20 times earnings, an analyst compares that P/E
ratio with other companies in the same industry and with the ratio for the broader market. In equity
analysis, using ratios like the P/E to value a company is called a multiples-based, or multiples
approach, valuation. Other multiples, such as EV/EBITDA, are compared with similar companies
and historical multiples to calculate intrinsic value.

5.Limita�ons of Valua�on

When deciding which valuation method to use to value a stock for the first time, it's easy
to become overwhelmed by the number of valuation techniques available to investors. There are
valuation methods that are fairly straightforward while others are more involved and complicated.
Unfortunately, there's no one method that's best suited for every situation. Each stock is
different, and each industry or sector has unique characteristics that may require multiple valuation

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methods. At the same time, different valuation methods will produce different values for the same
underlying asset or company which may lead analysts to employ the technique that provides the
most favorable output.
Those interested in learning more about valuation and other financial topics may want to
consider enrolling in one of the best personal finance classes.

6.What Is an Example of Valua�on?

A common example of valuation is a company's market capitalization. This takes the share
price of a company and multiplies it by the total shares outstanding. For example, if a company's
share price is $10, and the company has 2 million shares outstanding, its market capitalization
would be $20 million.

7.How Do You Calculate Valua�on?

There are many ways to calculate valuation and will differ on what is being valued and
when. A common calculation in valuing a business involves determining the fair value of all of its
assets minus all of its liabilities. This is an asset-based calculation.

8.What Is the Purpose of Valua�on?

The purpose of valuation is to determine the worth of an asset or company and compare
that to the current market price. This is done so for a variety of reasons, such as bringing on
investors, selling the company, purchasing the company, selling off assets or portions of the
business, the exit of a partner, or inheritance purposes.

9.The Botom Line

Valuation is the process of determining the worth of an asset or company. Valuation is

important because it provides prospective buyers with an idea of how much they should pay for
an asset or company and for prospective sellers, how much they should sell for.
Valuation plays an important role in the M&A industry, as well as in regard to the growth
of a company. There are many valuation methods, all of which come with their pros and cons.

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III.Valuation Analysis

1.What Is Valuation Analysis?

Valuation analysis is a process to estimate the approximate value or worth of an asset,

whether its a business, equity, fixed income security, commodity, real estate, or other assets. The
analyst may use different approaches to valuation analysis for different types of assets, but the
common thread will be looking at the underlying fundamentals of the asset.

KEY TAKEAWAYS

• Valuation analysis seeks to estimate the fair value or intrinsic value of an asset, such as
business or a security.
• Valuation analysis relies on several different methodologies and models in order to come
up with a single price based on different inputs or variables.
• Different valuation processes will be employed depending on the type of asset being
considered, whether that asset produces cash flows, and what the purpose of the valuation
is for.

2.Understanding Valuation Analysis

Valuation analysis is mostly science (number crunching), but there is also a bit of art
involved because the analyst is forced to make assumptions for model inputs. The value of an
asset is basically the present value (PV) of all future cash flows that the asset is forecasted to
produce. Inherent in the estimation model for a company, for example, is a myriad of assumptions
regarding sales growth, margins, financing choices, capital expenditures, tax rates, discount rate
for the PV formula, etc.

Once the model is set up, the analyst can play with the variables to see how valuation
changes with these different assumptions. There is no one-size-fits-all model for assorted asset
classes. Whereas a valuation for a manufacturing company may be amenable to a multi-
year DCF model, and a real estate company would be best modeled with current net operating
income (NOI) and capitalization rate (cap rate), commodities such as iron ore, copper, or silver
would be subject to a model centered around global supply and demand forecasts.

3.How Valuation Analysis is Used

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The output of valuation analysis can take many forms. It can be a single number, such as a
company having a valuation of approximately $5 billion, or it could be a range of numbers if the
value of an asset is largely dependent on a variable that often fluctuates, such as a corporate bond
with a high duration having a valuation range between par and 90% of par depending on the yield
on the 30-year Treasury bond. Valuation can be expressed as a price multiple. For example, as a
tech stock is trading at a price-to-earnings (P/E) multiple of 40x, a telecom stock is valued at
6x enterprise value-to-earnings before interest, taxes, depreciation and
amortization (EV/EBITDA) or a bank is trading at 1.3x price-to-book (P/B) ratio. Valuation
analysis can also take the final form of as asset value per share or net asset value (NAV) per share.

4.Valuation and Intrinsic Value

Valuation analysis is important for investors to estimate intrinsic values of company

shares in order to make better-informed investment decisions. Fair values of bonds do not deviate
much, if at all, from intrinsic values, but opportunities do arise once in a while in the case of
financial stress of a heavily indebted company. Valuation analysis is a useful tool for comparing
companies within the same sector or estimating a return on an investment over a given time
period.

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IV. Financial Statements: List of Types and How to Read Them

1.What Are Financial Statements?

Financial statements are written records that convey the business activities and the
financial performance of a company. Financial statements are often audited by government
agencies, accountants, firms, etc. to ensure accuracy and for tax, financing, or investing purposes.
For-profit primary financial statements include the balance sheet, income statement, statement of
cash flow, and statement of changes in equity. Nonprofit entities use a similar but different set of
financial statements.

KEY TAKEAWAYS

• Financial statements are written records that convey the business activities and the
financial performance of an entity.
• The balance sheet provides an overview of assets, liabilities, and shareholders' equity as a
snapshot in time.
• The income statement primarily focuses on a company’s revenues and expenses during a
particular period. Once expenses are subtracted from revenues, the statement produces a
company's profit figure called net income.
• The cash flow statement (CFS) measures how well a company generates cash to pay
its debt obligations, fund its operating expenses, and fund investments.
• The statement of changes in equity records how profits are retained within a company for
future growth or distributed to external parties.

Fast fact

Not all financial statements are created equally. The rules used by U.S. companies is called
Generally Accepted Accounting Principles, while the rules often used by international companies
is International Financial Reporting Standards (IFRS). In addition, U.S. government agencies
use a different set of financial reporting rules.

2.Understanding Financial Statements

Investors and financial analysts rely on financial data to analyze the performance of a
company and make predictions about the future direction of the company's stock price. One of
the most important resources of reliable and audited financial data is the annual report, which
contains the firm's financial statements.

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 The financial statements are used by investors, market analysts, and creditors to evaluate
a company's financial health and earnings potential. The three major financial statement reports
are the balance sheet, income statement, and statement of cash flows.

Not all financial statements are created equally. The rules used by U.S. companies is called
Generally Accepted Accounting Principles, while the rules often used by international companies
is International Financial Reporting Standards (IFRS). In addition, U.S. government agencies use
a different set of financial reporting rules.

3.Balance Sheet

The balance sheet provides an overview of a company's assets, liabilities, and

shareholders' equity as a snapshot in time. The date at the top of the balance sheet tells you when
the snapshot was taken, which is generally the end of the reporting period. Below is a breakdown
of the items in a balance sheet.

Assets

• Cash and cash equivalents are liquid assets, which may include Treasury
bills and certificates of deposit.
• Accounts receivables are the amount of money owed to the company by its customers for
the sale of its product and service.
• Inventory is the goods a company on hand it intends to sell as a course of business.
Inventory may include finished goods, work in progress that are not yet finished, or raw
materials on hand that have yet to be worked.
• Prepaid expenses are costs that have been paid in advance of when they are due. These
expenses are recorded as an asset because the value of them has not yet been recognized;
should the benefit not be recognized, the company would theoretically be due a refund.
• Property, plant, and equipment are capital assets owned by a company for its long-term
benefit. This includes buildings used for manufacturing for heavy machinery used for
processing raw materials.
• Investments are assets held for speculative future growth. These aren't used in operations;
they are simply held for capital appreciation.
• Trademarks, patents, goodwill, and other intangible assets can't be physically be touched
but have future economic (and often long-term benefits) for the company.

Liabilities

• Accounts payable are the bills due as part of the normal course of operations of a business.
This includes the utility bills, rent invoices, and obligations to buy raw materials.
• Wages payable are payments due to staff for time worked.

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 • Notes payable are recorded debt instruments that record official debt agreements including
the payment schedule and amount.
• Dividends payable are dividends that have been declared to be awarded to shareholders
but have not yet been paid.
• Long-term debt can include a variety of obligations including sinking bond funds,
mortgages, or other loans that are due in their entirety in longer than one year. Note that
the short-term portion of this debt is recorded as a current liability.

Shareholders' Equity

• Shareholders' equity is a company's total assets minus its total liabilities. Shareholders'
equity (also known as stockholders' equity) represents the amount of money that would
be returned to shareholders if all of the assets were liquidated and all of the
company's debt was paid off.
• Retained earnings are part of shareholders' equity and are the amount of net earnings that
were not paid to shareholders as dividends.

Example of a Balance Sheet

Below is a portion of ExxonMobil Corporation's (XOM) balance sheet for fiscal-year 2021,
reported as of Dec. 31, 2021.

• Total assets were $338.9 billion.

• Total liabilities were $163.2 billion.
• Total equity was $175.7 billion.
• Total liabilities and equity were $338.9 billion, which equals the total assets for the
period.1

4.Income Statement

Unlike the balance sheet, the income statement covers a range of time, which is a
year for annual financial statements and a quarter for quarterly financial statements. The
income statement provides an overview of revenues, expenses, net income, and earnings
per share.

Revenue
Operating revenue is the revenue earned by selling a company's products or services.
The operating revenue for an auto manufacturer would be realized through the production and
sale of autos. Operating revenue is generated from the core business activities of a company.

Non-operating revenue is the income earned from non-core business activities. These
revenues fall outside the primary function of the business. Some non-operating revenue examples
include:

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 • Interest earned on cash in the bank
• Rental income from a property
• Income from strategic partnerships like royalty payment receipts
• Income from an advertisement display located on the company's property

Other income is the revenue earned from other activities. Other income could include gains
from the sale of long-term assets such as land, vehicles, or a subsidiary.

Expenses

Primary expenses are incurred during the process of earning revenue from the primary
activity of the business. Expenses include the cost of goods sold (COGS), selling, general and
administrative expenses (SG&A), depreciation or amortization, and research and development
(R&D).

Typical expenses include employee wages, sales commissions, and utilities such as electricity
and transportation.

Expenses that are linked to secondary activities include interest paid on loans or debt. Losses
from the sale of an asset are also recorded as expenses.

The main purpose of the income statement is to convey details of profitability and the financial
results of business activities; however, it can be very effective in showing whether sales or
revenue is increasing when compared over multiple periods.

Investors can also see how well a company's management is controlling expenses to determine
whether a company's efforts in reducing the cost of sales might boost profits over time.

Example of an Income Statement

Below is a portion of ExxonMobil Corporation's income statement for fiscal-year 2021,

reported as of Dec. 31, 2021.

• Total revenue was $276.7 billion.

• Total costs were $254.4 billion.
• Net income or profit was $23 billion.2

5.Cash Flow Statement

The cash flow statement (CFS) measures how well a company generates cash to pay
its debt obligations, fund its operating expenses, and fund investments. The cash flow statement
complements the balance sheet and income statement.

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 The CFS allows investors to understand how a company's operations are running, where
its money is coming from, and how money is being spent. The CFS also provides insight as to
whether a company is on a solid financial footing.

There is no formula, per se, for calculating a cash flow statement. Instead, it contains three
sections that report cash flow for the various activities for which a company uses its cash. Those
three components of the CFS are listed below.

Operating Activities

The operating activities on the CFS include any sources and uses of cash from running the
business and selling its products or services. Cash from operations includes any changes made in
cash accounts receivable, depreciation, inventory, and accounts payable. These transactions also
include wages, income tax payments, interest payments, rent, and cash receipts from the sale of
a product or service.

Investing Activities

Investing activities include any sources and uses of cash from a company's investments in
the long-term future of the company. A purchase or sale of an asset, loans made to vendors or
received from customers, or any payments related to a merger or acquisition is included in this
category.

Also, purchases of fixed assets such as property, plant, and equipment (PPE) are included
in this section. In short, changes in equipment, assets, or investments relate to cash from investing.

Financing Activities

Cash from financing activities includes the sources of cash from investors or banks, as
well as the uses of cash paid to shareholders. Financing activities include debt issuance, equity
issuance, stock repurchases, loans, dividends paid, and repayments of debt.

The cash flow statement reconciles the income statement with the balance sheet in three
major business activities.

Example of a Cash Flow Statement

Below is a portion of ExxonMobil Corporation's cash flow statement for fiscal-year 2021,
reported as of Dec. 31, 2021. We can see the three areas of the cash flow statement and their
results.

• Operating activities generated a positive cash flow of $48 billion.

• Investing activities generated negative cash flow or cash outflows of -$10.2 billion for
the period. Additions to property, plant, and equipment made up the majority of cash
outflows, which means the company invested in new fixed assets.

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 • Financing activities generated negative cash flow or cash outflows of -$35.4 billion for
the period. Reductions in short-term debt and dividends paid out made up the majority of
the cash outflows.3

6.Statement of Changes in Shareholder Equity

The statement of changes in equity tracks total equity over time. This information ties back to a
balance sheet for a same period; the ending balance on the change of equity statement is equal to
the total equity reported on the balance sheet.

The formula for changes to shareholder equity will vary from company to company; in general,
there are a couple of components:

• Beginning equity: this is the equity at the end of the last period that simply rolls to the
start of the next period.
• (+) Net income: this is the amount of income the company earned in a given period. The
proceeds from operations are automatically recognized as equity in the company, and this
income is rolled into retained earnings at year-end.
• (-) Dividends: this is the amount of money that is paid out to shareholders from profits.
Instead of keeping all of a company's profits, the company may choose to give some
profits away to investors.
• (+/-) Other comprehensive income: this is the period-over-period change in other
comprehensive income. Depending on transactions, this figure may be an addition or
subtraction from equity.

In ExxonMobil's statement of changes in equity, the company also records activity for
acquisitions, dispositions, amortization of stock-based awards, and other financial activity. This
information is useful to analyze to determine how much money is being retained by the company
for future growth as opposed to being distributed externally.

7.Statement of Comprehensive Income

An often less utilized financial statement, a statement of comprehensive income

summarizes standard net income while also incorporating changes in other comprehensive
income (OCI). Other comprehensive income includes all unrealized gains and losses that are not
reported on the income statement. This financial statement shows a company's total change
income, even gains and losses that have yet to be recorded in accordance to accounting rules.

Examples of transactions that are reporting on the statement of comprehensive income include:

• Net income (from the statement of income).

• Unrealized gains or losses from debt securities
• Unrealized gains or losses from derivative instruments
• Unrealized translation adjustments due to foreign currency
• Unrealized gains or losses from retirement programs
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In the example below, ExxonMobil has over $2 billion of net unrecognized income. Instead of
reporting just $23.5 billion of net income, ExxonMobil reports nearly $26 billion of total income
when considering other comprehensive income.

8.Nonprofit Financial Statements

Nonprofit organizations record financial transactions across a similar set of financial

statements. However, due to the differences between a for-profit entity and a purely philanthropic
entity, there are differences in the financial statements used. The standard set of financial
statements used for a nonprofit entity include:

• Statement of Financial Position: this is the equivalent of a for-profit entity's balance

sheet. The largest difference is nonprofit entities do not have equity positions; any residual
balances after all assets have been liquidated and liabilities have been satisfied is called
'net assets'.
• Statement of Activities: this is the equivalent of a for-profit entity's statement of income.
This report tracks the changes in operation over time including the reporting of donations,
grants, event revenue, and expenses to make everything happen.
• Statement of Functional Expenses: this is specific to non-profit entities. The statement
of functional expenses reports expenses by entity function (often broken into
administrative, program, or fundraising expenses). This information is distributed to the
public to explain what proportion of company-wide expenses are related directly to the
mission.
• Statement of Cash Flow: this is the equivalent of a for-profit entity's statement of cash
flow. Though the accounts listed may vary due to the different nature of a nonprofit
organization, the statement is still divided into operating, investing, and financing
activities.

Fast Fact

The purpose of an external auditor is to assess whether an entity's financial statement have been
prepared in accordance with prevailing accounting rules and whether there are any material
misstatements impacting the validity of results.

9.Limitations of Financial Statements

Although financial statements provide a wealth of information on a company, they do

have limitations. The statements are open to interpretation, and as a result, investors often draw
vastly different conclusions about a company's financial performance.

For example, some investors might want stock repurchases while other investors might
prefer to see that money invested in long-term assets. A company's debt level might be fine for
one investor while another might have concerns about the level of debt for the company.

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 When analyzing financial statements, it's important to compare multiple periods to
determine if there are any trends as well as compare the company's results to its peers in the same
industry.

Last, financial statements are only as reliable as the information being fed into the reports.
Too often, its been documented that fraudulent financial activity or poor control oversight have
led to misstated financial statements intended to mislead users. Even when analyzing audited
financial statements, there is a level of trust that users must place into the validity of the report
and the figures being shown.

What Are the Main Types of Financial Statements?

The three main types financial statements are the balance sheet, the income statement, and
the cash flow statement. These three statements together show the assets and liabilities of a
business, its revenues and costs, as well as its cash flows from operating, investing, and financing
activities.

What Are the Main Items Shown in Financial Statements?

Depending on the corporation, the line items in a financial statement will differ; however,
the most common line items are revenues, costs of goods sold, taxes, cash, marketable securities,
inventory, short-term debt, long-term debt, accounts receivable, accounts payable, and cash flows
from investing, operating, and financing activities.

What Are the Benefits of Financial Statements?

Financial statements show how a business operates. It provides insight into how much and
how a business generates revenues, what the cost of doing business is, how efficiently it manages
its cash, and what its assets and liabilities are. Financial statements provide all the detail on how
well or poorly a company manages itself.

How Do You Read Financial Statements?

Financial statements are read in several different ways. First, financial statements can be
compared to prior periods to better understand changes over time. For example, comparative
income statements report what a company's income was last year and what a company's income
is this year. Noting the year-over-year change informs users of the financial statements of a
company's health.

Financial statements are also read by comparing the results to competitors or other
industry participants. By comparing financial statements to other companies, analysts can get a
better sense on which companies are performing the best and which are lagging the rest of the
industry.

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What Is GAAP?

Generally Accepted Accounting Principles (GAAP) is the set of rules in which United
States companies must prepare their financial statements. It is the guidelines that explain how to
record transactions, when to recognize revenue, and when expenses must be recognized.
International companies may use a similar but different set of rules called International Financial
Reporting Standards (IFRS).

10.The Bottom Line

Financial statements are the ticket to external evaluation of a company's financial

performance. The balance sheet reports a company's financial health through its liquidity and
solvency, while the income statement reports a company's profitability. A statement of cash flow
tie these two together by tracking sources and uses of cash. Together, financial statements
communicate how a company is doing over time and against its competitors.

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 V. Balance Sheet: Explanation, Components, and Examples

1.What Is a Balance Sheet?

The term balance sheet refers to a financial statement that reports a company's assets,
liabilities, and shareholder equity at a specific point in time. Balance sheets provide the basis for
computing rates of return for investors and evaluating a company's capital structure.

In short, the balance sheet is a financial statement that provides a snapshot of what a company
owns and owes, as well as the amount invested by shareholders. Balance sheets can be used with
other important financial statements to conduct fundamental analysis or calculate financial ratios.

KEY TAKEAWAYS

• A balance sheet is a financial statement that reports a company's assets, liabilities, and
shareholder equity.
• The balance sheet is one of the three core financial statements that are used to evaluate a
business.
• It provides a snapshot of a company's finances (what it owns and owes) as of the date of
publication.
• The balance sheet adheres to an equation that equates assets with the sum of liabilities and
shareholder equity.
• Fundamental analysts use balance sheets to calculate financial ratios.
•
2.How Balance Sheets Work

The balance sheet provides an overview of the state of a company's finances at a moment
in time. It cannot give a sense of the trends playing out over a longer period on its own. For this
reason, the balance sheet should be compared with those of previous periods.1

Investors can get a sense of a company's financial wellbeing by using a number of ratios
that can be derived from a balance sheet, including the debt-to-equity ratio and the acid-test ratio,
along with many others. The income statement and statement of cash flows also provide valuable
context for assessing a company's finances, as do any notes or addenda in an earnings report that
might refer back to the balance sheet.1

The balance sheet adheres to the following accounting equation, with assets on one side,
and liabilities plus shareholder equity on the other, balance out:

Assets=Liabilities+Shareholders’ EquityAssets=Liabilities+Shareholders’ Equity

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 This formula is intuitive. That's because a company has to pay for all the things it owns
(assets) by either borrowing money (taking on liabilities) or taking it from investors (issuing
shareholder equity).

If a company takes out a five-year, $4,000 loan from a bank, its assets (specifically, the
cash account) will increase by $4,000. Its liabilities (specifically, the long-term debt account)
will also increase by $4,000, balancing the two sides of the equation. If the company takes
$8,000 from investors, its assets will increase by that amount, as will its shareholder equity. All
revenues the company generates in excess of its expenses will go into the shareholder equity
account. These revenues will be balanced on the assets side, appearing as cash, investments,
inventory, or other assets.

Balance sheets should also be compared with those of other businesses in the same
industry since different industries have unique approaches to financing.

3.Special Considerations

As noted above, you can find information about assets, liabilities, and shareholder equity
on a company's balance sheet. The assets should always equal the liabilities and shareholder
equity. This means that the balance sheet should always balance, hence the name. If they don't
balance, there may be some problems, including incorrect or misplaced data, inventory or
exchange rate errors, or miscalculations.1

Each category consists of several smaller accounts that break down the specifics of a
company's finances. These accounts vary widely by industry, and the same terms can have
different implications depending on the nature of the business. But there are a few common
components that investors are likely to come across.

4.Components of a Balance Sheet

Assets

Accounts within this segment are listed from top to bottom in order of their liquidity. This is the
ease with which they can be converted into cash. They are divided into current assets, which can
be converted to cash in one year or less; and non-current or long-term assets, which cannot.

Here is the general order of accounts within current assets:

• Cash and cash equivalents are the most liquid assets and can include Treasury bills and short-
term cer�ficates of deposit, as well as hard currency.
• Marketable securi�es are equity and debt securi�es for which there is a liquid market.

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 • Accounts receivable (AR) refer to money that customers owe the company. This may include an
allowance for doub�ul accounts as some customers may not pay what they owe.
• Inventory refers to any goods available for sale, valued at the lower of the cost or market price.
• Prepaid expenses represent the value that has already been paid for, such as insurance,
adver�sing contracts, or rent.

Long-term assets include the following:

• Long-term investments are securi�es that will not or cannot be liquidated in the next year.
• Fixed assets include land, machinery, equipment, buildings, and other durable, generally capital-
intensive assets.
• Intangible assets include non-physical (but s�ll valuable) assets such as intellectual property and
goodwill. These assets are generally only listed on the balance sheet if they are acquired, rather
than developed in-house. Their value may thus be wildly understated (by not including a globally
recognized logo, for example) or just as wildly overstated.

Liabilities

A liability is any money that a company owes to outside parties, from bills it has to pay to
suppliers to interest on bonds issued to creditors to rent, utilities and salaries. Current liabilities
are due within one year and are listed in order of their due date. Long-term liabilities, on the
other hand, are due at any point after one year.

Current liabilities accounts might include:

• Current por�on of long-term debt is the por�on of a long-term debt due within the next 12
months. For example, if a company has a 10 years le� on a loan to pay for its warehouse, 1 year
is a current liability and 9 years is a long-term liability.
• Interest payable is accumulated interest owed, o�en due as part of a past-due obliga�on such as
late remitance on property taxes.
• Wages payable is salaries, wages, and benefits to employees, o�en for the most recent pay
period.
• Customer prepayments is money received by a customer before the service has been provided
or product delivered. The company has an obliga�on to (a) provide that good or service or (b)
return the customer's money.
• Dividends payable is dividends that have been authorized for payment but have not yet been
issued.
• Earned and unearned premiums is similar to prepayments in that a company has received
money upfront, has not yet executed on their por�on of an agreement, and must return
unearned cash if they fail to execute.
• Accounts payable is o�en the most common current liability. Accounts payable is debt
obliga�ons on invoices processed as part of the opera�on of a business that are o�en due within
30 days of receipt.

Long-term liabilities can include:

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 • Long-term debt includes any interest and principal on bonds issued
• Pension fund liability refers to the money a company is required to pay into its employees'
re�rement accounts
• Deferred tax liability is the amount of taxes that accrued but will not be paid for another year.
Besides �ming, this figure reconciles differences between requirements for financial
repor�ng and the way tax is assessed, such as deprecia�on calcula�ons.

Some liabilities are considered off the balance sheet, meaning they do not appear on the
balance sheet.

Shareholder Equity

Shareholder equity is the money attributable to the owners of a business or its shareholders. It
is also known as net assets since it is equivalent to the total assets of a company minus its
liabilities or the debt it owes to non-shareholders.

Retained earnings are the net earnings a company either reinvests in the business or uses to
pay off debt. The remaining amount is distributed to shareholders in the form of dividends.

Treasury stock is the stock a company has repurchased. It can be sold at a later date to raise
cash or reserved to repel a hostile takeover.

Some companies issue preferred stock, which will be listed separately from common
stock under this section. Preferred stock is assigned an arbitrary par value (as is common stock,
in some cases) that has no bearing on the market value of the shares. The common stock and
preferred stock accounts are calculated by multiplying the par value by the number of shares
issued.

Additional paid-in capital or capital surplus represents the amount shareholders have invested
in excess of the common or preferred stock accounts, which are based on par value rather than
market price. Shareholder equity is not directly related to a company's market capitalization. The
latter is based on the current price of a stock, while paid-in capital is the sum of the equity that
has been purchased at any price.

Par value is often just a very small amount, such as $0.01.2

5.Importance of a Balance Sheet

Regardless of the size of a company or industry in which it operates, there are many
benefits of a balance sheet,

Balance sheets determine risk. This financial statement lists everything a company owns
and all of its debt. A company will be able to quickly assess whether it has borrowed too much
money, whether the assets it owns are not liquid enough, or whether it has enough cash on hand
to meet current demands.

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 Balance sheets are also used to secure capital. A company usually must provide a balance
sheet to a lender in order to secure a business loan. A company must also usually provide a
balance sheet to private investors when attempting to secure private equity funding. In both
cases, the external party wants to assess the financial health of a company, the creditworthiness
of the business, and whether the company will be able to repay its short-term debts.

Managers can opt to use financial ratios to measure the liquidity, profitability, solvency,
and cadence (turnover) of a company using financial ratios, and some financial ratios need
numbers taken from the balance sheet. When analyzed over time or comparatively against
competing companies, managers can better understand ways to improve the financial health of a
company.

Last, balance sheets can lure and retain talent. Employees usually prefer knowing their
jobs are secure and that the company they are working for is in good health. For public
companies that must disclose their balance sheet, this requirement gives employees a chance to
review how much cash the company has on hand, whether the company is making smart
decisions when managing debt, and whether they feel the company's financial health is in line
with what they expect from their employer.

6.Limitations of a Balance Sheet

Although the balance sheet is an invaluable piece of information for investors and analysts, there
are some drawbacks. Because it is static, many financial ratios draw on data included in both the
balance sheet and the more dynamic income statement and statement of cash flows to paint a
fuller picture of what's going on with a company's business. For this reason, a balance alone may
not paint the full picture of a company's financial health.

A balance sheet is limited due its narrow scope of timing. The financial statement only
captures the financial position of a company on a specific day. Looking at a single balance sheet
by itself may make it difficult to extract whether a company is performing well. For example,
imagine a company reports $1,000,000 of cash on hand at the end of the month. Without context,
a comparative point, knowledge of its previous cash balance, and an understanding of industry
operating demands, knowing how much cash on hand a company has yields limited value.

Different accounting systems and ways of dealing with depreciation and inventories will
also change the figures posted to a balance sheet. Because of this, managers have some ability to
game the numbers to look more favorable. Pay attention to the balance sheet's footnotes in order
to determine which systems are being used in their accounting and to look out for red flags.

Last, a balance sheet is subject to several areas of professional judgement that may
materially impact the report. For example, accounts receivable must be continually assessed for
impairment and adjusted to reflect potential uncollectible accounts. Without knowing which
receivables a company is likely to actually receive, a company must make estimates and reflect
their best guess as part of the balance sheet.

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7.Example of a Balance Sheet

The image below is an example of a comparative balance sheet of Apple, Inc. This
balance sheet compares the financial position of the company as of September 2020 to the
financial position of the company from the year prior.

In this example, Apple's total assets of $323.8 billion is segregated towards the top of the
report. This asset section is broken into current assets and non-current assets, and each of these
categories is broken into more specific accounts. A brief review of Apple's assets shows that
their cash on hand decreased, yet their non-current assets increased.

This balance sheet also reports Apple's liabilities and equity, each with its own section in
the lower half of the report. The liabilities section is broken out similarly as the assets section,
with current liabilities and non-current liabilities reporting balances by account. The total
shareholder's equity section reports common stock value, retained earnings, and accumulated
other comprehensive income. Apple's total liabilities increased, total equity decreased, and the
combination of the two reconcile to the company's total assets.

8.Why Is a Balance Sheet Important?

The balance sheet is an essential tool used by executives, investors, analysts, and
regulators to understand the current financial health of a business. It is generally used alongside
the two other types of financial statements: the income statement and the cash flow statement.

Balance sheets allow the user to get an at-a-glance view of the assets and liabilities of the
company. The balance sheet can help users answer questions such as whether the company has a
positive net worth, whether it has enough cash and short-term assets to cover its obligations, and
whether the company is highly indebted relative to its peers.

9.What Is Included in the Balance Sheet?

The balance sheet includes information about a company’s assets and liabilities. Depending on
the company, this might include short-term assets, such as cash and accounts receivable, or long-
term assets such as property, plant, and equipment (PP&E). Likewise, its liabilities may include
short-term obligations such as accounts payable and wages payable, or long-term liabilities such
as bank loans and other debt obligations.

10.Who Prepares the Balance Sheet?

Depending on the company, different parties may be responsible for preparing the
balance sheet. For small privately-held businesses, the balance sheet might be prepared by the
owner or by a company bookkeeper. For mid-size private firms, they might be prepared
internally and then looked over by an external accountant.

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 Public companies, on the other hand, are required to obtain external audits by public
accountants, and must also ensure that their books are kept to a much higher standard. The
balance sheets and other financial statements of these companies must be prepared in accordance
with Generally Accepted Accounting Principles (GAAP) and must be filed regularly with
the Securities and Exchange Commission (SEC).3

11.What Are the Uses of a Balance Sheet?

A balance sheet explains the financial position of a company at a specific point in time.
As opposed to an income statement which reports financial information over a period of time, a
balance sheet is used to determine the health of a company on a specific day.

A bank statement is often used by parties outside of a company to gauge the company's
health. Banks, lenders, and other institutions may calculate financial ratios off of the balance
sheet balances to gauge how much risk a company carries, how liquid its assets are, and how
likely the company will remain solvent.

A company can use its balance sheet to craft internal decisions, though the information
presented is usually not as helpful as an income statement. A company may look at its balance
sheet to measure risk, make sure it has enough cash on hand, and evaluate how it wants to raise
more capital (through debt or equity).

14.What Is the Balance Sheet Formula?

A balance sheet is calculated by balancing a company's assets with its liabilities and
equity. The formula is: total assets = total liabilities + total equity.

Total assets is calculated as the sum of all short-term, long-term, and other assets. Total
liabilities is calculated as the sum of all short-term, long-term and other liabilities. Total equity is
calculated as the sum of net income, retained earnings, owner contributions, and share of stock
issued.

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