How to use fundamental analysis when reviewing corporate balance sheets.

Fundamental Investment Analysis is about diagnosing a company’s current state of health. It’s one of the basic keys to understanding if a company is in a strong or weak fiscal position; whether its business is growing or declining; and whether it is well or poorly positioned relative to its competitors. Fundamental analysis is particularly important in helping to understand whether or not a company is fairly valued through its stock price, and if the long term prospects of a company are positive or negative. At its heart, fundamental analysis is about understanding financial statements such as the balance sheet, properly reading an income statement and analyzing a company’s cash flow. Using this information as a foundation, you will then be in a better position to assess the overall health of a company and its valuation in the market.

Public companies issue a series of interrelated financial statements to the investing public. These statements provide a wealth of information about the company’s ongoing revenues, profitability, expense levels, cash position, available cash flows and indebtedness. All of this information helps to inform an investor about a company’s health relative to its competitors. However, to reach these conclusions, an investor must first know how to read and make sense of a balance sheet and income statement as well as perform a cash flow statement analysis. Here are a few tips on parsing one of the most important statements, the balance sheet.

The following screenshot shows a sample balance sheet for Caterpillar (NYSE:CAT). This sample covers 2003 through 2007. TradeKing clients can access this and other balance sheets under Quotes + Research > Financials. Simply enter the ticker symbol you want from there.

Balance sheets can usually be evaluated in two halves, on the left side are assets and on the right side are liabilities and shareholder equity. (The screenshot formats these differently: assets are on top, liabilities in the middle and Shareholders’ Equity at bottom.)

The Assets section covers the company’s various resources and their current worth— items like Cash & Short Term Investments, Receivables, Inventory, Prepaid Expenses and Property, Plant and Equipment.. Current Assets — Total is a category of assets that can be quickly converted into cash, with the largest item typically made up of Customer Receivables and Inventory. Long-term assets are the next big item and includes assets likeProperty, Plant & Equipment, which depreciate or drop in value over time, and other assets with longer life spans.

Liabilities (see above) include all obligations the firm made to outside parties. These outside parties — also known as creditors — hold no equity ownership stake in the company, but they may have lent money or supplies to the company and expect repayment. The obligation on behalf of the company to re-pay these debts are known as liabilities.

Items included under Liabilities include Accounts Payable, Income Taxes Payable, Accrued Payroll, Other Accruals and Payables and Debt.. Like Current Assets, Short-Term Current Liabilities are listed separately from Long term Liabilities.

Assets and Liabilities should balance mathematically with each other; that’s where the name balance sheet comes from. CAT’s balance sheet above shows $54,579 million in assets, but only $45,696 in liabilities. The difference, $8,883 million, has to be accounted for before the sheet is truly balanced.

That’s where Shareholders’ Equity comes in. Notice that CAT’s Common Equity is exactly $8,883 million — the difference between Assets and Liabilities, calculated above. Equity refers to capital obtained from sources other than creditors. These sources include Paid in Capital, which refers to monies investors paid the company to buy shares of stock, either during the IPO or from any subsequent sales of new stock.

However, it’s another figure, Retained Earnings, that makes all the figures balance. This figure refers to income that has been kept (retained) by the company over the years and either reinvested into the business or held in cash reserves.

CAT’s Retained Earnings were $17,398 million in 2007. Put another way, this means CAT has re-invested over $17 billion back into the business over the years, making the company more valuable. Retained Earnings are typically growing in a healthy company and shrinking in an unhealthy one. Although there may be certain situations, such as in a young fast-growing company, where a company needs more capital than it’s generating through operations to support its growth. In this case, negative retained earnings may be perfectly okay.

A balance sheet alone offers an incomplete picture of a business — but when it’s combined with the company’s income and the cash flow statements, a more accurate picture of what’s going on in the company emerges. Understanding the company’s lifeblood in fundamentals can be a key to successful investing.

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