A disturbing reality about financial statements is that they are inherently inaccurate and incomplete. Fundamental investors are told to apply a series of popular balance sheet ratios to test working capital and financial strength. Observing trends in the current ratio and debt ratio, for example, reveal the status of rising, falling, or unchanging degrees of financial control.
All of those tests are valuable. However, the balance sheet is not a complete report of a company's assets, liabilities or net worth. On the liability side, accounts are broken down into two major categories: First are the current liabilities, debts that have to be paid within 12 months. These include 12 months of debt service on longer-term notes as well as accounts and taxes payable. Second are long-term liabilities, the obligations of the company beyond the next 12 months. These accounts include long-term debts and bonds issued.
A lot of significant obligations are left off of the balance sheet, however. Even with a thorough audit, these important matters are found buried in the lengthy and complicated footnotes, and their real meaning may also be cloaked behind technical language that is difficult to decipher.
Two examples: contingent liabilities and contractual agreements are not shown on the list of liabilities.
A contingent liability is a possible debt that has not yet been realized but could come to pass in the future. So if a lawsuit has been filed against a company seeking $80 million in damages, it is not a liability. But if the case is won by the plaintiffs, it becomes a liability. This contingency is not included on the balance sheet, but is disclosed in the footnotes.
A contractual agreement may include leases on autos and trucks, or even very long-term leases on occupied buildings and warehouses. Even though these obligations can run into the millions, they do not show up under current or long-term liabilities. You have to search through the footnotes to find them. They are very real obligations, but under the accounting rules they are simply not listed on the balance sheet.
To truly judge a company's financial and working capital strength, you need to understand both continent liabilities and contractual obligations currently known by the company. The footnotes disclose all of these and require some selective reading. You do not need an accounting degree to understand what these notes reveal … but it helps. Everyone can at the very least identify contingencies and obligations that are not included on the balance sheet, with a little investigative analysis. This is one of many ways to ensure accurate comparisons between two or more companies you are considering as investment possibilities.
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