Assets: What the company owns.

Liabilities: What the company owes.

Shareholder's Equity: Essentially the "net worth" of the company.

If you think about the divisions in terms of personal finance, assets are all the things you own, like your house, car, bass boat, stocks or collection of Lady Di commemorative china plates.

Your liabilities are any loans you have outstanding, like your mortgage, credit cards or that 10 bucks you owe your buddy for lunch last week.

The difference between your assets and liabilities is your net worth, or whatever is left after you sell all your stuff and pay off all of your debt.

The format reflects the condition that the two sides of the balance sheet must equal each other. Or, as every accountant has tattooed on the backs of their eyelids:

Assets = Liabilities + Shareholder's Equity

Sources of Data

Getting balance sheets for your favorite companies is like finding bagels in Manhattan -- people will practically throw them at you. If you don't feel like ordering a free annual report or financial statement from the firm's investor-relations department, just log on to FreeEdgar . Not only does the site sport up-to-date figures straight from the SEC, it offers a really slick free optional plug-in that allows you to download reports directly into your Excel spreadsheet for further analysis (something that'll come in handy later).

Just look for the 10-K (annual financials) or 10-Q (for the most recent quarter). Usually, balance sheets only list two years' worth of data, so download two or three reports from past years to give some meaningful trend information for comparison. For my examples, I'll be using Anheuser Busch (BUD:NYSE - news), a fairly predictable blue-chip with a simple product line -- beer. So I downloaded the '97 and '95 10-Ks to get four years of stats.

Overview

Assets are listed in descending order of liquidity (cash first, buildings and machinery last). The same goes for liabilities (accounts payable first with long-term debt bringing up the rear). Anything collectible in the short term (usually under one year) is considered a "current" asset, while anything owed by the company in the same time frame is a current liability.

You can tell a lot about the makeup of a company just by thinking logically about the numbers as a whole (a classic B-school hazing ritual includes figuring out the industry of an anonymous company just by studying the balance sheet). A brief tour of BUD's financial structure shows that its "Plant and Equipment" accounts for a whopping $7.75 billion of the $11.72 billion in total assets.

This makes sense since canning 80 million barrels of fermented grain per year requires some pretty big vats and not much else. A bank, on the other hand, will probably show outstanding loans as its biggest asset, while a mail-order computer reseller might show high product inventories. The bottom line is that the assets should fit with the company's business. If something seems out of whack, compare it with other firms in the same industry to see what's going on.

Next, check to see how the assets are financed (or "capitalized") by looking at the right side of the balance sheet -- the liabilities and shareholder equity section. In BUD's case, long-term debt in the form of bonds makes up a fairly substantial part of the firm's capitalization, at around $4 billion. Since the risk on hard assets like buildings and machinery is relatively low and their lifetimes are long, borrowing money from bond investors for, say, 30 years is an inexpensive way for the company to pay off the assets throughout their productive life. Again, a good fit.

On the other hand, if a company finances substantial long-term assets with mostly short-term debt, watch out. A one-year bond might seem like a good deal for the company at, say, 5% interest, but if conditions change and it's forced to renew the loan at 7% next year, those extra interest payments could easily total in the millions for a big loan.

Since you can't just pawn off $1 billion worth of brewing equipment at your corner flea market, those increased loan payments could financially strap the company and land it in bankruptcy faster than you can say rate hike. Long-term bonds, on the other hand, may seem more expensive at first, but the rate is locked in over a long time frame, so they're a much more predictable liability -- perfect for financing big, illiquid assets.

Working Capital and the Current Ratio

When you pay your phone bill or buy a hot dog, you do it with money that you've got on hand to meet living expenses. The same goes for corporations. The current liabilities of a company (like accounts payable and short-term loans) get paid with current assets (like cash, or accounts receivable). The difference between the ready funds of a company (current assets) and what they owe in the short-term (current liabilities) is called "net working capital."

Just like your own personal savings cushion, the amount of net working capital that a company employs largely determines its ability to pay bills, meet payroll, finance growth of operations and capitalize on new opportunities. Companies that fail to keep an adequate buffer are like folks that constantly overspend and rack up credit card bills they have no hope of paying off. Sooner or later, the situation catches up with them and they've got armed goons on their doorstep repossessing the TV -- not exactly a situation that makes for a profitable investment.

So how big of a cushion is enough? First, divide the total current assets by the current liabilities to get the "current asset ratio." Most pundits claim that a ratio of 2.0 (twice as many current assets as current liabilities) is a good benchmark, but it depends on the business. High-growth companies need a larger cushion to finance rapid expansion, while big, established firms can get away with less.

BUD rings in at a scant 1.06 compared with its competitor, Coors (ACCOB:Nasdaq - news), at 1.44. This difference could be an indicator of BUD's future growth prospects -- or lack thereof -- since they don't really have the free bucks needed to go on a major shopping spree and expand operations into new markets.

But more importantly, take a look at the current ratio trend over time. (This is one place where an Excel spreadsheet can facilitate your analysis.) A low, but stable current ratio like BUD's is less of a problem than a sharply declining ratio that might signal either unsustainable growth or a deteriorating business. Both conditions are serious red flags for any investor.

Price-to-Book Value

In accounting terms, assets are recorded on the balance sheet at "book value" (the original cost of an asset minus any depreciation over time). Although the figures don't always match with the actual market value of a particular asset at a given time, the book value of a firm is often used to give a baseline worth if a company were simply liquidated and the pieces sold off.

This book value is pretty much synonymous with shareholder's equity and is totaled up for you on the bottom of the balance sheet. In BUD's case, the book value was $4.04 billion in 1997.

Next, find the number of shares outstanding by pulling the figure out of the financial footnotes (often listed under separate tables on FreeEdgar), or just cheat and look it up on RapidResearch.com . Dividing BUD's book value by the number of shares outstanding at 487 million, we get a book value per share of $8.30.

Right away, you're probably thinking, "Hey, that's way less than the market price of the stock on the Big Board in the high 40s," and you're 100% correct. The excess above market price is viewed as the amount management has increased the value of the company through prudent deployment of its assets, and can vary greatly across industries.

Generally, however, the lower the price-to-book value relative to the rest of the industry, the greater the stock's growth potential if the existing management gets replaced or gets whipped into shape, and the greater the likelihood the firm will get bought out by a competitor. Both are potentially positive events for shareholders.

To compare book values of different firms, first divide the market price of the stock by the book value per share to get the price-to-book ratio. In BUD's case, the number was 5.3 at the end of '97 compared with Coors, at a measly 1.66. And BUD's figure is twice as high as the industry average, according to RapidResearch.com. So far, BUD isn't shaping up to look like much of a value compared to other alternatives.

Debt-to-Equity Ratio

Dividing the amount of long-term debt of a firm by its shareholder's equity yields the debt-to-equity ratio, which gives some insight into how the firm is capitalized. Again, the figure can vary greatly across industries. Because interest payments on bonds are tax deductible to the corporation while dividends to shareholders are fully taxed, companies have an incentive to carry at least some debt on their books.

However, getting overloaded with debt reduces management's flexibility and increases the risk to shareholders. Companies way above the industry debt average might be a source of concern while those well below might be buying opportunities.

BUD had a debt-to-equity ratio of 1.08 at the end of 1997 ($4.37 billion in long-term debt divided by $4.04 billion in shareholder's equity), well above the industry average and competitor Coors, at 0.20. Some ardent value-oriented investors -- including Ben Graham, co-author of the now classic Securities Analysis -- say to avoid any stocks with a debt-to-equity ratio above 1.0. The basic belief is that it's not prudent to owe more than you own.

Summary

The beginner's trip through the balance sheet might look something like this:

Overview: Does the overall financial structure of the company make sense for its industry? If not, compare it to other companies to find out what's going on.

Current Ratio: Over 2.0 or in line with industry averages and stable over time gets a thumbs up; relatively low and declining gets a big thumbs down.

Price-to-Book Value: In line with the industry average is neutral; significantly higher suggests the stock is overvalued; significantly lower (or even less than 1.0) indicates an undervalued opportunity.

Debt-to-Equity Ratio: Strict value adherents only buy companies with a ratio under 1.0; others are content if the figure is within industry averages.
By now, a basic picture of how fundamental analysts evaluate the structure of a company should be starting to emerge. If it seems just as much art as it is science, you're getting the point.

The work is hard, but the rewards are substantial -- both personally, in terms of broadening your own foundation of investment knowledge, and financially, when you discover the next market gem based on solid facts and diligent research. (OK, that might sound a little highfalutin, but I'm trying to keep your interest!)

In the next part, we'll dissect the income statement, where we use earnings to answer the central question of fundamental analysis: What's a company really worth?