Reading a balance sheet
The balance sheet shows what a company owns and how it's financed. Four line items are enough for a first impression: assets, debt, equity, and cash.
A balance sheet has two sides, always equal in size. The left shows what the company owns. The right shows who it belongs to: partly creditors, as debt, partly owners, as equity.
Four numbers are enough for a first impression. How large is equity relative to total assets? How much cash is there? How much debt is there? And how much of it is due next year?
A high equity ratio means the company can weather a bad stretch without depending on lenders. A low one means the opposite, which boosts returns in good times and turns dangerous in bad ones.
Two things aren't on the balance sheet and still matter: profit, which sits in the income statement. And actual cash flow, which sits in the cash flow statement. Only together do the three give you a picture.
The balance sheet equation is assets equal liabilities plus equity. For judging resilience, maturity structure matters alongside the equity ratio: short-term liabilities need to be compared against short-term available assets, expressed in metrics like the liquidity ratio.
The leverage ratio, net debt to operating earnings before depreciation, indicates how many years of operating income would be needed to repay it. It needs to be judged relative to industry: capital-intensive businesses with stable earnings can carry higher values than cyclical ones with volatile earnings.
The distinction between earnings and cash flow matters a great deal. Reported earnings include non-period and non-cash components and are subject to valuation discretion. Operating cash flow leaves less room for manipulation. A persistent gap between the two, especially earnings well above operating cash flow, is a well-established warning sign and was visible early in several known accounting scandals.
Summary
- Equity ratio shows how well a company survives hard times.
- Maturity matters more than the raw amount of debt.
- Earnings well above operating cash flow is a warning sign.
Did you get it?
What's the balance sheet equation?
Assets equal liabilities plus equity. Both sides are always equal.
Why isn't the amount of debt alone enough?
Because maturity matters. Short-term liabilities need to be matched against short-term available assets.
What's a well-established warning sign in the numbers?
Reported earnings persistently and substantially above operating cash flow.
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