Reading a balance sheet
The balance sheet shows what a company owns and how it paid for it. For a first impression, four items are enough: assets, debt, equity and cash.
Learning objective: After this lesson you can read and interpret the four most important items on a balance sheet.
A balance sheet has two sides that are always the same size. On the left is what the company owns: machines, buildings, stock, cash. On the right is who it belongs to: partly lenders as debt, partly the owners as equity.
Four First Questions
For a first impression four questions are enough. How high is equity compared with total assets? How much cash is there? How high is the debt? And how much of it has to be repaid next year?
Interpreting the Equity Ratio
A high equity ratio means the company can get through a bad period without depending on banks. A low one means the opposite. In good times that brings a higher return on equity, in bad times it becomes dangerous.
What the Balance Sheet Leaves Out
Two important things aren't on the balance sheet. Profit is in the income statement. And how much money actually came in and went out is in the cash flow statement. Only all three together give a picture.
Reading a balance sheet step by step
Berger Woodworks doesn't exist. Its figures are made up and rounded for practice, all amounts in millions of euros.
| Item | € million |
|---|---|
| Machinery and buildings | 60 |
| Inventory | 15 |
| Money owed by customers | 15 |
| Cash | 10 |
| Total | 100 |
| Item | € million |
|---|---|
| Equity | 40 |
| Bank loans, long term | 35 |
| Bank loans due next year | 10 |
| Unpaid supplier invoices | 15 |
| Total | 100 |
- Compare the totals. Both sides add up to 100 million. If they don't, you've misread something, because a balance sheet always balances.
- Work out the equity ratio. 40 of the 100 million belong to the owners, which is 40 percent. Berger could lose a lot of its assets before its lenders have to worry about their money.
- Check what falls due soon. Next year Berger has to pay 25 million, 10 to the bank and 15 to suppliers. Against that stand 40 million that turn into cash quickly, namely inventory, receivables and cash. That's comfortably enough. Cash alone, though, would only cover 10 of the 25 million.
- Look at net debt. Berger owes the bank 45 million and has 10 in its account. That leaves 35 million net. If the company earns 14 million a year before interest, taxes and depreciation, it would take two and a half years on paper to pay this debt off. The 14 million come from the income statement.
- Compare with the previous year. A single balance sheet is a snapshot. If the equity ratio was 45 percent last year and is 40 now, it's worth asking why. A new loan for a factory hall can make sense. Losses eating into equity are a bad sign.
After these five steps you know whether Berger is soundly financed. Whether it also earns good money is covered in the lesson Skimming an annual report.
The basic rule of the balance sheet is: assets equal debt plus equity. To judge how resilient a company is, what matters besides the equity ratio is above all when the debts fall due. What has to be repaid soon should be covered by assets that can be turned into cash soon. Figures like the liquidity ratio express that.
Debt and EBITDA
A common figure compares net debt with operating profit before depreciation, EBITDA. It says roughly how many years the company would need to repay its debt from ongoing business. What counts as a good value depends on the industry. A power grid operator with very stable income can carry more debt than a car parts supplier whose profits swing with the economy.
Profit Versus Cash Flow
The difference between profit and cash flow is very important. Reported profit contains items where no money changed hands, and the company has leeway in valuing things. Cash flow from ongoing business is harder to dress up. If profit is well above cash flow for years, that's a well known warning sign. With Wirecard, for example, it could be seen long before the collapse in 2020.
Summary
- The equity ratio shows how well a company gets through bad times.
- When debts fall due matters more than how big they are.
- Profit persistently above cash flow is a warning sign.
Did you get it?
What's the basic rule of the balance sheet?
Assets equal debt plus equity. Both sides are always the same size.
Why isn't the amount of debt alone enough?
Because what matters is when it falls due. What's due soon must be covered by assets available soon.
What warning sign can you spot in the figures?
Reported profit that stays well above cash flow from ongoing business for years.
How do you read a balance sheet step by step?
First compare the totals of both sides, then work out the equity ratio. After that, check what falls due next year, look at net debt and finally compare everything with the previous year.
Check your understanding
Your task
An invented company has $80 million in total assets, $20 million in equity, $12 million in cash and $15 million of debt due next year. Calculate the equity ratio and write down whether the cash covers the debt that is due. Then answer the same questions for the balance sheet of a company of your choice.