A balance sheet is a snapshot of what a company owns and owes on a single date. Assets equal liabilities plus shareholders' equity, always. The income statement tells you how a year went and the balance sheet tells you whether the company can survive the next one.
Why it is the survival statement
Profit is about performance. The balance sheet is about endurance. Companies rarely fail because they stopped being profitable; they fail because an obligation came due and the money was not there. Everything that decides whether a bad year is survivable sits here.
It is also a snapshot rather than a period, taken on one date. A company can arrange its affairs to look stronger on that date than it was the week before, which is why the direction across several years carries more information than any single one.
The five steps
Check whether the company can pay its bills
Start with current assets against current liabilities. The current ratio divides one by the other, and anything comfortably above 1.0 means near-term obligations are covered. Below 1.0 is not automatically a problem, since supermarkets and subscription businesses routinely run negative working capital because customers pay before suppliers do, but it needs an explanation you can name.
Read the debt, and when it comes due
Total debt matters less than its timing and cost. Find the maturity schedule in the notes: debt due within two years in a business with weak cash generation is a different risk from the same amount due in a decade. Then check interest coverage, operating profit divided by interest expense, where above 5x is comfortable and below 2x means lenders are effectively in control.
Find out what the assets actually are
Total assets is a number without meaning until you see the composition. Cash and receivables are real. Property and equipment are usually real. Goodwill is the premium paid over fair value in past acquisitions, and it is a record of what management spent rather than anything that can be sold. When goodwill is a large share of assets, past acquisitions are much of the balance sheet.
Compare equity to what the company has actually earned
Shareholders' equity is assets minus liabilities. Inside it, retained earnings shows cumulative profit kept rather than paid out. A company with large equity but small retained earnings has been funded by issuing stock rather than by earning money, which tells you where the value came from.
Watch the direction over five years
One balance sheet is a photograph. Five is a story. Rising debt alongside flat operating profit, goodwill growing faster than revenue, or receivables growing faster than sales are all patterns invisible in a single year and obvious across several. The direction is the finding.
Worked example
A company reports $900M of current assets, $600M of current liabilities, $1,400M of total debt, $350M of operating profit and $70M of interest expense.
Current ratio = $900M ÷ $600M = 1.5×
Interest coverage = $350M ÷ $70M = 5.0×
Debt to operating profit = $1,400M ÷ $350M = 4.0×
Near-term bills are covered and interest is comfortably earned. Four years of operating profit to repay all debt is manageable for a stable business and heavy for a cyclical one, which is the judgement the ratios hand back to you.
Three things that hide off the balance sheet
- Operating leases now largely appear, following accounting changes, but the older history you are comparing against may not include them. Check whether a jump in debt is a real change or an accounting one.
- Pension obligations sit in the notes and can be very large for older industrial companies. The balance sheet number depends on assumed return rates that are themselves estimates.
- Commitments and contingencies, meaning litigation, guarantees and purchase obligations, appear only in the notes. They are the least read part of a filing and occasionally the most important.
What good looks like by phase
Expectations should move with the lifecycle phase. A hyper-growth company burning cash should hold plenty of it and carry little debt, because it cannot service borrowing from profits it does not have. A capital-return company can carry meaningful debt safely, since its cash flows are predictable enough to cover it. A company in decline with rising debt is the combination that ends badly, and it is visible here years before it is announced.
Judge the balance sheet against the phase
Heavy debt is reckless in hyper growth and routine in capital return. Phase Check reads any US-listed company's financials, places it on the lifecycle, and names what to judge management on there.
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Frequently asked questions
Related
- How to read an income statement, the performance side of the same company
- How to read a cash flow statement, where the cash actually moved
- Working capital, the balance sheet lines that move with trading
- How to analyze a stock, the seven-step framework all three feed