Reading the Balance Sheet

When you buy a stock, you become part-owner of a business. So it makes sense to look at what that business owns and whom it owes money to. That’s exactly what the balance sheet shows. It looks dry at first glance, but it tells a surprising amount – above all about whether a company can survive a crisis.

Three statements, one company#

Public companies regularly publish three core financial statements – in the US in their annual report (Form 10-K) and quarterly reports (Form 10-Q), available free on the SEC’s EDGAR database and every company’s investor relations site:

1. The balance sheet: what does the company own and owe, on a given date?
2. The income statement: how much did it earn over a period?
3. The cash flow statement: how much cash actually came in and went out?

This lesson covers the balance sheet; the next covers the other two.

The structure: two sides that always match#

A balance sheet has two sides. One lists what the company owns – its assets. The other shows how those assets were financed – with liabilities (debt and other obligations) or with shareholders’ equity. Both sides are always exactly equal, because every asset was either paid for with borrowed money or with owners’ money.

The asset side#

• Non-current assets serve the business for years: buildings, machines, vehicles, and intangibles such as software, patents, licences and brands – if they were bought. A special item is goodwill, more on that below.
• Current assets usually turn into cash within a year: inventory, receivables (bills customers haven’t paid yet) and cash.

The financing side#

• Shareholders' equity: money shareholders paid in plus all profits retained over the years. On paper, it belongs to the owners.
• Long-term liabilities: bonds, long-term loans, pension obligations, lease liabilities.
• Current liabilities: supplier bills, short-term debt, taxes owed – everything due within a year.

Key measures#

Equity ratio#

Example Corp has 400 ÷ 1,000 = 40%. The higher it is, the more cushion a company has to absorb losses. What counts as “good” depends heavily on the industry: software companies need few assets, utilities and real estate companies traditionally use a lot of debt, and banks run with very little equity relative to their balance sheet.

Net debt#

Net debt shows how much debt would remain if the company used its cash to pay it down. It’s most telling relative to operating profit: net debt above three to four times EBITDA is considered high in many industries. Companies with more cash than debt have net cash.

Short-term liquidity#

The current ratio compares current assets with current liabilities. For Example Corp: 400 ÷ 250 = 1.6. A value well below 1 can mean a company will struggle to pay its bills – unless its business model collects cash from customers before paying suppliers, as many retailers do.

Goodwill: the premium paid for acquisitions#

If a company buys another for $1 billion whose book equity is only $400 million, it pays a $600 million premium – for brands, customer relationships, know-how and expected synergies. That premium sits on the balance sheet as goodwill.

Goodwill isn’t cash or a building, it’s a hope. If expectations aren’t met, it must be written down. Big goodwill impairments are usually a late admission that a deal was overpriced.

Book value vs. market value#

Equity on the balance sheet is also called book value. It’s largely based on historical purchase prices minus depreciation. Market value – the market capitalisation – reflects what investors will pay for future profits.

For technology and brand-driven companies, market value is often ten times book value or more, because their most important assets – self-built software, a strong brand, network effects – don’t appear on the balance sheet at all. For banks or industrial firms in trouble, market value can fall below book. The ratio of the two is the price-to-book ratio, covered in the valuation lesson.

Warning signs#

Summary#

The balance sheet shows what a company owns and how it’s financed. Equity is the difference between assets and liabilities. The equity ratio, net debt and short-term liquidity reveal how resilient a company is. Goodwill is paid-for hope, and book value isn’t market value. The next lesson looks at how much a company earns – and how much of that arrives as actual cash.