A Balance Sheet is one of the fundamental financial statements of a company, also known as the “Statement of Financial Position”. It is comparable to the “Net Worth” of the business and represents a snapshot of the assets, liabilities, and shareholder’s equity at a particular point in time. The Balance Sheet is the most critical statement when assessing the financial well-being of a business in terms of debt, cash, financial strength, and durability.

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What is the Balance Sheet?

The Balance Sheet provides a snapshot of a business’s overall financial health. Unlike the Income Statement and Cash Flow Statement which record the flow of money in and out, the Balance Sheet captures how much money the company has, what it owes in debt, and its capital structure. In simpler terms, it tells us who the company owes and what it owns.

The Balance Sheet is the best statement to gauge the stability of a business and is broken down into three sections. Assets represent what the business owns and uses to bring in revenue and operate. Liabilities are what the company owes and includes the use of debt to raise capital. Lastly, Shareholders Equity (Owners Earnings) is the amount of equity the shareholders own. If the company were to be liquidated, this is what would be left for shareholders.

Why is it called a Balance Sheet? The reason is due to the accounting method that seeks to balance out Assets with Liabilities and Shareholders Equity. Liabilities and equity are sources of capital brought in to fund the assets that are required to operate the business.

Assets = Liabilities + Shareholders Equity.

To compare the Balance Sheet to our personal lives, let’s use a simple example. Your “Net Worth” is determined by deducting all your debts, loans and what you owe from what you own. Let’s assume you own a home worth $1 million and owe $750k to the bank. There is $250k of equity left over if you were to sell. The debt and equity combined would equal the value of the home at $1m.

If Total Liabilities exceeds Total Assets then there will be negative shareholders equity. Which is not a great sign.

Why is the Balance Sheet Important?

The Balance Sheet is a crucial tool to determine the financial health of a business. The quote “Opportunity is on the Income Statement, but RISK is on the Balance Sheet” is very accurate.

The balance sheet provides investors with an insight into the financial stability and strength of a business. When we talk about financial strength, we look for a significant difference between what the company owns (Assets) and what the company owes (Liabilities). We also assess the company’s ability to service its debt, pay its bills to keep its operations running, and have sufficient cash to expand the business.

Never invest in a company without understanding its finances. The biggest losses in stocks come from companies with poor balance sheets.

Peter Lynch

Although there are many areas to analyse on a balance sheet, it doesn’t take much time to identify if a company is under financial pressure. While the Income Statement can show the potential of a profitable investment, a poorly stacked balance sheet can dash all such hopes.

Many business failures occur due to running out of cash, taking on excessive debt, not managing accounts receivables, and inventory efficiently. In my own varied business experiences, things started to go haywire when one of these areas was not in order. Business is already hard enough with an ultra-competitive marketplace to succeed. Having a poor balance sheet is just another added risk to a business.

When a balance sheet is too top-heavy, time can be an enemy, making it difficult to turn around a business weighed down by liabilities. It becomes a race to pay bills, service debt, or worse, raise capital during the worst of times. I’ve survived a lot of tough times in business simply because I paid attention to the balance sheet strength.

The Key areas on the Balance Sheet.

The Balance Sheet is divided into three main parts: Assets, Liabilities, and Shareholder’s Equity. Each section consists of different account line items that make up the Total Assets and Total Liabilities of a company. These line items are usually categorised as either Current (less than 12 months) or non-current (more than 12 months).

It’s important for investors to understand each line item, as it’s not as simple as just looking at the last line item of Assets and Liabilities, and assuming a company is healthy. There are pros and cons to certain line items, and investors need to analyse how the numbers have been determined.

The balance sheet should always be read in conjunction with the accompanying notes to the financial statements. We will go through this in another blog, How to read an annual report. However, it deserves an important mention here. The notes reveal a lot more information about the line items and how they came to those numbers. NEVER read a balance sheet without reading the notes alongside it.

Current Assets

Under the assets section, there will be two segments. The first is current assets. These are usually liquid assets that can typically be converted to cash within a year. Current assets are usually the foundation of working capital.

Cash and cash equivalents: This is usually cold hard cash that can be used to cover any short-term obligations or near-term operational needs. It is usually the most liquid form of current assets. Anything from short-term fixed interest accounts or treasury bills.

Marketable Securities: These are usually short-term investments the business makes to get a return on its cash holdings. Usually into a bond market. These are also highly liquid investments.

Accounts Receivables: This is money that is owed to the company for products or services already delivered, and usually settled within a year. Any invoices and accounts that are yet to be paid or fall due. It’s counted as current assets as the company expects this cash flow to come through so it can be used for working capital. A section of this will also include “Doubtful Accounts” which are accounts the company does not expect to be settled.

Inventory: These are any goods or products that are yet to be sold. It can be sold within a year, converting inventory into cash. They are items that will eventually be sold so it is included in Current Assets. It can also include raw materials or in-progress products, anything that goes into the finished product that the company already has in hand.

Prepaid Expenses: This refers to payments received in advance. It could be rent in advance, insurance premiums or deposits for yet to be completed works. Any money paid upfront and in advance.

Non-Current Assets

Non-current assets are any assets that cannot be converted to cash in less than a year or assets that won’t be converted to cash. This is broken down into tangible assets and intangible assets. Tangible assets are those assets like property, plant, and equipment. They are actual physical assets or fixed assets. Intangible assets are assets that are not physical like patents. The majority of non-current assets are always reflected with a depreciation amount. The price that is recorded on the balance sheet is the price outlaid for the asset. This needs to then be depreciated to account for the reduction in value over time.

Fixed Asset: This is usually in the form of property, land, machinery, factories, and capital intensive assets. These are important assets that help to drive the primary activity of the business and generate revenue.

Intangible Assets: The assets within this line item are very important. It could be anything from copyrights, patents, or intellectual property. These are valuable assets that are non-physical. The biggest one to look out for is Goodwill. This is the amount or “premium” paid in an acquisition above the underlying value of the business.

Long-Term Investments: Anything that is a long-term investment not convertible within a year. Say an investment of cash in a treasury bill maturing in a few years. It may provide some additional revenue and return on idle cash but it is often not liquid.

Current Liabilities

Current liabilities are all liabilities that must be paid within a year. This could be anything from operational expenses such as wages and rent to debt that is due soon. It’s important to read this section alongside the current assets section. The reason is that Short-term assets will be used to cover short-term liabilities. Current liabilities are at the opposite side of current assets in terms of working capital.

Payroll Expenses: People need to get paid! Payroll is the salary costs, employee costs, staffing costs, and management’s excessive salary packages. All the short-term obligations to pay for the company’s team and staff.

Interest Payable: Interest is the cost to service debt. This could be interest expenses on both short-term and long-term debt and is not about debt repayments. It is purely the cost of servicing loans. Every month debt has to be serviced.

Accounts Payable: These are accounts that need to be paid within a year. It is usually to pay back suppliers or creditors. It excludes payroll. This could be certain operational expenses that the company is expected to pay. The most common is vendors that are yet to be paid.

Rent Expenses: The cost to rent out premises and assets that the company does not own. This can be for infrastructure, vehicles, and other asset classes unrelated to property. Anything that a company leases and does not have ownership over.

Short-Term Debt: This refers to debt that is due to be repaid. It could be short-term financing arrangements, lines of credit or overdrafts that the business must repay in full. It defers from long-term borrowings.

Non-Current Liabilities

Non-current liabilities are anything the company owes that is not due for over a year. These include non-debt financial obligations.

Long-Term Debt: This is the most common line item to look at. What does the company owe long-term? These could be loans to purchase assets, fund working capital and are liabilities that have a long-term obligation attached. It includes interest and the principal on bonds that have been issued by the company.

Deferred Tax Liabilities: These are taxes that are owed that are not yet due. A company accrues taxes but has time to pay them.

Leases: These are long-term leases on assets that the company does not own. This is classified as non-current liabilities as leases can be 10+ years or longer. This then is a long-term obligation to pay for lease and property costs. For example, a company may take a 25-year lease on a warehouse to build a manufacturing facility.

Shareholders Equity

The owners’ equity is the final piece of the balance sheet. This outlines the “net worth” of the business and the shareholder’s value. This is the total value left over after all liabilities have been satisfied. The owner’s equity is usually last to be paid out in the event of a liquidation. It is important to understand that debt and other liabilities are prioritised and if there is anything left shareholders have a claim to it.

The Shareholders Equity is the amount of money invested into the business. A company can raise capital by using debt or equity. This section is a summary of the value that builds up for the equity holders.

Retained Earnings: At the end of the year, a company that declares a net profit has various options to consider with what to do with the money. It can pay out a dividend or issue a buyback. If the company decides to keep the money and use it to reinvest in the business this then becomes Retained Earnings. The Net income transfers from the income statement to the balance sheet under Shareholders Owners Equity and becomes retained earnings.

Paid Up Capital: This is the largest section of the Shareholder’s Equity and represents all the money that has been raised by the issuance of shares in the business. This is all the money investors have allocated to the business in exchange for shares. This does not represent the market cap of a business as it accounts for the sum of equity that has been committed at any price.

A table layout of the Balance Sheet.

Let’s lay the balance sheet out to see how it flows and how each segment evolves.

Line Item
ASSETS
Cash & Cash Equivalents	A
Marketable Securities	B
Accounts Receivables	C
Inventory	D
Prepaid Expenses	E
CURRENT ASSETS (F)	A + B + C + D + E = F
Fixed Assets	G
Intangible Assets	H
Long-Term Investments	I
NON-CURRENT ASSETS (J)	G + H + I = J
TOTAL ASSETS	F + J
LIABILITIES
Payroll Expenses	K
Interest Payable	L
Accounts Payable	M
Rent Expenses	N
Short-Term Debt	O
CURRENT LIABILITIES (P)	K + L + M + N + O = P
Long-Term Debt	Q
Deferred Tax Liability	R
NON-CURRENT LIABILITIES (S)	Q + R = S
SHAREHOLDERS EQUITY
Retained Earnings	T
Paid-Up Capital	U
TOTAL LIABILITIES & EQUITY (V)	S + T + U = V
Total Assets will Equal Liabilities + Equity.	F + J = V

You can simply determine the equity component by starting with Total Assets which are F & J and deducting Total Liabilities which is P & S. This will leave you Shareholders Equity.

What I look for on the Balance Sheet?

When analysing a balance sheet, I monitor several factors. I first look at the cash, I want to know where it came from. If there is a lot of cash built up or invested in marketable securities, I want to understand how it was obtained. Was it through raising capital via equity or converting revenue into free cash flow?

Next, I compare the cash to obligations and short-term debt. I like minimal to no debt in my holdings. If a company does have debt, I like to see it is capable of servicing their obligations for years.

The next area of assets is goodwill. I pay attention to the legacy of goodwill since companies write it off after a certain period of time. If goodwill represents a large chunk of the assets, it can warp the financial health of the business. Goodwill is paid for in cash or equity and then written off. I am not a fan of intangible assets, especially those made up of goodwill. However, if it is made up of strong brands, patents, or other valuable resources that are beneficial to the business’s primary activity, then that is fine.

I also observe the change in the balance sheet year over year. Is accounts receivable starting to pile up? Are doubtful accounts increasing? If a business is collecting money more slowly, I want to understand why. The same goes for inventory turnover. This can provide great insight into a company that is no longer moving products as fast. Turnover ratios are very helpful in this type of analysis.

The one area where I think opportunity is often hidden is depreciation. Depreciation writes down the value of assets over a certain time frame, however, these assets have increased in value and are not reflected on the balance sheet.

Investment Ratios to use.

The balance sheet has a host of investment ratios to use to determine value, strength, and comparison to other companies. The below are the most common investment ratios to use. They are usually liquidity or solvency based to determine whether a business has the ability to cover its obligations. There are profitability ratios that use other metrics from the Income Statement against line items within the balance sheet.

• Debt-to-Equity: Measures how much equity there is relative to the liabilities.
• Debt-to-Capital: A measure of financial leverage comparing liabilities to total capital.
• Current Ratio: A liquidity ratio to ensure a company can meet short-term obligations.
• Working Capital: Measures capital needs by deducting current liabilities from current assets.
• Return-on-Assets: Measures how efficiently a company is using its assets to earn a return.
• Return-on-Capital: Measures the profitability of a company against the capital invested.
• Return-on-Equity: Measures the net income of a business against the equity invested.
• Inventory Turnover: This measures the turnover efficiency of inventory.
• Accounts Receivable Turnover: A great measure to see how fast companies are getting paid.

➡️ Learn more about Investment Ratios.

An Example of a Balance Sheet.

In this example, we will use the balance sheet of the same small-cap company we used in the Income Statement example. It has a straightforward financial statement and is easy to understand. The way this founder-led company presents itself sets an example for many other businesses.

To analyse this balance sheet, an investor would start from the top with current assets and go through each line item. It’s essential to compare year-on-year or use horizontal analysis to identify the changes in the line items. When looking at this particular balance sheet, you can immediately see its financial strength. There are no areas that raise concerns, and all the small numbers associated with the line items can be read in the accompanying notes of the financial statements.

The notes will indicate what went into coming up with the numbers, and they can answer all the questions and highlight the important areas to understand. From this statement, an investor can calculate all the investment ratios needed to analyse solvency and liquidity. Although this balance sheet may seem simple, my portfolio mostly consists of businesses like this. However, some balance sheets can be incredibly complex, such as those of financial institutions, that even top management may find difficult to interpret.

If I don’t understand what went into assets and liabilities, I skip the company. It means missing out on certain opportunities from time to time, but investors need to read and interpret the financial statements of their potential investments.

This balance sheet reveals a healthy business that converts revenue to value and has the means to continue to self-sufficiently grow its business. The inventory and receivables have grown in line with the revenue growth, and the retained earnings have also grown as a result of an increase in net income.

🚩 Red Flags to keep an eye on?

The balance sheet has a few areas that need to be monitored to ensure the company remains healthy. These are the most common I’ve found. When analysing new investment opportunities or monitoring existing holdings, I keep a close eye on these areas. It’s best to know how the business makes money and what assets on the balance sheet are needed for the company to generate earnings. This is another factor investors need to be observant of.

What are the key assets that the company uses to conduct its primary business activity? This can help to put the balance sheet in context.

Goodwill makes up a large amount of Assets

Goodwill is an area to be very mindful of. If Goodwill makes up a large portion of assets, I am always sceptical of the business not able to grow organically. If the business is acquiring its revenue i.e. bolting on businesses to keep fuelling top-line growth, we must ensure that it is doing so prudently. A serial acquirer ends up accumulating a lot of goodwill. This ends up being written off although it is paid for by equity or cash. Goodwill is not convertible to cash and so if it makes up a big chunk of the assets, it is a cause for concern.  

More debt than Cash

Most of the time I want to see cash and cash equivalents well over the company’s total debt. Cash is truly king, and I want to see financially strong companies that have more current assets than total debt. Not total liabilities, just total debt. If a company has more debt than cash, then it adds an unnecessary layer of risk. Financially healthy companies with a lot of cash that can meet short- and long-term debt obligations are ideal. Fragile companies with debt-ridden balance sheets do not need a lot to push them over the edge.

Accounts Receivables is rising too fast

If accounts receivables are rising too fast or rising faster than revenue it is not a great sign. It means the company is not collecting on reported revenue. A growth in revenue is pointless if it can’t convert that revenue into earnings and cash in the bank. It could indicate that management is not paying attention to settling accounts, and may have their priorities in the wrong place. If there are sudden changes to the timeframe of accounts being settled, then I pay closer attention. The turnover ratios can be handy here.

Accounts Receivables in doubt

It is quite common to see a line item under accounts receivables that indicates the period of outstanding bills. This line item may have a breakdown schedule of bills that are not yet due, some that are slightly overdue, and others that are “Doubtful”. This means that there is a low probability of receiving payment. There can be various reasons for this, such as having poor customers, a lack of due diligence in choosing clients, or companies that owed money and went bankrupt. It could also be due to disputed bills. I have observed this issue in smaller companies where management is trying to increase revenue at all costs, leading them to take on bad customers.

Inventory is rising and not converting to $

This indicates a company may be struggling to offload its products. It could be due to a lot of factors. Consumer taste has changed, a competitor has come in, a pricing war, lack of innovation, down markets, can lead to a company holding onto inventory. Inventory ties up working capital as it has already or needs to be paid for. Inventory that is piling up and can not be used means it cannot be converted into revenue or worse, it needs to be written off. Look for companies that have fast inventory turnaround times or don’t require a large amount of inventory on hand to operate. This can be monitored in line with earnings. More inventories should mean more profit.

Inadequate Intangible Assets to generate Revenue

Like Goodwill, intangible assets need to be monitored especially if it makes up a large amount of overall assets. Intangible assets are great if they help the company generate revenue. A strong brand, patent or copyright gives a business a competitive edge. Tangible assets can be converted to cash so rank higher. Investors need to understand how important the intangible asset is to the company’s ability to earn revenue from it. If it is not something the company can convert to cash or allows the business to earn future revenue from, then it needs to be questioned. Especially if it is a large amount.

Negative Retained Earnings

Negative retained simply means the company is losing money. This means the company is unprofitable and has not generated any returns for its owners. Some companies are the exception especially high growth opportunities. However, if a company has negative earnings, a poor balance sheet and a sub-par offering, I just move past it.

Ballooning Debt

Ballooning debt will tip the balance sheet into fragile territory. Even if the company has enough cash to meet obligations, I am always cautious of a company that continues to take on debt. What is the debt being used for? Why can’t it self-fund growth from operations? What is the cost of the debt? I am anti-debt so if a company starts to abuse debt it usually is a red flag. Yes, debt can be very helpful to a company that can use it intelligently. However, so many things can go wrong in investing and with a business, debt just creates another layer of risk.

In Summary…

This is how I interpret a balance sheet. Similar to the Income Statement, the statement can be analysed using vertical or horizontal analysis. It’s essential to compare the changes from year to year.

The balance sheet is not difficult to understand. It’s crucial to keep an eye on obvious factors such as debts or goodwill and ensure there are adequate reserves to cover short-term obligations. For smaller companies, the balance sheet is vital. Smaller businesses are more fragile and face greater risks. Scaling a business and competing with bigger operations is already challenging. The companies with the strongest balance sheets can survive and do well in different market conditions.

I compare the balance sheet to my own perspective and experiences, looking for companies that operate in the way I want to operate personally. I don’t want to have debt or too many obligations that could topple me over in difficult times. Challenges faced by companies are inevitable, the ones with strong foundations survive.

Many successful companies are still around because they had a robust business model, but they also had financially bulletproof balance sheets that allowed them to weather many storms. While fragile companies can generate a return if selected wisely, I believe most investors should invest in financially sound and secure companies, especially long-term investors. A company with a fantastic business model, great management, and an excellent product or service can still go bankrupt when faced with a burdened balance sheet and a slight hiccup in business operations.