The balance sheet sets out the assets owned by the company, their value, and how they’ve been financed – all at a single point in time. Here’s an example of a simple balance sheet:
On the left is everything the firm owns – split into current assets (cash and other things, like client bills, expected to be converted into cash within a year), long-term assets it’s holding on to, and intangible assets – things that aren’t physical in nature, like intellectual property and goodwill. Goodwill, by the way, is the lingering result of past acquisitions: it’s the excess amount often paid for a company above and beyond its accounting value.
The right-hand side of the balance sheet shows how all these assets are financed. It’s usually split into current liabilities (those due within a year), long-term liabilities, and shareholders’ equity. Note how the total value of the firm’s assets is equal to liabilities plus equity (hence the term “balance” sheet).
Analyzing a balance sheet mainly involves making an assessment of the company’s ability to satisfy both its short-term obligations and its long-term debt. For the former, investors typically look at the company’s current ratio: current assets divided by current liabilities. A ratio above 1 is considered good, while anything below is a potential red flag 🚩
To get a rough sense of how worrying a firm’s debt pile might be, we can look at the firm’s debt-to-total-assets ratio, which is calculated as total debt (both short- and long-term) divided by total assets. But to properly assess a firm’s ability to meet its obligations, investors often compare net debt (total debt minus any cash on the balance sheet) to some measure of earnings – most often a measure of operating income known as EBITDA.
EBITDA refers to earnings before interest, tax, depreciation, and amortization. It’s calculated by adding back the latter two (both of which are non-cash expenses) to the operating income we looked at earlier. A company’s net-debt-to-EBITDA ratio provides a proxy for how many years it would take for a company to pay back its debt – and this time it’s the lower the better. Anything above 5 is a potential red flag.
To better illustrate all of this, let’s once again compare two hypothetical companies in the same industry: StrongCo and WeakCo.
A few things stand out. StrongCo has a nice cash pile, which helps give the firm a healthy current ratio of 2. The firm’s debt-to-total-assets is a modest 30% – and better yet, its net-debt-to-EBITDA ratio is 2 (you can’t see StrongCo’s income statement here, but it made $165 in EBITDA last year; 200 + 430 - 300 = 330, and 330 / 165 = 2). Taken together, we can conclude that StrongCo is a healthy company in a good position to meet its short-term obligations and its long-term debt 😋
Now let’s look at WeakCo’s balance sheet:
This is not a company you want to invest in. WeakCo barely has any cash, and its current ratio of 0.5 is shaky. The firm has a high debt-to-total-assets ratio of 65% – and to make matters worse, its net-debt-to-EBITDA ratio is 6 (WeakCo made $260 in EBITDA last year; can you do the math?). All of this should be cause for concern: WeakCo doesn’t seem set to keep its debt plates spinning in either the short or the long term 😰
Also, did you notice the large amount of goodwill on WeakCo’s balance sheet? That could be seen as a red flag too: it indicates WeakCo has made a lot of acquisitions in the past and potentially overpaid for them. A company that can grow organically is always preferable to one that can only do so by taking over others.
