How to analyse a company's balance sheet

If the income statement is the film of the year, the balance sheet is the snapshot of what the company owns and owes on a given day. It is where risks that do not show up in profit hide: debt, lack of liquidity or assets worth less than the books say. We use a fictional company, Example Corp, with the same figures throughout this series, so you can see how the income statement, balance sheet and cash flow fit together.

  • Assets = liabilities + equity: what the company owns is financed with debt or shareholders' money.
  • Separate short and long term: a profitable company can struggle if it cannot pay what falls due this year.
  • Calculate net debt, working capital and the current ratio.
  • Check goodwill: if large, part of the assets depends on past acquisitions.
  • Compare several years: the trend in debt matters as much as its level.

The structure of the balance sheet

Example Corp's year-end balance sheet, in millions of dollars:

The essential ratios

  • Net debt = financial debt − cash = 500 − 100 = $400M.
  • Net debt / EBITDA = 400 / 180 = 2.2x: a little over two years of EBITDA to repay the debt. See net debt to EBITDA.
  • Working capital = current assets − current liabilities = 400 − 300 = $100M. Positive: short-term obligations are covered by assets that will soon become cash.
  • Current ratio = 400 / 300 = 1.33.
  • Debt to equity = 500 / 600 = 0.83.
  • ROE = net income / equity = 82.5 / 600 = 13.75%. See ROE.

Goodwill and intangibles

Goodwill appears when a company buys another for more than its book value. It cannot be sold separately or used to pay debts. If the acquisition goes badly, it is impaired and equity drops at once.

At Example Corp, goodwill (200) is a third of equity (600): not alarming, but worth knowing which acquisitions it comes from and how they are doing.

Working capital: receivables, inventories and payables

Working capital accounts say a lot about business quality:

  • Receivables growing faster than revenue: the company is collecting later, or relaxing terms to grow.
  • Inventories piling up: products may not be selling.
  • Suppliers financing the company: some businesses (retail, for example) collect before they pay and run negative working capital without it being a problem.

The question is always the same: does it fit the business model and the competitors?

Red flags

  • Debt growing year after year faster than EBITDA.
  • Lots of short-term debt and little cash: dependence on refinancing.
  • Negative or falling equity without explanation (except heavy buybacks, which also reduce it).
  • Goodwill larger than equity.
  • Receivables or inventories soaring relative to revenue.

Frequently asked questions

What is a balance sheet?

The financial statement showing, at a specific date, what a company owns (assets), what it owes (liabilities) and what belongs to shareholders (equity).

What is working capital?

Current assets minus current liabilities. If positive, short-term assets cover short-term obligations.

How much debt is too much?

It depends on the sector and business stability. As a reference, net debt above 3–4 times EBITDA requires careful analysis.

What is goodwill?

The difference between what a company paid for another and its book value. It is impaired if the acquisition underperforms.