“A strong balance sheet is a good indicator of a company’s stamina, its ability to survive when the going gets tough.” — Christopher H. Browne
Strong balance sheet—it’s a term that’s been so bandied about these days, we’ve started wondering how many people from Wall Street to Main Street really understand what the term means. In case you’re not sure, perhaps this article will give you a better understanding about the function of balance sheets and financial statements in general.
Before investors purchase stock in any corporation, they should be able to answer these four questions: “How well is the company managed, what is its current financial situation, how has it fared in the past, and what are the prospects for its future growth?”
If you know where to look, a company’s financial statements might provide answers to those questions. The numbers can reveal potential problems and help you determine the company’s long-term viability. Understanding how to read financial statements will allow you to make a more informed decision before purchasing stock rather than relying purely on the news that a company has a strong balance sheet.
The balance sheet, be it strong or weak, is just one of the three main components of financial statements. Let’s start with a quick overview of these documents and then see how the balance sheet fits in. “Financial statements” actually include the Balance Sheet, the Income Statement, and the Statement of Cash Flows.
1.) The Balance Sheet reports what a company owns, what it owes, and what’s left for the stockholders at the end of a specific period of time—for most companies the last day of a month, quarter or calendar year. What you read on a balance sheet represents where the company stood financially at that time. It’s basically a snapshot of a business' financial situation. In reality a balance sheet can vary greatly from day to day, month to month, or quarter to quarter. |
2.) The Income Statement, informally called a profit & loss statement or “P&L,” shows how the company performed financially, monthly, quarterly or annually. This is where you’ll find a record of revenue earned, expenses paid out, and whether its operations resulted in profits or losses during the period covered. While the balance sheet shows the fundamental soundness of a company by reflecting its financial position at a given point in time, the Income Statement is of great value to investors because it shows how the company generates its cash, pays its expenses, and the net profit that results from day-to-day operations. |
3.) The Statement of Cash Flows, or cash flow statement functions like a checking account register—it’s a record of cash taken in and then spent during the period being reported. |
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The Strong Balance Sheet
"A strong financial position is something that is measured not so much by the presence of assets as by the absence of significant encumbrances." – Martin Whitman
A weak or strong balance sheet correlates to poor or good financial health. In the simplest terms, a strong balance sheet generally refers to a firm that is not overly burdened with debt. But that’s not always a cut-and-dried definition, as you’ll see later.
The balance sheet is divided into three main parts — assets, liabilities, and shareholder equity. It follows, this straightforward formula: assets = (liabilities + shareholders' equity).
• Assets, the numbers listed on the left or top half of a balance sheet, reflect the value of everything owned by the company such as cash and cash equivalents, accounts receivable, as well as physical property such as plants, trucks, equipment and inventory. Assets also include intangible things that the company considers valuable such as licenses, trademarks and patents. |
• Liabilities are listed on the right side of a balance sheet or directly beneath total assets, and represent everything the company owes including outstanding short and long-term debts such as loans, money owed for supplies or services, payroll, taxes, and so on. |
• Shareholder Equity is listed either on the right below the liabilities, or at the bottom of the balance sheet. Sometimes referred to as capital or net worth, it’s the amount that would be left if a company sold all of its assets and paid off all of its debts. As the name implies, shareholder equity is the amount of money that belongs to the shareholders, or the owners, of the company. |
A very simple example
Let’s say at the end of the year, Amalgamated Monolith has a balance sheet that looks like this:
| Assets (in millions) | | |
| Cash on hand and in banks | 1,000 | |
| Accounts Receivable | 500 | |
Plant & Equipment
| 2,500 | |
| Other Property | 1,000 | |
| Total Assets | | $5,000 |
| | | |
| Liabilities | | |
| Short-term Debt (under 12 mos) | 500 | |
| Long-term Debt (over one year) | 1200 | |
| Trade Payables | 800
| |
| Taxes | 700 | |
| Other Obligations | 250 | |
| Total Liabilities | | $3,450 |
| Shareholder Equity | | $1,550 |
Because Amalgamated Monolith’s assets equal liabilities plus shareholder equity, the accounts are “in balance” — thus the term Balance Sheet.
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What Determines a Strong Balance Sheet?
In general, having a strong balance sheet means that a company’s assets (especially cash) are considerably greater than its liabilities (including borrowings), therefore if the company runs into financial problems, the balance sheet is a good indicator of how well it can weather the storm.
Put simply, companies with ample financial strength can withstand long periods of adversity without going under. They possess the staying power to avoid getting into financial distress and eventual bankruptcy. That would lead one to conclude that an investment in a company with a strong financial position is far less risky than in one with a weak balance sheet.
Financial analysts often refer to balance sheets as being “strong” or “weak.” But like most financial terms, the definitions don’t automatically fit every situation. While a company with little or no debt on its balance sheet is generally considered to be a financially strong company, this may not always the case. Likewise, having a large amount of cash on the balance sheet does not necessarily translate to financial strength. A company may have very little cash and still be in a strong financial position, a solid company could conceivably have a weak appearing balance sheet, and a troubled firm could have a healthy amount of net assets.
There are no unqualified boilerplate conditions by which a company’s financial strength can be quantified. But here’s a suggestion for another way to asses a company’s strength: Have the company’s balance sheet in front of you and try applying the following three financial ratios to the numbers: the current ratio, the cash to debt ratio, and the debt-to-equity ratio.
Don’t let the term “financial ratios” frighten you away. These ratios involve simple fourth-grade math, but they’re a quick way to measure a company’s liquidity and ability to leverage. In other words, their ability to convert assets to cash and meet short-term obligations of less than one year, and the amount of debt and the ability to meet long-term obligations of more than one year.
Current Ratio:
This ratio measures current assets to current liabilities:
Current Assets
Current Ratio = -------------------
Current Liabilities
Companies with a higher current ratio are more likely to be viewed favorably by creditors that extend short-term debt because these companies pose less financial risk. On the other hand, a lower current ratio is more attractive to shareholders as it indicates that more of the firm’s assets are being used to grow the company. Look for a current ratio that’s greater than 1, or ideally between 1.5 and 2.
Cash-to-Debt Ratio:
This ratio is determined by adding cash and short-term investments, and dividing the results by the total of the short-and long-term debt.
Cash and short-term investments
Cash to Debt Ratio = ------------------------------------------
Short and long-term Debt
Investors should look for companies whose cash is generated from operations rather than having a high percentage of debt. While some debt can be good, it may also represent more risk. A cash-to-debt ratio of 1.5 or more is desirable.
Debt-to-Equity Ratio:
This is ratio is determined by the total liabilities divided by shareholders' equity.
Total Liabilities
Debt to Equity Ratio = ------------------------
Shareholders Equity
This is the most common and simplest ratio used for measuring financial health. It indicates the relative proportion of equity and debt used to finance a company's assets.
But financial ratios not withstanding, in order to really measure the strength of a company’s balance sheet, investors should track the numbers over time, taking note of any positive or negative trends to determine whether the numbers are improving or deteriorating. It’s also important to compare the results to those of a company's peers as well as with average ratios within the same industry.
A quick check with leading credit-rating agencies like Moody's, Standard & Poor's, Duff & Phelps and Fitch ratings will reveal how the companies are ranked in terms of their ability to repay their debt. Look for high-quality rankings and avoid those that don’t measure up.
Does a strong balance sheet equate to a buy signal? Maybe, but we hope we’ve given you enough information and the incentive to take some time to do a little research first. Most analysts agree that investors should look for more than a balance sheet that's low on debt and high on assets. It’s more important to find a business that has the ability to be around for the long haul. The time you spend doing the extra research could pay off in the long run.
