The income statement says how much a company earns. But whether it survives the winter - a recession, expensive credit, slow-paying customers - you learn from the balance sheet and the cash flow statement. This article covers the third area of the Stock Analyst certification.
The balance sheet: a snapshot of a single day
The balance sheet captures the company's position as of a single day - which is what distinguishes it from the income statement, which describes performance over a whole period. The balance sheet is a photograph, the income statement a film.
On one side stand assets: the property the company owns - cash, inventory, receivables, buildings and machinery. On the other side liabilities and equity: obligations (loans, issued bonds, unpaid supplier invoices) and shareholders' equity. The basic equation holds: equity = assets minus liabilities. A company with 100 billion in assets and 60 billion in liabilities has 40 billion in equity - the book value of the shareholders' stake, which need not match the market price of the shares. Liabilities further divide into current and long-term - the dividing line is maturity within roughly one year. And equity is not a fixed number: profit the company does not pay out to shareholders stays in it as retained earnings - profitable years thus raise equity year after year, while losses eat into it.
Among the assets you will also find goodwill - it arises exclusively in an acquisition, as the difference between the purchase price and the book value of the acquired company. A company cannot write its own brand onto its balance sheet.
Assets differ in liquidity, that is, how quickly they convert into money: cash is liquid by definition, inventory must first be sold, and selling a factory building is a matter of months.
Debt, cash and net debt
Debt is not automatically bad - cheap credit can finance growth. The risk lies in its fixed nature: interest and installments must be paid even in quarters when revenue is falling. The higher the debt relative to the size of the business, the smaller the cushion the company has left for harder times.
The true burden is shown by net debt: total debt minus cash. A company with 50 billion in debt and 20 billion in cash has net debt of 30 billion - it could repay part of its obligations immediately from its own reserves.
Cash flow: where the real money moves
The cash flow statement tracks actual movements of money - without the accounting constructions of the income statement. It splits into three parts: operating (the core business), investing (purchases and sales of assets) and financing (loans, dividends, share issues).
The most important is operating cash flow: the money the business itself generates. This is where the difference between profit and cash shows up. When customers do not pay on time, receivables grow - part of working capital (current assets minus current liabilities) - and the company can report a profit while money is missing from its accounts. That is exactly how even a profitable company gets into cash trouble.
Free cash flow and capex
Capex (capital expenditures) are investments in long-term assets: buildings, machinery, technology. Subtract capex from operating cash flow and you get free cash flow - the spare money the company has left after paying for operations and investments. Dividends are paid from it, shares are bought back with it, and debt is repaid with it. For many analysts free cash flow is a more important number than accounting profit, because it is harder to embellish.
What a strong balance sheet is
When people say a company has a strong balance sheet, it means two things: plenty of cash and low debt relative to the size of the business. Such a company survives a recession without existential questions - and on top of that it can invest and buy competitors at exactly the moment others are cutting back. Neither revenue growth nor the stock price's trajectory says anything about the strength of the balance sheet.
Test yourself
The balance sheet and cash flow form the third of the six areas of the Stock Analyst certification exam. Bulios Black members face 30 questions with a 100% bar - you can verify your knowledge in the Bulios certification.