Tutorial: read a balance sheet
The income statement tells you how the year went. The balance sheet tells you whether there will be another one.
Judge whether a company can survive something going wrong.
How read a balance sheet works, in one picture
The same argument as the text, as a chain. Each step is what makes the next one possible.
Why the debt is the engine
Put in 30, borrow 70, secure the loan against the company you are buying. A 30% rise in the business doubles your money. The same arithmetic works in reverse, which is why buyouts fail loudly.
- 1
It always balances, which is the point
Assets equal liabilities plus equity, by construction. Equity is therefore the leftover: what would be yours if everything were sold at the value the accounts claim. Which is a large claim, and worth doubting.
- 2
Find out what the assets actually are
Cash is worth exactly what it says. Inventory might be worth much less if nobody wants it. Goodwill, the premium paid in past acquisitions, is not an asset you can sell at all, and can be written off overnight in one brutal charge.
Strip goodwill and intangibles out and you get tangible book value: the hard, saleable substance. If it is negative, the equity rests entirely on future earnings and on nothing you could liquidate.
- 3
Read the liabilities by when they are due
Debt due in ten years is a fact of life. The same debt due in nine months is an emergency. Check the current ratio: current assets over current liabilities. Below 1 needs an explanation, though some superb businesses run below 1 on purpose because customers pay them before they pay suppliers.
- 4
Then check they can afford the interest
Interest coverage: operating profit divided by the interest bill. It is a better danger signal than the size of the debt, because it measures whether the company can carry it. Below 2, a mild downturn puts the lenders in charge.
Most companies that fail are not insolvent on paper. They simply run out of cash on a Tuesday.
You can say whether this company could survive its revenue falling by a third for two years.
Read next
The income statement tells you how the year went. The balance sheet tells you whether there will be another one.
Businesses that will survive what kills their competitors, and can buy the wreckage afterwards.