Debt, Assets, and Opportunity: Your Step-by-Step Balance Sheet Playbook
A step-by-step guide to decoding balance sheets, assessing financial health, and making confident investment decisions with a professional analyst’s checklist
Dear Reader: This isn’t your typical Polymath article. Think of it more as a how-to guide designed for educational purposes. I’ll be publishing this post under a new Education section, where I’ll build a repository covering the many different facets of company analysis. These pieces won’t be sent out to the main subscriber list, as they’re aimed more at beginners or casual visitors to the site—rather than the experienced, more advanced readers who typically receive the newsletter. That’s it—this is the first post in the series. Let’s dive in.
How many times have you found yourself at the crossroads of deciding whether to invest in a company, but you’re held back by not fully understanding what makes a strong or weak balance sheet?
How can you tell if the company you’re considering investing in is truly in a good financial position? This is one of the most common concerns faced by all investors, especially those taking their first steps in the world of investing.
Understanding and analyzing a balance sheet can seem like an overwhelming task, but it doesn’t have to be. With this guide and the comprehensive checklist I’m sharing below, you’ll be one step ahead of other investors, and I hope it gives you the confidence needed to make well-informed investment decisions. Let’s get started.
The Importance of a Good Checklist
Atul Gawande wrote one of the best-selling nonfiction books in recent years. In it, he discusses the growing complexity of modern professions like airline pilots or surgeons. For these professions, he proposes a unique solution: the use of checklists. His book? The Checklist Manifesto.
That’s why today I want to share not only the ultimate guide you’ll need to analyze how strong a balance sheet is, but also a checklist I’ve specially written for you to use as a reference when analyzing a company.
I know, nothing is as simple as it seems, but I believe that analyzing the balance sheet of a publicly traded company can be fairly straightforward if you dedicate at least a few hours to reviewing the information presented in the financial statements.
If you do this, you’ll already have done more than 90% of investors. Now, what does it mean to “have a strong balance sheet”?
What Does It Mean for a Company to Have a “Strong” Balance Sheet?
First things first. What does it mean for a company to have a strong balance sheet, and why is it important for you as an individual investor?
A strong or weak balance sheet can make the difference between experiencing a mild loss on your investment or losing everything in the event of a company bankruptcy.
Having a strong balance sheet means the company has the necessary assets to meet its obligations, both short-term and long-term, thereby avoiding not only bankruptcy but also seizing opportunities during a crisis to acquire other companies at bargain prices.
How Much Debt Can a Company Take On?
Obviously, there’s no one-size-fits-all answer to determine the maximum amount of debt a company can take on in a given period. However, the answer clearly must consider the amount and stability of the company’s cash flows, as well as the value of the assets it holds on its balance sheet.
The more stable the cash flows, the more debt a company can take on (at least that’s the theory). I wrote about how I prefer companies with no debt i the article below:
Unburdened: In Praise Of No Debt
It was April 20, 2010, and the rig exploded in the Gulf of Mexico, killing 11 workers and triggering the worst oil spill in U.S. history. A faulty blowout preventer and misread pressure tests were the internal failures that unleashed 4.9 million barrels of oil to the sea.
Now, each industry has different variability in the cash flows it generates, and these are often correlated with the economic cycle.
Utility companies, for example, such as electricity providers, have very stable cash flows; people don’t stop paying their electricity bills even during recessions. For this reason, utility companies often have a high degree of leverage.
On the other hand, more cyclical companies that also depend on the price of a commodity to determine their profits should take on much less debt.
Among the internal factors that determine a company’s level of debt are:
Profitability,
Stability of cash flows,
The relative size of debt compared to assets,
The composition of assets (how liquid they are, etc.),
The company’s competitive position in the industry.
On the other hand, external factors for determining how much credit a company can take include:
Market conditions,
Central bank interest rates, etc.
What’s the Compass for Navigating a Balance Sheet?
The main goal you should have when analyzing a balance sheet is to seek certainty that the company can meet its debts (both those on the balance sheet and those off it, such as leases, pension plans, etc.) with the cash flows generated by the company’s operations.
As you know, the cash flows generated by a company’s operations can vary over time, so it’s important to have a good margin of safety to compensate and cover all obligations during crises, when operating cash flows may be affected by the country’s economic situation or the emergence of a new competitor.
Before diving into the first steps for reviewing a company’s balance sheet, I think it’s important to keep in mind the motivation behind the debt: What was the reason the company took on debt in recent years?
Was it to finance an acquisition?
Was it to pay a special dividend or repurchase shares?
Was it to cover losses?
Was it to invest in new product lines?
It’s important to know the company’s motivation for taking on debt in the past, as this can say a lot about the company’s financial health. Now, why is it good to have low debt? Basically, for two fundamental reasons:
It reduces the risk of bankruptcy, and
It allows the company to be opportunistic and acquire other companies during times of weakness when crises occur.
What’s the downside? Well, it could mean the company grows a bit more slowly instead of growing rapidly by using debt.
First Steps to Analyze a Balance Sheet
What’s in the Liabilities section?
Let’s see, a company goes bankrupt when it can’t meet its obligations. Where are those obligations? In the liabilities section of the balance sheet.
That’s why the first task of the analyst is to thoroughly understand everything in the liabilities. What can we find there? Let’s explore.
The first thing I’m going to look at is financial debt, the debt that pays interest. What I’ll try to understand is:
The total amount,
How much interest is paid,
Whether the interest rate is fixed or variable (a fixed rate is easier to project and brings less uncertainty; a variable rate, since it’s hard to predict future interest rates, adds uncertainty),
When the next debt maturities are.
What else should you investigate about the characteristics of liabilities? Let’s see.
I mentioned earlier that it’s key to understand when the various obligations on the balance sheet mature to gauge future cash needs. If the company has most of its debt issued at low rates and needs to refinance in a high-interest-rate environment, like today, the new interest rates could seriously affect its profitability.
Another area to analyze is “loan covenants,” where all the conditions and restrictions agreed upon when the debt was taken on are outlined. Violating any of these covenants could result in a technical default or a total default for the company. These covenants often restrict corporate actions a company can take while the loan is outstanding, actions that could affect liquidity ratios, such as the current ratio I mention later.
Finally, it’s important to know whether the company’s debt is recourse or non-recourse. What does this mean? If the debt is non-recourse, it’s backed by a specific asset, and in case of default, only that asset is affected, not the entire company.
If the company stops paying, the lender has the right to take the asset in exchange for waiving any future claims on that particular loan.
What’s in the Assets Section?
Now that you’ve seen what to look for when analyzing liabilities, let’s look at what to consider when analyzing assets.
Not all assets are created equal, so it’s crucial to understand the degree of liquidity of the different components of assets. Cash on hand is much more liquid and immediately available than machinery installed in a factory.
It’s always essential to know how long it would take the company to convert each asset into cash that can be used to pay the company’s debts.
Let’s look at the main components of assets.
Cash:
Undoubtedly the most liquid of all, though sometimes there may be details that make cash not immediately available. For example, a multinational company might have cash accumulated in foreign jurisdictions and not repatriate it to the United States to avoid paying taxes. Therefore, to use that cash in the U.S., they might have to pay taxes of up to 30%.
Another adjustment to consider when looking at cash is the business’s seasonal working capital needs. The level of cash on hand can vary during the year because the company needs to increase inventory purchases to maximize stock for peak seasons or hire more employees, draining more cash.
Accounts Receivable:
In companies that sell on credit, it’s especially important to understand the quality and liquidity of accounts receivable.
Regarding quality, it’s not the same to have accounts receivable from a multinational like Amazon as from a small local business.
It’s also important to calculate the “receivables turnover,” which indicates the average time it takes the company to convert those receivables into cash. This helps understand if there’s a mismatch between the time it takes to collect and the time it takes to pay suppliers.
To calculate “receivables turnover,” divide the net sales generated during the year by the average accounts receivable for each quarter. Dividing this number by 365 gives the number of days needed to convert accounts receivable into cash for the company.
Inventory:
In retail companies, it’s crucial to understand how long it takes the company to turn inventory into cash, as inventory is ultimately cash in the form of merchandise.
To calculate this number, divide the “cost of goods sold” accumulated during the year by the average inventory for the four quarters of the year. Once you have this number, divide it by 365 to get the number of days it takes for inventory to turn into cash.
Efficient inventory use is critical because too much inventory can lead to unnecessary storage costs and tie up cash. On the other hand, too little inventory can result in lost sales.
Analyzing a Company’s Liquidity Ratios
This is one of the most common ways to quickly assess a company’s financial position. There are coverage ratios and static ratios. Let’s look at both.
Coverage Ratios
These indicators compare the income available during a given year with the payment of interest or fixed charges for that same period. Depending on the earnings considered, we have:
EBITDA/Interest: Earnings before depreciation, amortization, interest, and taxes compared to the interest payable during that period.
EBIT/Interest: Same as above but with earnings after depreciation and amortization.
Operating Cash Flow/Interest: Cash flow generated solely by the company’s operations compared to the interest it has to pay.
It’s preferable to use the last measure since cash flows are harder to manipulate compared to earnings metrics.
The more cyclical a company’s cash flows, the more coverage we’ll need to account for that variability and unpredictability. Oil and gas companies, for example, have high cash flow variability compared to healthcare companies.
Static Ratios
These are indicators that measure a company’s ability to pay at a specific point in time. These include:
Current Assets/Current Liabilities
Debt/Equity
Debt/Total Assets
One of the ratios I use most to quickly gauge how leveraged a company is, is the ratio:
Net Debt/EBITDA: Total debt minus available cash divided by the EBITDA generated during the year.
This indicator tells us how many years it would take the company to repay its debt using only the EBITDA generated during the period.
A ratio > 3x is risky unless it’s a company with stable cashflows.
A ratio < 3x and > 1x is moderate.
A ratio < 1x is definitely a low debt level.
All the ratios mentioned always make sense when compared to competitors or the industry in general, as the optimal debt level can vary from industry to industry.
Using Debt Conservatively
Okay, imagine a situation where the company has no choice but to take on debt. There’s no other alternative; it’s something they have to do. Can they do it conservatively? Yes, they just need to ensure the following:
Use long-term debt whenever possible, preferably with a fixed rate, to finance predictable long-term cash flows.
Maintain an investment-grade credit rating. This ensures investor confidence and allows the company to access lower interest rates.
Issue non-recourse debt, meaning debt backed by specific assets and not compromising the entire business’s performance.
Borrow only what can be repaid within a business cycle. The time this takes depends on the industry the company operates in.
Structure debt payments in a staggered manner. This allows the company to avoid having to face all maturities at once, which could cause liquidity issues.
Maintain access to a variety of financial markets. This ensures the company can obtain capital at all stages of the business cycle.
Conclusion
If you’ve made it this far, you likely have a clear idea of the process for evaluating a company’s financial health. We discussed how to analyze both liabilities and assets, with a special focus on the liquidity and quality of the latter. Additionally, we delved into the importance of understanding a company’s debt structure and how it can affect its ability to generate returns for investors.
Understanding these dynamics is important for any investor looking to make well-informed decisions and minimize risks. To make this process easier for you, I’ve prepared a comprehensive checklist with all the questions you should ask when analyzing a company’s financial health. I hope it helps!
Below, you can find a list of the main questions to consider when analyzing a company’s balance sheet.
General Analysis
What is the company’s goal for taking on debt?
Was it to finance an acquisition?
Was it to pay a special dividend or repurchase shares?
Was it to cover losses?
Was it to invest in new product lines?
How are the company’s free cash flows? Are they predictable, or do they have a lot of volatility? Are they growing or declining?
What is the company’s competitive position in the industry? Does it have a chance to guarantee those cash flows in the future?
What is the state of the credit market? Are banks lending easily, or is it very difficult to obtain financing?
What is the prevailing policy of central banks? Is it an environment of rising rates or low rates?
What is the company’s net worth? – Net worth is the difference between a company’s assets and liabilities. Growing net worth can be a good indicator of the company’s financial health.
How does the company’s balance sheet compare to its competitors? – Comparing the balance sheet to competitors can give an idea of how the company is positioned in its industry.
Does the company have strategic investments that could drive future growth? – Investments in new projects, technology, or acquisitions can be signs of future growth.
Does the company have significant provisions? – Provisions for future liabilities can reduce the company’s net worth.
Who is the company’s auditor? Is it a recognized firm? Is it one of the “Big 4”?
Liability Analysis
What is the total debt incurred by the company, and with what instruments? Has it issued bonds, does it have a bank line of credit, has it issued negotiable obligations, etc.?
What is the average interest rate paid on outstanding debt? Is it fixed or variable?
What are the upcoming debt maturities the company must face?
Is short-term debt increasing? – An increase in short-term debt could signal liquidity issues.
Is there off-balance-sheet debt?
Is there operating leasing?
Are there outstanding warrants?
Are there pending purchase contracts?
Is there outstanding pension fund debt?
Are there obligations pending from a lawsuit?
What are the loan covenants?
What percentage of debt is recourse vs. non-recourse?
Asset Analysis
How are the assets composed? What percentage of assets are immediately liquid compared to less liquid assets? – This question seeks a detailed description of the assets the company holds. Assets can be tangible, such as property and equipment, or intangible, such as patents and trademarks.
What are the company’s largest assets?
What is the amount of current and non-current assets? – Current assets are those expected to be converted to cash within a year, while non-current assets are those the company expects to hold for more than a year.
Has the company made significant investments in intangible assets? – Intangible assets, such as patents and trademarks, can be valuable but may also be difficult to value.
What investments has the company made recently? – Recent investments can provide clues about the company’s future strategy.
What is the quality of accounts receivable? – Are they from multinational companies or clients with questionable collectability?
What is the trend in accounts receivable? – An increase in accounts receivable could indicate short-term liquidity issues or difficulties collecting from clients. Are they growing at the same rate as sales?
What is the average time it takes the company to convert accounts receivable into cash? – Divide the net sales generated during the year by the average accounts receivable for each quarter. Dividing this number by 365 gives the number of days needed to convert accounts receivable into cash for the company.
How long does it take the company to turn inventory into cash? – Divide the “cost of goods sold” accumulated during the year by the average inventory for the four quarters of the year. Once you have this number, divide it by 365 to get the number of days it takes for inventory to turn into cash.
How has inventory changed over time? – A steady increase in inventory could indicate sales issues or poor inventory management.
Has the company revalued any of its assets? – Revaluations can significantly alter the appearance of the balance sheet.
Ratio Analysis
How does the annual free cash flow compare to the payments due for interest and principal on outstanding debt? Is there a margin of safety to protect against cash flow fluctuations?
EBITDA/Interest: Earnings before depreciation, amortization, interest, and taxes compared to the interest payable during that period.
Operating Cash Flow/Interest: Cash flow generated solely by the company’s operations compared to the interest it has to pay.
EBIT/Interest: Same as above but with earnings after depreciation and amortization.
Net Debt/EBITDA: Total debt minus available cash divided by the EBITDA generated during the year. This indicator tells us how many years it would take the company to repay its debt using only the EBITDA generated during the period.
A ratio > 3x is risky unless it’s a utility company.
A ratio < 3x and > 1x is moderate.
A ratio < 1x is definitely a low debt level.
Current Assets/Current Liabilities (Current Ratio): This is a key indicator of a company’s short-term liquidity. It measures the company’s ability to pay its short-term obligations with its most liquid assets (those that can be quickly converted to cash). A high current ratio suggests the company is well-positioned to cover its short-term obligations. However, a value too high may indicate the company isn’t using its resources efficiently to generate revenue.
Debt/Total Assets (Debt Ratio): This ratio indicates what proportion of the company’s total assets is financed by debt. It’s a measure of the company’s financial leverage. A high ratio suggests the company has taken on significant debt to finance its assets, which can increase financial risk.
Debt/Equity (Leverage Ratio): This ratio shows the relationship between the money the company has borrowed (debt) and the money shareholders have invested in the company (equity). A high ratio indicates the company has been largely financed with debt. While leverage can increase return potential, it can also increase risk if the company cannot meet its debt obligations. It’s crucial to compare this ratio to others in the same industry, as different industries have different acceptable debt levels.
Does the company have enough liquidity to cover its short-term obligations? – The relationship between a company’s current assets and current liabilities, known as the current ratio, can indicate whether the company has enough liquidity to cover its short-term obligations.
How much working capital does the company have? – Working capital, which is the difference between current assets and current liabilities, indicates the company’s ability to meet its short-term obligations.
How has the working capital ratio changed? – A change in this ratio can indicate a change in the company’s ability to meet its short-term obligations.
What does the acid-test ratio indicate? – This ratio is similar to the current ratio but excludes inventories from the numerator. It’s useful for seeing how the company could cover its short-term debts without having to sell inventory.