The income statement shows a film of the year. The balance sheet is a photograph of one day: everything the company owns, everything it owes, and the difference, which belongs to shareholders. Most companies that fail show it here first.
The balance sheet always balances: assets equal liabilities plus shareholders' equity. You are looking for whether the company could survive a bad year without raising money on bad terms, and whether its assets are as solid as they look.
What to look at
- Assets = Liabilities + Equity, always.
- Cash and short-term investments are the cushion. Compare them with debt due in the next year or two.
- Net debt = Total debt − Cash. Negative net debt means more cash than borrowing.
- Current ratio = Current assets ÷ Current liabilities. Below 1 means bills due within a year exceed liquid assets.
- Goodwill and intangibles come from acquisitions. Large goodwill can be written down, cutting equity suddenly.
The shape of it
Net debt = Total debt − Cash and equivalents
An example
Two companies each earn $1 billion a year. One holds $5 billion of net cash; the other carries $8 billion of net debt maturing in two years. In a recession, the first can buy back stock while the second may have to sell shares at a low price.
Where people go wrong
Shareholders' equity is an accounting figure, not market value. A company can have negative equity because of buybacks and still be very healthy, or positive equity built on goodwill that is worth little.
You do not need to audit the balance sheet. You need to know whether the company controls its own fate. Cash against near-term debt answers that question surprisingly often.