What is a balance sheet? Assets = liabilities + equity

The income statement covers a period, such as a year; the balance sheet is a snapshot at the end of that period. Every asset was paid for either with borrowed money or with the owners’ money, which is why the two sides must be equal. In the drawing at the top, XYZ’s $1,500 million of assets equal $900 million of liabilities plus $600 million of equity.

Equity is not cash in a drawer. It is an accounting residual: the money shareholders put in plus the profits the company has kept over the years (retained earnings), minus any shares it has bought back. XYZ’s $600 million is $200 million of paid-in capital plus $400 million of retained earnings.

Assets
Resources the company controls that should bring future benefits: cash, money owed by customers, inventory, equipment, buildings, patents.
Liabilities
Obligations to others: bills from suppliers, wages and taxes owed, loans, bonds and leases.
Shareholders’ equity
Assets minus liabilities, also called book value: what would be left for the owners if every asset were sold at its balance sheet value and every debt repaid.

Current vs non-current: what is on each side

Both sides are split by time. Current assets are cash or should turn into cash within a year; current liabilities fall due within a year. Everything else is non-current. The drawing below shows XYZ’s simplified balance sheet, in millions of dollars:

  • Current assets, 600: cash and short-term investments 240, accounts receivable 160, inventory 200.
  • Non-current assets, 900: property and equipment 600, goodwill and intangible assets 300.
  • Current liabilities, 400: accounts payable, accrued expenses and deferred revenue 350, short-term debt 50.
  • Non-current liabilities, 500: long-term debt 250, leases and other liabilities 250.
  • Shareholders’ equity, 600. Total: 1,500 on each side.

Turn your phone sideways to read the drawing. Tap to close.

Two hand-drawn stacked columns of the same height, in $ millions: assets 1,500 on the left (cash 240, receivables 160 and inventory 200 in solid green; property and equipment 600 and goodwill and intangibles 300 hatched) and liabilities plus equity 1,500 on the right (current liabilities 400 in solid red; long-term debt 250 and other liabilities 250 hatched; shareholders’ equity 600 in yellow), with an equals sign between them and a key: solid means current, within a year; hatched means non-current.

Cash, receivables and inventory: what to look for

Cash is the least ambiguous line, so compare it with debt. XYZ has $240 million of cash against $300 million of total debt ($50 million short-term plus $250 million long-term), so its net debt is $60 million. A company with more cash than debt has net cash.

Accounts receivable are sales already booked but not yet paid for; inventory is goods waiting to be sold. Both should grow roughly in line with revenue. If receivables jump while sales are flat, customers may be paying slowly or sales may have been pulled forward; if inventory piles up, demand may be weaker than the income statement suggests. Both tie up cash, which shows in free cash flow.

Goodwill is what a company paid for acquisitions above the value of the assets it bought. It is not cash, it cannot be sold on its own, and it is written down (an impairment) if the acquisition disappoints.

Current ratio, quick ratio and working capital

These measure liquidity: can the company pay what falls due within a year? In the drawing below, XYZ’s current ratio is current assets ÷ current liabilities = 600 ÷ 400 = 1.5. The quick ratio leaves out inventory, which may take time to sell: (240 + 160) ÷ 400 = 1.0. Working capital is the difference: 600 − 400 = 200.

There is no universal target. A ratio below 1 is a reason to look closer, not proof of trouble: retailers that sell their stock before they pay suppliers, and subscription businesses that collect cash in advance, often run below 1. Compare with the company’s own history and with direct peers.

Turn your phone sideways to read the drawing. Tap to close.

Hand-drawn bars on the left: a current assets column of 600 (cash 240 and receivables 160 solid, inventory 200 hatched on top) next to a red current liabilities column of 400; a dashed line at the top of the liabilities column and a green double arrow mark the part of current assets above it as working capital, 200. On the right, a card with three rows: current ratio 600 ÷ 400 = 1.5, quick ratio (240 + 160) ÷ 400 = 1.0 with the note leaves out inventory, and working capital 600 − 400 = 200.

Debt and book value per share

Debt-to-equity = total debt ÷ shareholders’ equity: 300 ÷ 600 = 0.5 for XYZ. Some sources divide total liabilities instead, so check the definition before comparing. Look at when the debt falls due, too: a large amount maturing next year matters more than the same amount due in ten years. Debt magnifies results in both directions, as the return on equity guide shows.

Book value per share = shareholders’ equity ÷ shares outstanding. XYZ has 90 million shares: $600 million ÷ 90 million ≈ $6.67. Tangible book value leaves out goodwill and intangibles: ($600 million − $300 million) ÷ 90 million ≈ $3.33. The share price divided by book value per share is the P/B ratio from valuation ratios, most useful for banks and insurers.

Book value is an accounting figure, not what the business is worth. Brands, software and know-how built in-house barely appear on the balance sheet, and stock buybacks shrink equity, so an excellent company can show a tiny or even negative book value.

Balance sheet red flags

Read at least three years side by side; one balance sheet says little on its own. These patterns deserve a closer look in the notes to the accounts and in the earnings report:

  • Receivables growing much faster than revenue, year after year.
  • Inventory piling up faster than sales.
  • Debt rising while cash falls, especially when much of the debt is short-term.
  • A current ratio below 1 that the business model does not explain.
  • Goodwill that is large compared with equity: a write-down can wipe out much of the book value.
  • Negative equity: find the cause. Years of losses are a warning; years of buybacks can produce the same sign at a healthy company.

Turn your phone sideways to read the drawing. Tap to close.

A hand-drawn paper card titled balance sheet red flags, with a small red flag before each of six lines: receivables growing faster than sales, inventory piling up faster than sales, debt rising while cash falls, current ratio below 1: ask why, goodwill large next to equity, and negative equity: find the cause.