Balance sheets, cash flow, debt and financial health
- Read the balance sheet equation
- Explain why cash flow can differ from profit
- Judge debt with simple ratios
The balance sheet
The balance sheet is a snapshot of what a company owns and owes on one date. Assets (cash, inventory, buildings) equal liabilities (what it owes) plus shareholders’ equity (what would be left for owners).
Assets = Liabilities + Equity. If a company has $10 billion of assets and $6 billion of liabilities, equity is $4 billion.
Cash flow is not profit
The cash flow statement tracks actual cash moving in and out. A company can report profit while running short of cash, for example if customers have not paid yet or it is building inventory.
Operating cash flow is cash from the business itself. Subtract capital spending on equipment and buildings and you get free cash flow, the cash available to repay debt, pay dividends or reinvest.
Debt: useful and dangerous
Borrowing can help a company grow, but interest must be paid in good years and bad. The debt-to-equity ratio compares total debt with equity; a higher number means more reliance on borrowing.
What counts as ‘high’ depends on the industry. Utilities with steady income often carry more debt than young technology companies with uncertain income.
Signs of financial health
Healthy companies tend to show positive and growing free cash flow, debt they can comfortably service, and enough cash or short-term assets to cover near-term bills. The current ratio, current assets ÷ current liabilities, is a quick check; below 1 can signal a squeeze.
A furniture maker reports $5 million of profit but customers owe it $8 million in unpaid invoices and it spent $3 million on new machines. Its operating cash flow could be negative even though it is ‘profitable’.
If it has $20 million of debt due next year and only $2 million in cash, it may need to borrow again or raise money by selling shares, which dilutes existing owners.
Key terms
- Balance sheet
- A snapshot of a company’s assets, liabilities and equity on a date.
- Assets
- What a company owns, such as cash, inventory and equipment.
- Liabilities
- What a company owes, such as loans and unpaid bills.
- Shareholders’ equity
- Assets minus liabilities; the owners’ stake.
- Cash flow statement
- A report of cash moving in and out of a company.
- Free cash flow
- Operating cash flow minus capital spending.
- Debt-to-equity
- Total debt divided by shareholders’ equity.
- Current ratio
- Current assets divided by current liabilities; a short-term liquidity check.
- Dilution
- A fall in existing owners’ percentage stake when a company issues new shares.
For a company you follow, find its free cash flow and debt-to-equity in VEXA’s Fundamentals card. Would you call it financially strong? Why?
Key takeaways
- Assets = liabilities + equity.
- Cash flow can differ sharply from profit.
- Free cash flow funds dividends, buybacks and debt repayment.
- Judge debt against the industry and the company’s cash generation.