What it owns and owes
Source: Buffett & Clark, chs. 18-43
The balance sheet has two halves that always match. One half lists the assets, everything the company owns: cash, money owed by customers, inventory, buildings, equipment, and so on. The other half lists the liabilities, everything it owes, plus equity, the owners' leftover stake. The two halves are equal by a simple rule: what you own equals what you owe plus what the owners put in.
That owners' stake, equity, is also called book value. It is what would be left for shareholders if the company sold its assets at their recorded prices and paid off every debt. Book value is a useful floor for companies that own a lot of hard assets, like banks and property firms. It means much less for companies whose real worth is a brand or software, because those do not sit on the balance sheet. That is why a company like Coca-Cola can be worth many times its book value and still be cheap.
Can it survive a bad year?
Source: Graham; Buffett & Clark, ch. 27
The first job of the balance sheet is to tell you whether the company can take a punch. A great business with a fragile balance sheet can still go under when money gets tight. Look at two things: how much it owes, and whether it can pay what is due soon.
- Cash against debt. Compare the company's total debt to its yearly profit. Buffett likes to see debt that the company could clear with three or four years of earnings. If it owes many times its profit, you are betting that nothing goes wrong. Some companies even hold more cash than debt, which is a position of real strength.
- Debt to equity. This compares total debt to the owners' stake (the book value). A figure of 0.5 means the company owes 50 cents of debt for every dollar the owners have in the business. Lower is safer, since less of the company is funded by lenders who can demand repayment. A close cousin, debt to assets, compares the same debt to everything the company owns rather than to the owners' stake. Both read the same way: the less debt does the funding, the harder the company is to knock over.
- The current ratio. This compares the assets the company can turn into cash within a year against the bills due within a year. Above 1.5 is comfortable. Below 1.0 is a warning, though a few strong companies run low on purpose because their cash is busy earning more elsewhere.
- The quick ratio. The same idea, but stricter: it leaves out inventory, since unsold goods can be hard to turn into cash in a pinch. It is the better test for a company carrying a lot of stock.
Working capital
Source: Penman; standard analysis
Working capital is the cash tied up in running the business day to day. It lives in three lines, and the trend in each one, watched over several years, often warns you before the income statement does.
- Receivables are sales the company has booked but not yet been paid for. If receivables grow faster than sales, customers are taking longer to pay, which can mean trouble collecting or a company pulling sales forward to look good.
- Inventory is unsold goods. If it piles up faster than sales, products are not moving as fast as they are being made, which often comes right before discounts and write-downs.
- Payables are bills the company owes its own suppliers but has not paid yet. Paying suppliers later is a free source of funding. Companies like Walmart turn this into a real advantage.
To turn each of these three lines into a number you can track, analysts convert them into days. Each one answers "how many days of business does this line tie up?"
- Days sales of inventory (DSI) is how many days, on average, goods sit in inventory before they sell. Lower is leaner. Costco runs near 30 days. A rising DSI while sales stay flat is the cleanest sign that products are not moving as fast as they are made.
- Days sales outstanding (DSO) is how many days, on average, customers take to pay after a sale. A shop paid at the register runs near zero. Companies that sell to other businesses run 30 to 60 days. Rising DSO usually means trouble collecting.
- Days payable outstanding (DPO) is how many days, on average, the company takes to pay its own suppliers. Higher is better here, because every extra day is free supplier funding. Walmart and Amazon stretch this well past 60 days.
Put together, these tell you the cash conversion cycle, which is how many days cash is locked up between paying for goods and collecting from customers. It is the three day-counts combined: DSI plus DSO minus DPO. A short or even negative cycle, where the company collects from customers before it has to pay suppliers, is a quiet sign of a powerful business, because growth then funds itself instead of eating cash.
Is it compounding?
Source: Buffett & Clark, chs. 30-31
The second job of the balance sheet is to show whether the owners' wealth is growing year after year. Four lines tell that story.
- Retained earnings are the profits the company has kept and reinvested over its whole life, rather than paying them out. This is the engine of compounding. They should grow every year. If they stall, profit is leaking out instead of building up.
- Treasury stock is the company's own shares that it has bought back and is holding rather than cancelling. A growing balance here means steady buybacks, which leave each remaining share owning a bigger slice of the business. But many companies retire the shares they repurchase instead of parking them here, so a small or absent treasury balance does not mean no buybacks — the falling share count is the reliable signal to watch.
- Goodwill is the extra amount the company paid to buy other companies, above the value of their hard assets. Steady or shrinking goodwill is fine. Goodwill that keeps climbing while profit does not is a sign of overpaying for deals, and it often leads to write-downs later.
- Property and equipment shows how asset-heavy the company is. A railroad needs huge amounts of it; a software company needs almost none. Asset-light companies can grow without pouring cash into machinery, which is part of why they compound so well.
Two ratios put a number on how productively the company uses its assets, and both read higher-is-leaner. Asset turnover is yearly sales divided by total assets, so it tells you how much revenue each dollar of assets produces (this is also one of the three drivers of ROE in the DuPont breakdown below). Fixed asset turnover is the same idea but narrowed to just property and equipment: sales divided by net property, plant, and equipment. A high fixed asset turnover marks an asset-light business that squeezes a lot of sales out of little hard equipment; a low one marks a capital-heavy business like a factory or a fleet that needs a large physical base just to operate. Because capital intensity sets a ceiling on returns, a business that gets more sales per dollar of equipment can compound faster.
What value investors look for
Source: Graham; Buffett & Clark
The short list for the balance sheet, again read across several years:
- Total debt no more than three or four years of profit, or net cash.
- A current ratio above 1.5, read in the context of the business.
- Receivables and inventory growing no faster than sales, with a short cash conversion cycle.
- Retained earnings rising every year.
- A growing balance of bought-back shares.
- Stable goodwill, not a rising pile from constant deal-making.
A balance sheet that passes these is what investors call a fortress: it lets the company survive bad years and keep compounding through them. Next, the cash flow statement checks whether the profit on the income statement is backed by real cash.