A photograph taken on one specific day, showing what the business has, who has a claim on it, and what is left over for the owners. It is the statement that tells you whether a bad year is survivable.
13 min read · Level 3
The balance sheet gets less attention than the income statement for a reason that has nothing to do with its usefulness: it has no narrative. Profit rose or fell, and that is a story; assets equal liabilities plus equity, and that is a constraint. But the constraint is where the answer to the only question that ultimately matters lives, which is whether this business can meet its obligations when conditions are worse than anyone planned for. Businesses very rarely fail from making losses - they fail from running out of the ability to pay something on a particular day. That is a balance-sheet event, it is almost always visible a year or two before it happens, and it is visible mainly to people who bothered to read the statement nobody discusses.
The balance sheet lists, at a single moment, everything the business owns and everything it owes. What is left after subtracting the second from the first belongs to the owners, and is called equity. That is the whole of it: assets equal liabilities plus equity, by construction, which is why it balances.
Items are split by timing. Current assets are things expected to turn into cash within a year - money owed by customers, stock on the shelves, cash itself. Current liabilities are amounts due within a year. Everything else - buildings, machinery, long-term borrowing - sits below.
The equity section deserves particular attention, because it is where the income statement lands. Profit that is not paid out to owners accumulates in retained earnings, so the balance sheet at the end of a year contains, inside one line, every profit and loss the business has ever made and not distributed.
Because it answers the questions the income statement cannot. Can this business survive a bad year? Can it pay what falls due in the next twelve months? Is its growth being funded by owners, by lenders, or by not paying suppliers? None of those appear on a profit statement, and all of them decide whether an investor gets their money back.
It is also where the risk lives. A company fails when it cannot meet an obligation, not when it makes a loss. Plenty of loss-making businesses continue for years because their balance sheet permits it, and plenty of profitable ones fail because it does not.
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Northgate Tools, at the end of each year, in dollars:
End Year 1 End Year 2 Cash 320,000 45,000 Accounts receivable 560,000 790,000 Inventory 610,000 800,000 Total current assets 1,490,000 1,635,000 Property, plant and equipment 1,850,000 2,070,000 TOTAL ASSETS 3,340,000 3,705,000
Accounts payable 480,000 600,000 Total current liabilities 480,000 600,000 Long-term borrowings 1,200,000 1,100,000 TOTAL LIABILITIES 1,680,000 1,700,000
Share capital 500,000 500,000 Retained earnings 1,160,000 1,505,000 TOTAL EQUITY 1,660,000 2,005,000
Both years balance: 1,680,000 plus 1,660,000 is 3,340,000, and 1,700,000 plus 2,005,000 is 3,705,000.
Three things tie back to the income statement. Retained earnings rose from 1,160,000 to 1,505,000, an increase of exactly 345,000 - the Year 2 net profit, with nothing paid out to owners. Property, plant and equipment rose from 1,850,000 to 2,070,000, which is the 1,850,000 opening balance plus 400,000 spent on equipment minus the 180,000 depreciation charge. And borrowings fell by 100,000, which is why the interest expense fell.
Now read the liquidity. The current ratio - current assets over current liabilities - was 1,490,000 over 480,000, or 3.10, and is now 1,635,000 over 600,000, or 2.73. The quick ratio, which excludes inventory because stock is not reliably convertible, was 880,000 over 480,000, or 1.83, and is now 835,000 over 600,000, or 1.39.
And read the cash. It fell from 320,000 to 45,000. Against Year 2 operating costs excluding depreciation of 3,470,000 - that is cost of goods sold 2,520,000 plus selling 520,000 plus administration 430,000 - the daily rate is 9,507, so 45,000 is about 4.7 days of costs. At the end of Year 1 the 320,000 covered about 40 days.
The company that looked excellent on the income statement has just under five days of cash.
The first mistake is skipping it. The income statement is the one that gets discussed and the balance sheet is where survival is decided, so the attention is allocated exactly backwards.
The second is treating book value as worth. Equity is an accounting residue built from historical costs and accumulated profits; it is not what the business would sell for, and for asset-light companies it is barely related.
The third is reading debt without reading cash. Gross borrowings of 1,100,000 against 45,000 of cash is a different position from the same borrowings against 800,000 of cash. Net debt - borrowings minus cash - is the figure that matters, and here it is 1,055,000.
The fourth is being reassured by a healthy current ratio. Northgate's is 2.73, which looks comfortable, and most of the numerator is stock and unpaid invoices. A ratio built out of assets that only convert slowly says less about the next ninety days than it appears to.
Assets should equal liabilities plus equity. Then check that retained earnings moved by the year's profit less anything paid out to owners. If it did not, find out why before reading anything else - the explanation is always interesting.
Opening balance plus purchases minus depreciation should give the closing balance. This is how you discover whether a company is investing far above or far below the rate at which its assets are being consumed.
Borrowings minus cash. Then compare it with the year's EBITDA to see roughly how many years of earnings the borrowing represents. For Northgate that is 1,055,000 over 730,000, or about 1.45 years.
Take the year's operating costs excluding depreciation, divide by 365 to get a daily rate, and divide the cash balance by it. The answer is far more informative than the cash figure itself, and it is frequently startling.
The gap between them is inventory. A large gap means the comfortable-looking current ratio depends on selling stock, which is exactly the thing that stops happening in the conditions that create the need.
Compare the change in equity, in borrowings and in amounts owed to suppliers. Growth funded by owners, by lenders and by stretching suppliers are three quite different situations, and only the balance sheet distinguishes them.
Before relying on any profit figure, whenever a business is growing quickly, and whenever you need to know whether a bad year would be survivable rather than merely unpleasant.
Do not read a single year's balance sheet in isolation. It is a photograph, and one photograph cannot show direction - two consecutive years tell you far more than either does alone.
A shape that appears frequently in fast-growing businesses is that amounts owed to suppliers rise much faster than revenue. In the accounts it simply looks like a larger payables balance, and it genuinely does fund growth at no interest cost. What it also does is transfer a source of finance to parties who can withdraw it without notice: a supplier who shortens terms, or requires payment up front, removes that funding immediately and usually does so at the first sign of difficulty. Companies in this position often discover the dependency and the withdrawal in the same week.
Compare the growth in payables with the growth in revenue. Where payables are growing faster, part of the balance sheet is financed by people who are not lenders and have not agreed to be.
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