Balance Sheet

The Balance Sheet, also called the statement of financial position, is an accounting report that shows, at a given moment, the economic and financial position of an entity. It acts like a snapshot of its resources and obligations, usually at the end of the fiscal year, although it can be prepared at any date depending on management needs.

In this statement we need to talk about assets and liabilities.

The fundamental rule of assets and liabilities

Its structure is based on the principle of equality between assets and liabilities, where:

• Assets: represent the company’s resources (what it has).
• Liabilities and Equity: represent the source of those resources, where:
  • Liabilities: are the source of resources that were financed with external funding—loans, mortgages, etc.
  • Equity: is the source of “own” funding—the portion of resources contributed by the owners or generated by the company.

The assets and liabilities equation

The formula

This is what the theory says; now let’s explain it using Pepe.

Pepe and the balance sheet

For Pepe, assets and liabilities would mean the following:

Assets – Resources

Assets are everything Pepe owns that has economic value. They are his resources.

Fixed assets

What he owns for long-term use:

• The value of his house or apartment.
• Long-term investments (shares, mutual funds).
• Valuables such as jewelry or an art collection.

Current assets

What can be converted into cash quickly:

• Cash in his wallet and bank account.
• Savings accounts and short-term investments.
• The value of a car he could sell easily.

Liabilities – Source of resources, external funding

Liabilities are all the debts or obligations Pepe has to third parties. It is what he owes. In other words, it is where the money came from to pay for everything he has in Assets.

Non-current liabilities (long-term)

Debts he must pay in more than a year:

• The mortgage on his house.
• The remaining balance on his car loan.
• A long-term personal loan.

Current liabilities (short-term)

Debts he must pay in less than a year:

• His credit card balance.
• Pending bills (electricity, water, phone).
• The portion of the car loan that matures in the next 12 months.

Equity – Resources

Pepe’s equity is his net worth. It is the value that would remain if he sold all his assets and paid all his debts.

It is the result of the formula:

Let’s see it with an example, with numbers:

• If Pepe’s ASSETS (his house, car, money in the bank) add up to €300,000
• His LIABILITIES (his mortgage, loans) add up to €150,000
• His EQUITY would be €150,000.

This is his true net worth, his personal wealth.

In short, assets are what he has, liabilities are what he owes, and equity is what he is really worth financially as an individual.

Company

I hope the Pepe example has helped you understand the logic of assets and liabilities in a simple way.

The same structure and logic apply in exactly the same way to the business world. For a company, assets and liabilities would mean the following:

Assets – Resources

Fixed assets (non-current)

• Long-term investments
• Buildings
• Machinery
• Patents

Current assets

• Cash and equivalents
• Accounts receivable
• Inventories

Liabilities (source of resources – external funding)

Long-term liabilities (+12 months)

• Loans
• Corporate mortgages

Short-term liabilities (-12 months)

• Trade payables
• Bank credit

Equity

• Capital contributed by shareholders, retained earnings, etc.

This equation, in business, allows us to assess a company’s financial health.

Financial position: net debt and net cash

Financial position is a key metric that gives us an instant view of a company’s financial health, showing whether it has more debt than cash or the other way around. It is calculated as follows:

• A positive result means the company has more debt than cash, and that is why it is called Net debt.
• If the result is negative, it means the company has more cash than debt. This is considered a Net cash position.

What do we want to see from this formula?

As far as possible, we want the result to be negative. Let’s use Pepe as an example:

• Financial debt (loans, mortgages, etc.): €50,000
• Total cash (the money Pepe has in the bank): €100,000

Pepe’s financial position would be: -€50,000, net cash.

This would mean that Pepe has enough money to cover his debt and still has money left over. Without doubt a very favourable position for Pepe.

Now let’s look at the components or variables that make up the formula, but from a business perspective.

Total cash

Total cash is not limited to the money in the company’s safe. It includes all liquid assets or those that can be quickly converted into cash to meet short-term obligations. A large amount of cash is a sign of financial strength and flexibility, as the company can use those funds for acquisitions, paying down debt or investing in new projects.

The most common items included in total cash are:

• Cash and equivalents: Cash and bank deposits.
• Marketable securities: Negotiable securities, such as shares or bonds that can be easily sold.
• Money market funds: Very low-risk investment funds.
• Short-term government bonds: Government bonds with short-term maturities.

Debt

Financial debt is money a company borrows and on which it pays interest. Unlike trade debt (such as what it owes suppliers), a default on this debt can lead to bankruptcy. Analyzing it is crucial to understanding a company’s risk.

The most important types of debt are:

• Bank debt: Loans and credit lines. Often more expensive than bonds and subject to covenants.
• Corporate bonds: Debt that the company issues directly in the market. Usually for large amounts and with longer maturities. An advantage for bondholders is that they have priority over shareholders in the event of bankruptcy.

Bank debt

Bank debt often involves a more direct and tailored process than bond issuance. However, it usually comes with a set of conditions imposed by the bank to protect its investment, known as covenants.

What are covenants?

Covenants are contractual clauses that the bank imposes on the borrower. If the company fails to meet these conditions, the bank can declare a default and demand immediate repayment of the entire debt, together with the corresponding interest and penalties.

They could be thought of as “warning signals” for the bank and are very dangerous for the company.

Covenants are usually based on key financial metrics. Some common examples include:

• Debt ratio (Debt to EBITDA): Measures the company’s ability to pay its debt with its operating profit. A covenant might be, for example, to keep this ratio below 3x.
• Interest coverage ratio: Measures the company’s ability to cover its interest payments with its operating profit.
• Liquidity ratio (Current ratio): Measures the company’s ability to meet its short-term obligations.

How to evaluate covenants

To assess whether a company is at risk from its covenants, you need to go to its annual reports (10-K or 20-F in the U.S. or the equivalent reports in Europe) and look in the notes to the financial statements. There the covenant limits are described (for example, “Net debt / EBITDA must not exceed 3.0x”).

Then you calculate that ratio with the company’s current data and compare it to the limit. If the result is close to the limit, it is a warning sign.

Corporate bonds

When a company issues bonds, it becomes a debt issuer directly in the market. Unlike bank loans, bonds can be bought by a wide range of investors.

Key bond features

• Minimum purchase (minimum ticket): Bonds often have a high face value, which limits their purchase to institutional investors or large portfolios.
• Creditor hierarchy: In the event of bankruptcy, bondholders have payment priority over shareholders. Shareholders are the last to receive any remainder, and it is very rare for them to get anything.
• Bond buybacks: The company can buy back its own bonds in the secondary market. This is advantageous if the bonds trade below their face value (par), which allows the company to reduce its debt at a lower cost.
• Risk: Bonds also carry risk. If the issuer cannot make interest or principal payments, it is considered a default and the bonds can lose all their value.

Leverage metrics

Leverage metrics are like a financial thermometer for a company’s debt. They measure risk and the company’s ability to handle its financial obligations. It is crucial not only to calculate these ratios but also to understand their context.

Net debt / EBITDA

This is the most common and practical ratio, used by investors, analysts and banks. It measures how many years of operating profit (before interest, taxes, depreciation and amortization) it would take a company to pay off its net debt.

• Why is it important? EBITDA is a good approximation of the company’s operating cash flow—i.e. the money it generates from its main operations. This ratio tells you how exposed the company is if its profits fall.

• A ratio of 2x or less is considered conservative and healthy.

• If the ratio is higher, such as 4x or 5x, it is only acceptable in very stable and predictable businesses, such as utilities or toll roads, where revenue is constant and guaranteed. In these cases, “visibility and recurrence of profits” is so high that more debt can be tolerated.

Net debt / Equity

This ratio compares the company’s debt with shareholders’ equity. It is used mainly in financial companies (such as banks and insurers) because their business model is based on leverage.

For these companies, EBITDA is not a relevant metric for their operations, so equity (or book value) becomes the benchmark.

• How is it used? The key here is comparison. There is no universally “good” number. To know whether a financial company’s ratio is optimal, you must compare it with the sector average and with its main competitors. A ratio much higher than its peers could indicate excessive risk.

Net debt / FCF (Free Cash Flow)

This is the most conservative ratio and often the favourite of the most prudent investors. It measures how many years it would take a company to pay off its net debt with Free Cash Flow (FCF), which is the real money the company has left after covering all its capital expenditure.

Unlike EBITDA, FCF takes into account the investments needed to maintain the business.

• Why is it safe? FCF represents the money the company actually has available to pay down debt without affecting its operations. So this ratio offers a more realistic view of the company’s repayment capacity. A low ratio here is a sign of extremely solid financial health.
• If it’s so safe, why don’t banks use it as standard? The answer is simpler than it seems: because not all companies will have a positive ratio.

What debt tells us

Leverage is not inherently bad, but it is the main reason companies go bankrupt in times of crisis. It is a double-edged sword; hence the need to be very careful with it.

• Comparison is key: Leverage should always be analyzed in relation to competitors and the sector average. A company with a 3x ratio may be normal in its industry or a warning sign in another.
• Risk tolerance: Your tolerance for the level of debt should depend on the stability of the company’s revenue. The more predictable and recurring its profits (e.g. a software company with subscription revenue), the more debt it can support. By contrast, a cyclical company (such as construction) with volatile revenue should not have much leverage.
• Leverage to create value: High leverage is only good if the company is using it to create value for the shareholder—for example, to finance a profitable acquisition or to invest in growth projects that will generate returns above the cost of debt. If debt is used simply to cover operating losses or pay dividends, it is a clear WARNING!! sign.

In short, leverage is a powerful tool that, if managed carefully and used to create value, can be beneficial. However, mismanagement of it is one of the main causes of bankruptcy, so analyzing it is vital for any investor.

Working capital

Let’s explain working capital using Pepe as an example.

Imagine Pepe sits down at his desk, does the sums and realizes that to live the way he does—paying rent, buying food—he needs €12,000 per year.

He decides to save and manages to put aside that amount (€12,000). Now he feels more at ease because he knows he can maintain his lifestyle for another year.

In other words, he has a pot of money set aside for the following year’s expenses, and he repeats this every year until his lifestyle changes.

He buys a house and no longer has to pay rent. He sits down at his desk again and tries to work out how much money he needs. Now he finds he needs €6,000.

Pepe is pleased because from the pot of money he had set aside for the next year he has money left over, and he knows he can do whatever he wants with it (invest it, spend it on other things, etc.).

The pot of money has shrunk, but it has had the opposite effect on his bank account—it has added money, because now Pepe has €6,000 extra he can spend.

The years go by and the pot of money stays the same: €6,000.

Now imagine that, for work reasons, Pepe has to relocate to another city where he will have to pay rent again. He does the sums and again finds he needs €12,000 to maintain his lifestyle, so he has to start saving again.

The pot of money has to grow again, creating the opposite effect on his bank account, because this time money leaves Pepe’s bank account or savings.

What does Pepe’s working capital tell us?

It tells us the money Pepe needs each year to maintain his lifestyle, and with this we could analyze:

• His ability to cover expenses: We could tell whether Pepe has enough money available to cover his daily expenses, such as rent and food, without having to rely on immediate future income.
• His financial efficiency: We could assess whether he has managed to reduce his expenses, as when he moved into his own house and no longer paid rent. This allowed him to free up capital (the “extra” money left over from his “pot”), which is a sign of good financial management.
• The change in his needs: We could observe how his working capital needs change over time. For example, his “pot” became smaller when he bought a house and became larger when he moved to another city and had to pay rent again.

Positive and negative signals

• A positive signal would be Pepe’s working capital decreasing (his “pot of money” getting smaller). This indicates that he needs less money to maintain his lifestyle, which means he has more money left over that he can use to save, invest or spend on other things.
• A negative signal would be Pepe’s working capital increasing (his “pot of money” getting bigger). This means he needs more money for his daily expenses and has the “opposite effect” of having to take money out of his bank account or savings. An increase could indicate that his expenses have grown and that his financial situation has become heavier or tighter.

Company

Working capital (WC) tells us the amount of money the company needs to invest in its operating cash cycle in order to continue its day-to-day operations.

Working capital is closely related to sales and cash generation.

It is calculated as the difference between the short-term assets and liabilities of the operating cycle:

Assets

• Inventories: Represent the goods a company has to sell or is producing. It is an asset because it will ultimately become money when sold.
• Accounts receivable: The money customers owe the company for products or services already delivered. It is an asset because the company has the right to receive that cash.

Liabilities

• Accounts payable: The money the company owes its suppliers for goods or services it has already received. It is a liability because it is a short-term payment obligation.

Metric: WC as % of sales

We can use the following metric, which will give us a quicker, easier view of whether something is wrong:

This tells us the level of working capital the company requires relative to its sales.

• A low percentage (5–15%) is ideal, as it shows the company needs minimal investment to operate.
• A high percentage (>25%) is a sign that something is wrong—whether the company has trouble collecting from customers, is building up too much inventory, or is paying suppliers faster than necessary.

We should analyze this metric and its trend in detail, especially in companies with product-sales business models (retailers, industrials, etc.)

Negative working capital

Negative working capital is a very positive sign, common in companies with a business model that receives payment from customers before paying their suppliers.

Supermarkets are a perfect example of this. As the owner you want:

• Customers to pay you immediately
• Stock to turn over
• To pay your suppliers as late as possible

Example: You pay suppliers in 90 days. You have a pot of money you can use. It is usually not used, but you can (e.g. safe short-term investments—a deposit).