Using the Balance Sheet to Understand a Company’s Financial Health

To review, the big three in terms of financial statements are:

• the income statement,
• the balance sheet, and
• the cash flow statement.

In this post, we will talk about the importance of a balance sheet.

Remember that a balance sheet tells us what a company owns, i.e. its assets, versus what it owes, i.e. its liabilities.

Equity measures the extent to which assets exceed liabilities, and is what “belongs” to the owners of the company.

Assets and liabilities are connected with equity via the fundamental equation of accounting:

Assets – Liabilities = Equity

Finance for Scientists

More in this series

1. Why am I writing about finance?
2. How to learn the financial basics about a new (to you) business
3. Every scientist’s dream: Understanding financial statements
4. A first look at income statements: revenue, costs and profits
5. What scientists need to understand about revenue and its recognition
6. Income Statement Fun: What is included in the Cost of Sales and why you should care
7. How expenses and depreciation can affect the profitability of your scientific work
8. Profitability: the proverbial and literal bottom line
9. Using the Balance Sheet to Understand a Company’s Financial Health
10. Assets: tangible, intangible, and goodwill
11. Decoding Financial Health with Liabilities & Equity from the Balance Sheet
12. Navigating a company’s financial condition with the cash flow statement
13. The Anatomy of a Cash Flow Statement: Operating, Investing, and Financing
14. Budgeting 101: Using our newly acquired financial intelligence to make sense of the budgeting process
15. Making Sense of the Numbers Through Financial Ratios
16. Your Company’s Quarterly Earnings Call: How to Make Sense of It All
17. The “Big Five” Numbers — What Investors Care About and Why
18. Net Present Value: Making the Financial Case for Advancing Scientific Projects You Care About

Why do we care about balance sheets?

First, healthy companies have more assets than liabilities. And looking at how assets, liabilities, and equity have trended over time helps us understand whether a company is getting healthier or sicker.

Profitability (discussed in the income statement section) relates to equity, in the same way a grade in college relates to your overall GPA. You can think of profitability sort of like a single course grade, whereas equity is more like your grade point average. A single course grade will influence your GPA, but it doesn’t define it. Similarly, a strong quarter of profits will increase the equity in your balance sheet, and vice versa. Over time, the equity reflects the accumulation of profits and losses.

Second, balance sheets tell us about leverage (here’s a fun vocabulary lesson for you: a financial analyst’s word for debt is leverage). How much debt does the company rely on?

The higher the debt load, the higher the company’s debt service costs, which reduces its ability to invest or spend in other ways.

Balance sheet takeaways

These are the kinds of questions about a company’s financial health that you can answer with the balance sheet:

• How much debt does the company have relative to equity?
• How liquid is the business in the short term (less than one year)- can it pay its bills?
• What percentage of assets are tangible and what percentage comes from financial transactions?
• Is the financial health of the company moving in the right direction- is the equity increasing over time?

Short post for today, but next time we’ll dig into the first part of the balance sheet: Assets, including a particularly interesting asset category called ‘Goodwill.’