What Is a "Strong" Balance Sheet?

As a beginning-to-intermediate investor with a strong curiosity for things financial, I enjoyed reading the recent take "Understanding the Balance Sheet." Deep in earnings season, I have been immersing myself in the financial press and, along with "guidance below expectations," have come across the term "strong balance sheet." What the heck is a strong balance sheet? I thought I might do a little research and find out.

Your prerequisite for this take is the previous take, and we'll assume you're squared away on "assets = liabilities + stockholders' equity" and other like definitions. As we know from the previous take, the balance sheet is a point in time, as opposed to the income sheet, which covers a longer period.

The following, then, are three financial ratios for measuring balance sheet strength: the current ratio, cash-to-debt ratio, and debt-to-equity ratio. Really, they are nothing more than measures of liquidity (the ability to convert assets to cash and meet short-term obligations of less than one year) and leverage (the amount of debt in a firm's capital structure and the ability to meet long-term obligations of more than one year).

I'll use a company that I've been following, palmOne (Nasdaq: PLMO  ) , maker of handheld devices and smartphones, as an example. Let's see how strong its balance sheet is according to its 2005 fiscal second quarter, ending Nov. 30. And sure, you can look the numbers up elsewhere, but it's good practice for investors to pull them off the actual balance sheet (generally available on the company website), calculate the ratios, and then see the results at your favorite financial website.

Current ratio greater than 1, ideally between 1.5 and 2
The "current ratio," a measure of short-term liquidity risk, is current assets divided by current liabilities. How well can a company fund current liabilities (like accounts payable) with current assets (like cash) over the coming year? Any ratio less than 1 means that a company can't pay its bills (like accounts payable) and raises a red flag. Anything over 2 means the company can easily fund its current liabilities but may be tying up cash that might be used for other purposes, like paying down debt or making new investments.

palmOne's current ratio is 1.57. That's definitely in the sweet spot. But as a standalone number, it doesn't really mean much. More importantly, what's happening with the current ratio over a period of time? For the quarter ending May 31, palmOne's current ratio was 1.55, so over the following six-month period, it stayed relatively flat. Current liabilities are not growing faster than current assets, so the ratio is not decreasing. By comparison, rival Nokia (NYSE: NOK  ) is piling up cash with a current ratio of 2.4, but it plans to use some of that money for buying back stocks and paying dividends.

Cash-to-debt ratio of 1.5 or more
Investors typically like to see companies funded by piling up cash generated through operations rather than a high percentage of debt in the capital structure. Some debt can be good, but it also represents a risk to investors. The cash-to-debt ratio is determined by adding cash and short-term investments, and dividing the result by total short- and long-term debt. With a war chest of $313 million in cash and long-term convertible debt of $35 million and no short-term debt, palmOne's cash-to-debt ratio is 8.9, up from a cash-to-debt ratio of 7.2 in the period six months earlier, the result of growing cash and short-term investments. I'm likin' it!

Debt-to-equity ratio
This ratio measures the amount of long-term debt financing relative to equity in a firm's capital structure and is measured by dividing long-term debt by stockholder equity. A firm will have a target debt-to-equity ratio, but the degree of leverage varies significantly across industries. palmOne's debt-to-equity ratio is 6.4%, improved from 7.1% in the May quarter. While palmOne has no true peers, Apple (Nasdaq: AAPL  ) and Research In Motion (Nasdaq: RIMM  ) are frequently cited as points of comparison: Research In Motion's debt-to-equity ratio is 0.4%, and Apple has no debt at all.

Overall, then, palmOne has a relatively strong balance sheet. With a current ratio of 1.57, it can more than fund its current liabilities with current assets. Long-term debt has remained stable while cash is growing, and investors should take comfort in a ratio of almost nine times cash-to-debt, and a debt-to-equity ratio of 6.4% that represents an improvement since the May quarter.

As noted earlier, investors should view financial ratios that measure balance sheet strength not in isolation, but over a period of time, taking note of the trend to determine whether the numbers are improving or deteriorating, and also comparing results with those of a company's peers and with average industry ratios.

Is this just the tip of the financial statement iceberg? You bet. Want to check out the 90% you haven't seen? Head over to "How to Crack the Code: Read Financial Statements Like a Pro," the Fool's own how-to guide.

Fool contributorChris Catherowns none of the stocks mentioned and has a thing for financial statement analysis.


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