Nearly every financial crisis can be traced back to a foundation of weak balance sheets that cracked under the pressure of excessive debt. Companies, households, and governments load up on debt during good times, only to struggle to repay those debts when the economy takes a turn for the worse.
Having a strong balance sheet, on the other hand, is the key to surviving a downturn instead of going bust when things get bad. I'll show you a few ways to determine the strength of a company's balance sheet.
But first, let's quickly go over the basics.
What is a balance sheet to begin with?
A balance sheet is simply a financial statement that summarizes an organization's assets, liabilities, and shareholders' equity. It gives viewers a snapshot of what's owned and what's owed, and it follows this simple formula:
Assets = Liabilities + Shareholders' Equity
It's called a balance sheet because the two sides of the equation are always in balance. We measure the strength of a balance sheet by taking a closer look at the makeup of the two sides of the equation to find out where it might crack under pressure.
To discover what makes up a strong balance sheet, we'll use this sample balance sheet as our guide:
Again, to reiterate the "balance" part of the balance sheet, note that at the bottom of that sample, we see total assets of $644.3 million is equal to liabilities of $244 million plus owners' equity of $400.3 million.
Now let's take a closer look to see how strong this balance sheet is by analyzing it with some common balance sheet ratios.
Strength is in ratios, not in numbers
There are about a half-dozen different ratios we can use to determine a balance sheet's strength. You can see the math behind these ratios at the top of the sample balance sheet above. However, we'll just look at a couple of these ratios in order to gauge the strength of this particular balance sheet.
The first ratio we'll use is the current ratio, which is current assets divided by current liabilities. The current ratio, which is also known as the liquidity ratio, tells us whether or not a company can pay back its short-term liabilities with its short-term assets. A ratio of less than 1 suggests that a company cannot currently meet its obligations with its current liquidity. That doesn't necessarily mean the company is heading toward bankruptcy, but it does mean the company needs to tap other sources of liquidity to meet its current obligations.
In our sample balance sheet, we see the current ratio is 0.45 times, which suggests that the company's current liquidity is weak. However, this is mainly because a large current portion of long-term debt is due, likely thanks to a balloon payment. This debt could be refinanced, or the company could look to sell either fixed or other assets to meet this obligation. This is why its important to look at more than one ratio and see whether the balance sheet is stronger than one ratio would lead us to believe.
To look a little deeper, we'll use the debt ratio and the debt-to-equity ratio. The debt ratio is simply total debt divided by total assets. A debt ratio of less than 1 tells us the company has more assets than debt, so the lower the ratio, the stronger the balance sheet. In the case of our sample balance sheet, we see that the debt ratio is 0.26 times, which tells us the company has plenty of assets to cover its debt, suggesting that the current ratio isn't much of a concern.
Finally, we'll briefly look at the debt-to-equity ratio, which measures the company's financial leverage. It is calculated by dividing liabilities by shareholder equity. Here again, a higher debt-to-equity ratio is a sign of a weaker balance sheet. That said, there is no line in the sand to say that a ratio above 1, for example, is a concern, as it varies by industry. In the case of our mythical company's balance sheet, we find that its debt-to-equity ratio of 0.42 times would be safe in almost any industry.
Add it all up, and our sample balance sheet is in decent shape. Current liquidity is weaker than we'd like to see, but the other debt ratios are strong, which suggests the company could weather almost any storm.
Cheat sheet: Check the credit rating
Running a number of financial ratios will help investors better understand the relative strength of a company's balance sheet. In addition to that, investors should take a closer look at a company's credit rating, because an investment-grade credit rating by one of the big rating agencies is a sign that the balance sheet is strong, especially if its rating is toward the higher end of the spectrum.
While credit ratings are only opinions about the company's credit risk, these opinions matter. For example, junk-rated companies have been shut out of the credit markets during bleak economic times, making it impossible for them to roll over debt and thereby forcing them to go into bankruptcy. Meanwhile, a higher-rated firm is typically given more time and leeway to work out its issues. Suffice it to say that the stronger the credit rating, the stronger the balance sheet and the better a company can endure a rough economic stretch.
While the exact ratio is up for debate, a strong balance sheet absolutely needs to have more total assets than total liabilities. We'd also like to see current assets higher than current liabilities, as that means the company isn't reliant on outside factors to meet its obligations in the current year. Another good indication of a strong balance sheet is an investment-grade credit rating. This suggests the company's balance sheet has been thoroughly tested and deemed strong enough for debt investors to earn a relatively safe return under many different market conditions.