Balance Sheet vs Income Statement: One Shows Who Survives

A balance sheet does not tell you whether the business is good. It tells you how long the company has before it must ask the market for money, whether that means asking the bank to roll a loan or asking shareholders to fund a new issue. That is why I read assets and liabilities from the bottom, where cash and the debt due within a year sit, and always three years at once. One balance sheet can be posed for a day. Three cannot.

The income statement answers a different question: did the business earn money this quarter? Mixing the two questions up is the most common beginner mistake with financial statements, and most of this piece is about keeping them apart. It matters because a company with profit and no time ends the same way as a company with no profit, just with better press on the way down.

What assets and liabilities are#

Assets are everything the company holds that should bring it money: cash, receivables from customers, inventory in the warehouse, plants, licences, and goodwill, which gets its own chapter below. Liabilities and equity answer a different question, where the money for all of that came from: owners (shareholders' equity) or creditors (liabilities).

The two sides balance by definition. Every dollar in assets had to come from somewhere, and the right-hand side is simply the list of sources. Show 1 billion of assets on the left and the right has to show 1 billion of equity and debt combined, because there was nothing else to buy those assets with.

The right side then splits by who can demand repayment and when. Equity has no due date: owners get whatever is left, and nobody sets them a deadline. Long-term liabilities fall due in a year or later. Current liabilities fall due within a year, and it is those, rather than the total, that decide whether the company reaches its next filing. Since the right side is a list of sources, the first question to ask a balance sheet is how much of it is borrowed and due when. Compare two companies with 1 billion of assets each. The first financed 80% of them with equity, the second 80% with debt. Their left sides are identical, and the number of years each can survive without asking anyone for money is not.

Balance sheet vs income statement#

Textbooks say the balance sheet is a point in time and the income statement covers a period. True, but the day-versus-period distinction still does not tell you which statement to use for what. What does is the question each one answers.

The income statement answers whether the business earned money this quarter: revenue minus costs, net income at the bottom. The balance sheet answers whether the company reaches the next quarter: how much cash it holds, how much debt, and when that debt comes due. An excellent answer to the first question sits comfortably next to a terrible answer to the second. Suppose a company reports 100 million of net income on 500 million of revenue, which means it keeps 20 cents of every dollar. In the same year receivables grow by 150 million because customers pay late, and 300 million of bonds mature next year. That profit is real in the accounting sense, and the cash to repay the bonds is not there.

Beginners make the mistake in two mirror-image versions. "The company is profitable, so it is safe" confuses profitability with liquidity. "The company has 2 billion of assets, so it is good" confuses wealth with the return on it. Profit describes a period and assets describe a day; the time the company has only shows once you put cash next to debt at the bottom of the sheet.

Why I read the balance sheet from the bottom#

Ask how to read a balance sheet and most guides answer from the top: fixed assets, then current assets, then equity. I answer from the other end, the one where cash and the debt due within a year sit, and the reason is the layout of the page. A US balance sheet is ordered by liquidity, from what turns into cash fastest to what turns slowest: cash first, then receivables and inventory, plant at the end. On the other side, current liabilities, meaning whatever is due within a year, come first, then long-term debt, then equity. Most European statements run the same order in reverse, so "from the bottom" means from the liquid end; on a US sheet that end happens to be the top of the page.

A plant at the far end of the sheet will not pay for the bonds that mature in March. Cash will, and if cash runs short, new debt or a new share issue will. So I start with three comparisons, each taken across three consecutive years: cash against debt due within a year, the pace of debt against the pace of equity, goodwill against total assets.

Does cash cover the debt due within a year#

Say a company holds 200 million of cash and must repay 600 million within twelve months: 400 million of bonds and 200 million drawn on a revolving credit line. Operations bring in 100 million a year. After a year of the best possible work it therefore has 300 million and owes 600. The missing 300 million has to come from the market, and that is exactly the moment the company asks for money on terms somebody else sets.

The broader version of the same test is the current ratio, explained in one line: current assets divided by current liabilities. A result of 0.8 means that for every dollar due within a year the company holds 80 cents in cash, receivables and inventory, and the open question is where the other 20 cents come from.

The ratio has one trap. Inventory and receivables count in the numerator, and not every unit of inventory can be sold or every receivable collected. A grocery chain lives below 1 for years and nobody worries, because the customer pays at the till today and the supplier waits, say, two months for the transfer, so its current liabilities are a free loan from suppliers. A machinery maker at the same 0.8, with inventory that takes two years to clear, is somewhere else entirely. Which is why I read the plain version, cash against debt due within a year, first, and the ratio second.

When debt grows faster than equity#

One leverage ratio tells you where the company is; three tell you where it is heading, and the heading matters more. Take three consecutive balance sheets showing debt of 400, 600 and 900 million against equity of 1 billion, 1.05 billion and 1.1 billion. Debt to equity rises from 0.4 to over 0.8, which means that in three years the company doubled its dependence on creditors while adding 10% for its owners. Each of those sheets looks respectable on its own. The sequence says the business is not funding its own growth.

That need not be a bad sign. A company borrowing for a plant that will throw off cash in three years is doing what the debt market exists for. A company borrowing to pay a dividend or plug an operating loss is living on other people's money with less and less time to do it. Which case is it? The cash flow statement settles that: debt rising alongside capital expenditure is the first, debt rising alongside negative operating cash flow is the second.

So from three balance sheets I read the pace.

Debt at 0.8 of equity that has sat there for five years describes a business model. The same level reached in two years describes a direction, and direction is what the debt market charges extra for at the next refinancing.

How much goodwill on the balance sheet is too much#

Goodwill is the premium a company paid for an acquisition above the value of the assets it bought. It cannot be sold, pledged or turned into cash, because it is a record of a price that management once judged reasonable. It sits in assets because accounting has to put the money somewhere.

Picture a balance sheet with 2 billion of assets, 1.2 billion of it goodwill, and 1 billion of equity. Take goodwill out of both sides and you are left with 800 million of tangible assets and minus 200 million of equity, which means that without the premium paid for acquisitions the owners hold nothing and creditors are owed more than there are assets. A sheet like that can look healthy for years, until the day the auditor decides the acquired business is not worth what was paid for it and the write-down removes the equity in a single quarter.

That is why I read goodwill against total assets and against equity rather than as a standalone number.

Up to a fifth of assets, I move on. Above half, I stop reading the balance sheet and open the acquisitions note, because the price that company paid for other people's businesses says more about it than the assets in its own buildings.

Why three balance sheets at once#

One balance sheet is one day, and one day can be prepared. The company repays its credit line on 30 December and draws it again on 2 January. It holds supplier payments for two weeks so that cash on the reporting date looks better. It sells receivables to a factor just before quarter-end. None of that is illegal, and each move improves a single page.

Three pages at once cannot be improved, because a posed balance sheet leaves a trace in its neighbours. Cash that rises every December and vanishes every first quarter only shows once annual and quarterly sheets sit side by side. Receivables growing faster than revenue say the company is booking sales its customers have not paid for. Inventory growing faster than sales says goods are moving slower than management assumed. All of it shows only in sequence.

Four pairs I compare year on year, always in this order:

1. Cash and debt due within a year: is the gap closing or widening.
2. Debt and equity: which one grows faster.
3. Receivables and revenue: are customers paying at the pace the company sells.
4. Inventory and sales: is the warehouse growing faster than the market.

Three years is the floor; a credit cycle runs longer, and a balance sheet that has been through one recession says more than three years of a bull market. A US annual report gives you two balance sheets side by side, so the third has to come from the previous filing. Where the statements sit inside the annual report, and which parts of it are audited, is the subject of a separate piece on what an annual report is and which half to believe.

Book value vs market value#

Equity on the balance sheet is the company's book value: assets minus liabilities, at the prices the accountants recorded. Share price times share count is market value, which means what investors are paying today for future earnings. The gap between them is not an error on either side. The balance sheet records what has already happened, and the market pays for what has not happened yet.

Why, then, does a bank trade near book value while a software company can trade at many times it? A bank's assets are loans and securities, carried at roughly what they are worth, so the balance sheet and the market are looking at the same thing. A technology company's assets are code, a brand and people, none of which has a line on the sheet, so the market is paying for something accounting cannot see. The same price-to-book means two different things in a bank and in software, which is why I only compare it within an industry.

I think book value is read backwards from the way textbooks teach it. It says how much the owners have left inside and how much there is to lose before creditors take the rest. A cushion, not a valuation.

When not to trust the balance sheet#

The balance sheet is the most auditable of the statements, and that is precisely why it is the easiest to over-trust. Three limits, starting with the most common.

Totals do not see the risks that live in the notes. I once spent an evening on a filing I was ready to like, right up to a note three pages past where most people stop reading: one sentence saying two customers accounted for most of the revenue. The balance sheet at the front and the note at the back described two different companies, and the note was right. Since then I read filings from the back as often as from the front, and how to read the risk section is its own piece on the three risks the company had to disclose.

The second limit is that part of the debt does not sit on the line called "debt". Leases, pension obligations, guarantees for subsidiaries, contingent payments for acquisitions: each is a promise to pay, and not every one of them lands in the line a screener shows you. I compute net debt myself, from the notes, and only then compare it with cash.

The third is what book value leaves out, which in some industries is the whole story: the brand, the customer network, the team. The balance sheet of a company whose entire wealth is its people looks empty, even though that wealth walks back into the office every morning.

That is the boundary of what a balance sheet can do. It tells you how the company is financed and how much time it has, and its competence ends there. The quality of the business, the fairness of the price and the next move are questions for other documents. I do not know whether a company with a decent balance sheet survives a bad industry. I do know that a company with a bad one does not survive a bad year. If you do not believe in the business after reading the notes, a current ratio of 1.5 will not supply the belief.

What to do with this in the next week#

The filings are free. For US companies the balance sheet sits in the annual 10-K and the quarterly 10-Q, both searchable through the SEC's EDGAR filings search, and the SEC keeps its own beginner's guide to financial statements that walks through every line. Companies listed elsewhere file with their local regulator and post the same documents on their investor relations pages.

Take one company you hold, open its last three balance sheets and run the three comparisons from this piece on paper. Half an hour, and you will know more about its financing than a year of headlines would tell you. The balance sheet is one of the primary sources most investors skip, alongside the income statement, the cash flow statement and the notes, and it only starts to mean something once you have checked whether the business deserves the analysis at all.

In Taufolio that work is done by the Financial analysis section of a Full report. It takes the balance sheet from the filings themselves, lines up several years side by side, flags the shifts in debt and liquidity, and every figure carries a link to the document it came from. A Full report costs 100 credits, which is what a free account receives every month. What that looks like on a real company is in the sample reports.

And if you only have time for one balance sheet rather than three, open the one from the year the company last had a bad quarter.

Good years look good on everyone.