Read the Numbers, Understand the Business
Chapter 5 of 8 · 10 min read
Check the balance sheet for hidden pressure
A business can be highly profitable yet vulnerable if it must refinance debt during a downturn or cannot convert its assets into cash when bills fall due.
Liquidity and working capital
Working capital = Current assets − Current liabilities
Current assets may include cash, customer receivables and inventory. Current liabilities commonly include accounts payable, short-term borrowings and other obligations due within the next year.
Current ratio = Current assets ÷ Current liabilities
If current assets are $4 million and current liabilities are $2 million, the current ratio is 2.0. That suggests more current assets than current liabilities, but it does not guarantee cash will be available when needed. Inventory might be obsolete, receivables could be overdue, and large commitments may not appear as simple current liabilities.
2.0 = $4m ÷ $2m
Debt and interest
Debt can finance worthwhile investment, but it also creates fixed obligations. Assess the amount of debt, its interest rate, maturity schedule and whether cash flows can service it.
Interest coverage ≈ Operating profit ÷ Interest expense
If operating profit is $1.5 million and interest expense is $300,000, coverage is 5 times. That gives more room than coverage of 1.2 times, but the appropriate comfort level depends on volatility, the type of debt and the industry.
Don’t rely on debt-to-equity alone
Debt-to-equity ratios are useful but can be distorted by share buybacks, accounting values and unusually low or negative equity. Examine absolute debt, available cash, repayment dates and cash-generation capacity as well.
The risk of apparently strong asset values
Goodwill and some intangible assets can be valuable, yet their recorded accounting amounts may not be recoverable in a difficult market. Tangible equipment also may be worth much less in a forced sale than it cost to acquire.
A resilient balance sheet gives a business options under stress. A large asset total alone does not show whether those options exist.
A stricter test: the quick ratio
Inventory is usually the least liquid current asset: it must be sold, and often then collected from a customer, before it becomes cash. The quick ratio leaves it out:
Quick ratio = (Current assets − Inventory) ÷ Current liabilities
If the example company’s $4 million of current assets includes $1.2 million of inventory, its quick ratio is (4 − 1.2) ÷ 2 = 1.4. That still covers current liabilities, but with less room than the current ratio of 2.0 suggested. For businesses whose stock can become obsolete quickly, such as fashion or technology, the quick ratio is the more realistic view.
Net debt and how long it would take to repay
Gross debt overstates the burden when a company also holds substantial cash. Net debt subtracts cash from borrowings. If the company owes $6 million and holds $1 million in cash, its net debt is $5 million. Many companies now include lease liabilities in borrowings; check whether the figure you are using does, and be consistent.
A common gauge compares net debt with EBITDA, giving a rough sense of how many years of operating earnings the debt represents. With operating profit of $1.5 million and depreciation and amortisation of $0.4 million, EBITDA is $1.9 million, and net debt to EBITDA is about 2.6 times. The limits of EBITDA described in Chapter 3 apply here too: for a capital-intensive business, a ratio based on free cash flow gives a more cautious and often more realistic picture.
When does the debt fall due?
The total amount of debt matters less than when it must be repaid or refinanced. The borrowings note in the accounts usually shows a maturity profile: how much falls due within one year, between one and five years, and beyond.
In this fictional example, $4.5 million of the $6 million falls due in the second year. The company will need to refinance most of its debt at that point, on whatever terms lenders offer at the time. If that coincides with a downturn, a rise in interest rates or a weak year for the company, refinancing may be expensive or difficult. Debt spread evenly over many years, or with long maturities, leaves the business far less exposed to conditions on a particular date.
Read the covenants
Loans usually come with covenants: conditions the borrower must meet, such as keeping interest coverage above a set level or net debt below a multiple of earnings. Breaching a covenant can allow lenders to demand early repayment, raise the interest rate or impose new conditions, even if every repayment has been made on time.
Companies often disclose their main covenants, and whether they complied, in the borrowings note or the directors’ report. A company operating close to its covenant limits has little room for a weak year. Watch for language about lenders having granted waivers or amended the terms; it suggests the company has already come close to, or breached, a limit.
Look beyond the face of the balance sheet
Not every obligation appears as a liability on the balance sheet. The notes disclose contingent liabilities, such as legal claims whose outcome is uncertain, guarantees given for the debts of others, and commitments, such as contracts to buy equipment or materials in future years. Under current accounting, most leases are now on the balance sheet, but some short-term and low-value leases are not.
Read these notes for anything large relative to the company’s cash or profit. A guarantee of a joint venture’s borrowings, or a significant legal claim, can turn into a real cost quickly. They are easy to miss because they do not appear in the headline ratios.
Stress-test the coverage
Interest coverage looks very different under pressure. Using the example, coverage is 5 times with operating profit of $1.5 million and interest of $300,000, which on $5 million of net debt corresponds to an interest rate of about 6%.
Now suppose operating profit falls by 40% in a downturn, to $0.9 million. Coverage falls to 3 times. If, at the same time, the company must refinance at 8%, interest on $5 million rises to $400,000 and coverage falls to 2.25 times.
The point is not the precise numbers but the habit. Ask how the company would look if profit fell to the level of its weakest recent year and interest rates rose. A business that remains comfortable under those conditions has a resilient balance sheet; one that does not is depending on good conditions continuing.
Goodwill and impairment
When a company buys another business for more than the fair value of its identifiable net assets, the excess is recorded as goodwill. Goodwill is not depreciated. Instead, the company must test it at least once a year for impairment, comparing the value of the acquired business with its carrying amount and writing goodwill down if the business is worth less.
An impairment charge reduces profit and equity but uses no cash: the cash was spent when the acquisition was made. It is still important information, because it is management’s admission that an acquisition is worth less than was paid. A history of large impairments suggests a company that has overpaid for acquisitions, which is worth remembering when it announces the next one.
Check that current assets are really there
The liquidity ratios assume that current assets will turn into cash at roughly their recorded value. The notes show how far that is true. The receivables note usually discloses how much is overdue and the allowance for expected credit losses, the amount the company expects never to collect. A growing share of overdue balances, or an allowance that barely moves while overdue amounts rise, deserves attention.
The inventory note shows how stock is valued and any write-downs to net realisable value, the amount it could be sold for. Rising inventory alongside flat sales, combined with small write-downs, can mean slow-moving stock is being carried at more than it will fetch. Both notes help judge whether a comfortable current ratio rests on assets that will actually produce cash.
Count the undrawn facilities
Liquidity is not only cash on hand. Many companies have undrawn borrowing facilities: committed lines of credit from banks that they can draw on if needed. The borrowings or financial risk note usually discloses how much is available and when the facilities expire.
A company with modest cash but large, long-dated undrawn facilities may be more flexible than its cash balance suggests. A company whose facilities expire soon, or are already largely drawn, has less room than its balance sheet might imply. When assessing resilience, add available facilities to cash, but check their expiry dates and any conditions attached.
Read capital raisings as information
When a company raises new equity, it tells you something about its balance sheet. A raising to fund a clear growth opportunity, on terms that treat existing shareholders fairly, can be sensible. A raising made urgently, at a large discount to the share price, often follows a period in which debt became uncomfortable or covenants came under pressure.
Look at the reasons given, the price and how existing shareholders could participate. A history of repeated raisings to fund operating losses or repay debt suggests a business that has not been able to finance itself from its own cash. Each raising also increases the number of shares, which reduces each existing shareholder’s portion of future profits, a point Chapter 6 develops.
A resilience summary
After working through the balance sheet, a short summary helps bring the findings together:
- Avoid: Current and quick ratios comfortable, with realistic receivables and stock
- Avoid: Net debt modest relative to earnings and cash flow
- Avoid: No large maturity falling due in a single year
- Avoid: Covenants met with room to spare
- Avoid: Coverage still adequate if profit falls and rates rise
- Do: x No large guarantees, claims or commitments hidden in the notes
A company that passes all of these has the flexibility to survive a difficult year and to act when competitors cannot. One that fails several of them may still recover, but its future depends heavily on conditions it does not control.
Match the debt to the stability of earnings
The same level of debt can be prudent for one business and dangerous for another. What matters is how much earnings vary. A business with steady, contracted revenue, such as long-term service agreements or regulated income, can usually carry more debt safely than one whose profit swings with commodity prices, construction activity or consumer spending.
For the imaginary manufacturers, Precision Seal Systems, with multi-year supply agreements, might reasonably carry more debt than Harbour Fasteners, whose orders and prices can change quickly. When judging a company’s leverage, look first at how much its operating profit has varied over the past cycle. Then ask whether its debt could still be serviced comfortably in its weakest year, not its average one.
Fixed or floating interest rates
The borrowings note usually states how much debt carries a fixed interest rate and how much floats with market rates, and whether the company uses interest-rate swaps to fix part of its floating debt. The difference matters when rates move.
A company with mostly floating-rate debt feels a rise in rates almost immediately in its interest expense, as the stress test above showed. One with long-term fixed-rate debt is protected until that debt matures, but then faces whatever rates prevail at refinancing. Neither is better in all conditions. The useful question is whether the company’s interest costs could rise sharply within the next year or two, and whether its earnings could absorb the increase.
Companies often disclose a sensitivity, such as the effect on profit of a one percentage point rise in interest rates. Where it is given, it is one of the quickest ways to see how exposed the business is. Compare it with the company’s profit: a sensitivity that would remove a large share of annual earnings is a material risk, however comfortable the current coverage looks.
Provisions are obligations too
Alongside borrowings, the balance sheet lists provisions: amounts set aside for obligations whose timing or size is uncertain, such as employee leave entitlements, warranty claims, restoring leased premises at the end of a lease, or restructuring costs. They are real future calls on cash, even though they are not loans.
The provisions note shows how each one moved during the year: amounts added, amounts used and amounts released. A warranty provision that is regularly used up faster than it is topped up may mean products are failing more often than expected. A provision released back into profit can lift a year’s earnings without any improvement in the business. Reading the movements, not just the closing balances, shows whether the provisions are realistic.
Key takeaway
Financial resilience depends on the timing and reliability of cash resources relative to the company’s obligations.
Quick reference
- Are current obligations comfortably covered by usable resources?
- What debt matures within the next three years?
- Can the business pay interest if profits fall?
- Are receivables, inventory and recorded asset values realistic?