The balance sheet

A photo, not a movie

The income statement is like a movie of the whole year: money in, money out. The balance sheet is a photo of one day. It shows what the company owns, what it owes, and what's left for the owners.

Three parts

• Assets: what it owns. Cash, ovens, delivery trucks, shop kitchens, flour in the storeroom, and money customers still owe it.
• Liabilities: what it owes. Bank loans and bills it hasn't paid yet.
• Equity: what's left for the owners. Assets minus liabilities.

The two sides always match:

Assets = Liabilities + Equity.

That's why it's called a balance sheet. Think of your bike. It's worth $200, but you still owe your sister $50 for it. Your "equity" in the bike is $150.

Sunny Slice's photo

• It owns $12 million: $2.5 million in cash, $8 million of ovens, trucks and shop kitchens, and $1.5 million of supplies and money owed to it.
• It owes $7 million: a $6 million bank loan and $1 million of unpaid bills.
• Equity: $12 million minus $7 million = $5 million for the owners.

Book value vs market cap

Equity is also called book value. Sunny Slice's is $5 million. But remember, its market cap is $30 million. Why would investors pay six times more than the balance sheet says?

Because they're buying future profit, not used ovens. A brand people love, secret recipes, and shops in great spots are worth a lot, but they're hard to put on a balance sheet.

Debt: helpful and dangerous

Borrowing helped Sunny Slice open shops faster. But a loan has to be paid back, plus interest, in good years and bad years. Sunny Slice pays about $0.5 million of interest each year.

Is its debt OK? It owes $6 million, has $2.5 million in cash, and makes $1.5 million of profit a year. It could pay off the loan in a few years if it needed to. That's healthy.

Now meet Wobbly Waffles. It owes $50 million, has $1 million in cash, and makes $1 million a year. One bad year and it might not be able to pay the bank. A company that can't pay its debts can go bankrupt, and stock owners are last in line.

Questions investors ask:

1. Does it have more cash than debt, or more debt than cash?
2. Could its profit pay off the debt in a few years?
3. Is the debt growing faster than the business?

When interest rates go up, companies with lots of debt get hit hardest, because new loans cost more. You'll see why in the bonds lesson.

Bills due soon

Also look at what's due this year. Sunny Slice has $2.5 million of cash and $1 million of bills to pay soon. Easy. A company with $1 million of cash and $5 million of bills due this year has a problem, even if it's profitable.

Remember

• The balance sheet is a photo of one day: what a company owns and owes.
• Assets = liabilities + equity. Always.
• Equity, or book value, is what's left for the owners.
• Too much debt can sink a good business in one bad year.