Financial statements II: balance sheet and cash flow

The identity that cannot be faked

The balance sheet is a photograph at a moment — the last day of the quarter — and it obeys an identity that always balances: assets = liabilities + equity. Assets are what the company controls: cash, inventory, factories, what customers owe it. Liabilities are what it owes: suppliers, debt, tomorrow’s obligations. Equity is the residual — what would be left for the owners if every asset were sold and every liability paid at the printed values. The identity is not a theory; the books are kept so it holds, every quarter, to the dollar. That is why analysts trust this page’s structure even when they argue with its values.

Two readings matter most to an owner. The first is debt, honestly counted: total the borrowings — the interest-bearing debt, short-term and long-term — subtract cash and cash equivalents, and the result — net debt (or net cash, when the subtraction goes the other way) — is the load the business actually carries. Definitions vary at the edges (some counts fold in lease obligations, some don’t), so the honest habit is comparing like with like. The journal’s fundamentals quote it the same way for every name. The second is the cushion: short-term assets against short-term liabilities — whether the next twelve months’ bills are covered by the next twelve months’ resources, the corporate version of an emergency fund.

Net debt is also the bridge between a company’s two prices. The market capitalization prices only the equity — what the shares are worth. An acquirer effectively pays more: they assume the debt and keep the cash, so the whole-business price — enterprise value — is market cap plus net debt (or minus net cash). That is why leverage-neutral multiples divide by enterprise value: two businesses with identical operations and different borrowing should not look differently priced merely because one owner’s slice is thinner. The standard one has a name worth owning: EV/EBITDA — enterprise value divided by EBITDA (earnings before interest, taxes, depreciation, and amortization). The direction is the definition: the whole-business price on top, a whole-business earnings measure beneath it — EBITDA is stated before interest precisely because it belongs to lenders and owners together, the same crowd enterprise value prices. Written the other way up, the fraction is not a cheaper multiple; it is a different measure — a rough earnings yield.

The cash flow statement: earnings, audited

If the balance sheet is the photograph, the cash flow statement is the bank statement — and it exists because the income statement (Lesson I1) is written in accruals: revenue booked when earned, not when paid. The cash flow statement undoes the accruals and reports what actually moved, in three currents: operating (the business’s own cash generation), investing (buying and selling the long-lived stuff — factories, equipment, other companies), and financing (borrowing, repaying, dividends, issuing or buying back shares).

From the first two currents comes the number this track treats as the owner’s bottom line: free cash flow = operating cash flow − capital expenditure. It is what the business generated after paying to maintain and grow its asset base — the cash genuinely available to owners, lenders, and buybacks. A mature company’s earnings and its free cash flow should tell the same story over time. When they persistently do not, one of the statements is describing a business that does not exist.

The red flags

Three patterns, each visible with I1 and this lesson alone. Receivables outrunning revenue: customers’ unpaid bills growing much faster than sales can mean the ‘sales’ are being pushed into the channel to dress the income statement — revenue is being recognized that customers have not agreed, in cash, was worth it. Free cash flow chronically below net income: profits that never become cash are an accrual story told quarter after quarter; the cash flow statement is where it confesses. Debt funding the dividend: when the financing current shows borrowing rising while dividends and buybacks flow out, the company is paying its owners with its lenders’ money — sustainable exactly as long as the lenders agree.

None of the three requires an accounting degree to spot; they require lining the statements up together, which is why this track teaches them as one skill across two lessons. The income statement proposes. These two pages dispose.

The owner’s five-minute version

Compressed to the routine the Sunday read (Lesson 24) can hold: from the balance sheet, take the net debt and its direction (growing or shrinking against the business); from the cash flow statement, take operating cash flow, capital expenditure, and the free cash flow they imply; from I1, the net income. Then one comparison, the conversion test: free cash flow divided by net income, over the last several years. Mature businesses in a steady state often run at or above one — profits arriving as cash, with something left over. But the ratio is a diagnostic, not a verdict, and it is read in context: a fast-growing business can convert below one for years on honest arithmetic (receivables and inventory grow with its sales; capital spending runs ahead of depreciation), and a shrinking one can convert above one by starving its future. A business converting at a fraction of one, year after year, owes its owner an explanation — and the statements themselves have usually already given it. What the test never establishes, in either direction, is accounting quality or misconduct; it establishes only where to dig.

That is the fundamentals skill whole: three pages, read together, in the owner’s order. The valuation question (Lesson 8) and the portfolio question (Lesson I4) both stand on it — and so does the daily work of this desk, whose formulas you can now re-derive from any filing rather than take on trust.

Where this breaks

The gauges locate digging; they never deliver verdicts. Cash conversion below one can be honest growth arithmetic, and above one can be a shrinking business starving its future — the lesson’s own readings, not excuses. Net debt’s edges also move between publishers: some counts fold in lease obligations, some do not, so two sources can print two net debts for the same company and both be following their stated rules. Compare like with like, and read the definition before the number.

Practice

Compute, then judge, for a fictional company, Calder Works: short-term debt $1.2B, long-term debt $3.8B, cash and cash equivalents $1.5B, market capitalization $20B, EBITDA $2.5B, operating cash flow $2.1B, capital expenditure $0.6B, net income $1.3B. (1) Net debt. (2) Enterprise value, and EV/EBITDA — stating which number divides which. (3) Free cash flow and the cash-conversion ratio. (4) In one sentence: what none of these numbers, alone or together, establishes.

Answers: (1) ($1.2B + $3.8B) − $1.5B = $3.5B. (2) EV = $20B + $3.5B = $23.5B; EV/EBITDA = 23.5 ÷ 2.5 = 9.4 — enterprise value divided by EBITDA, never the reverse. (3) FCF = $2.1B − $0.6B = $1.5B; conversion = 1.5 ÷ 1.3 ≈ 1.15. (4) None of it establishes accounting quality or misconduct — it establishes where to dig.