The Balance Sheet: Assets, Liabilities and Equity
You learn to read an issuer's balance sheet, assess its liquidity and calculate working capital.
What the balance sheet shows
The balance sheet (in IFRS terminology, the statement of financial position) is a snapshot of the resources a company controls and the sources used to finance them, at a specific date — usually the end of the financial year. Unlike the income statement, which covers a period, the balance sheet captures a single moment.
For an investor, the balance sheet answers three questions: what the company owns, how much it owes and when, and how much is left for shareholders in accounting terms. Public-interest issuers generally report under international standards (IFRS), which makes balance sheet structures comparable across companies.
The structure of assets and funding sources
Items are classified by time horizon: current (realizable or due within 12 months or one operating cycle) and non-current (long-term).
- Fixed (non-current) assets: land, buildings, equipment, intangible assets, long-term financial investments.
- Current assets: inventories, trade receivables, other receivables, cash and cash equivalents.
- Long-term liabilities: bank loans and bonds maturing in more than one year, long-term provisions.
- Current liabilities: trade payables to suppliers, the current portion of loans, taxes and wages payable.
- Equity: share capital, reserves, retained earnings.
Balance sheet figures are largely accounting values: many assets are carried at historical cost less depreciation, so book value can differ substantially from market value. Internally developed brands or know-how often do not appear on the balance sheet at all.
Liquidity and working capital
Liquidity describes a company's ability to meet its short-term obligations. A profitable issuer can still run into trouble if its current assets do not cover its current liabilities when they fall due.
Interpretation: a current ratio of 1.5 looks comfortable, but a quick ratio below 1 shows that coverage depends on selling inventories. For an agricultural company with seasonal production this may be normal; for a services company it could be a warning sign.
Common pitfalls when reading a balance sheet
- Comparing ratios across sectors with different operating cycles.
- Ignoring asset quality: old receivables may be hard to collect, and inventories may be impaired.
- Analyzing a single balance sheet, without the multi-year trend and without the notes.
- Assuming that the book value of equity equals the true value of the business.
Key takeaways
- The balance sheet shows the financial position at a specific date: Total assets = Liabilities + Equity.
- Classifying items as current and non-current lets you assess liquidity and the funding structure.
- Working capital and liquidity ratios show the ability to meet short-term obligations.
- Book value often differs from market value; sound analysis requires a multi-year trend and reading the notes.
The Income Statement
You analyze an issuer's revenue, margins, EBITDA, net profit and earnings per share.
The cascading logic of the income statement
The income statement (profit and loss account) describes a company's performance over a period (quarter, half-year, year). It is structured as a cascade: starting from revenue, successive categories of expenses are deducted, producing intermediate profit levels that each tell you something different about the business.
- Revenue (turnover)Amounts earned from selling goods and services, recognized when the obligation to the customer is fulfilled, not necessarily when the cash is received.
- Gross profitRevenue minus cost of sales; it reflects production efficiency and pricing power.
- Operating profit (EBIT)Gross profit minus distribution, administrative and other operating expenses, including depreciation and amortization.
- Profit before taxEBIT plus finance income minus finance costs (mainly interest).
- Net profitProfit before tax minus income tax; this is the result attributable to shareholders.
Each step of the cascade isolates a different type of decision. Gross profit mainly reflects production and pricing policy, operating profit adds the efficiency of the overhead cost structure, and net profit includes the effect of financing decisions and taxation. That is why an analyst does not stop at the bottom line: two companies with the same net profit may have very different operating businesses, offset by different financing structures. Comparing all the intermediate levels over several years shows where value is created and where it is lost.
Margins and EBITDA
Margins let you compare companies of different sizes and track changes over time. A falling gross margin may signal pricing pressure or rising raw material costs; a falling net margin with a stable operating margin may point to a higher cost of debt.
A complete example and earnings per share
| Item (MDL thousand) | Amount | Margin on revenue |
|---|---|---|
| Revenue | 50,000 | 100% |
| Cost of sales | (32,000) | — |
| Gross profit | 18,000 | 36.0% |
| Distribution and administrative expenses (including depreciation of 3,000) | (8,000) | — |
| Operating profit (EBIT) | 10,000 | 20.0% |
| EBITDA = 10,000 + 3,000 | 13,000 | 26.0% |
| Interest expense | (2,000) | — |
| Profit before tax | 8,000 | 16.0% |
| Income tax (illustrative rate of 12%) | (960) | — |
| Net profit | 7,040 | 14.08% |
Earnings quality
Not all profit is equally valuable to an investor. Recurring profit from the core business is more relevant for valuation than non-recurring gains, such as the sale of land or the reversal of a provision.
- Separate exceptional items from the result of the core business.
- Compare revenue growth with growth in receivables: if receivables grow much faster, the quality of revenue may be questionable.
- Track margins over at least three to five years, not just in a single financial year.
- Compare net profit with cash flow from operating activities.
Also check whether the number of shares changed during the period through new issues or buybacks. EPS growth achieved only by reducing the share count does not mean the same thing as growth in net profit generated by the core business.
Key takeaways
- The income statement describes performance over a period, cascading from revenue down to net profit.
- Margins express each profit level relative to revenue and allow comparisons over time and across companies.
- EBITDA = EBIT + depreciation and amortization; it is useful for comparisons but is not the same as cash generated.
- EPS relates the profit attributable to ordinary shareholders to the weighted average number of shares.
- Recurring profit matters more for valuation than exceptional gains.
The Cash Flow Statement
You understand how cash is generated and used, and why accounting profit is not the same as cash received.
Why cash matters
Profit is calculated using accrual accounting: revenue and expenses are recognized when they are earned or incurred, not when cash is received or paid. That is why a company can report a profit and run out of cash at the same time. The cash flow statement reconciles these two perspectives.
For an investor, the cash flow statement is often the hardest of the three reports to "adjust," because cash coming in or going out can be verified. It shows whether the core business funds its own investments, how far the company depends on new loans or shareholder contributions, and whether dividends are backed by the cash it generates. Read together with the balance sheet and the income statement, it completes the economic picture of the issuer.
The indirect method for operating activities
Most issuers present operating cash flow using the indirect method: they start from net profit and adjust it for non-cash items and for changes in working capital.
- Start from net profitThis is the starting point of the reconciliation.
- Add back non-cash itemsDepreciation and amortization reduce profit but do not involve a cash outflow in the current period.
- Adjust for working capitalAn increase in receivables or inventories consumes cash (deducted); an increase in trade payables to suppliers keeps cash in the company (added).
- Arrive at cash flow from operating activitiesThe result shows how much cash the core business actually generated.
The classification of some items, such as interest paid or dividends received, may differ between issuers, because IFRS allows certain choices. In the example below, interest is included in operating cash flow.
Example: from profit to cash
| Nistru Agro SA — item (MDL thousand, illustrative) | Amount |
|---|---|
| Net profit | 7,040 |
| + Depreciation and amortization | 3,000 |
| − Increase in receivables | (1,200) |
| − Increase in inventories | (800) |
| + Increase in trade payables | 460 |
| Cash flow from operating activities | 8,500 |
| − Purchases of equipment (CAPEX) | (5,000) |
| + Proceeds from the sale of equipment | 300 |
| Cash flow from investing activities | (4,700) |
| − Loan repayments | (2,500) |
| − Dividends paid | (1,000) |
| Cash flow from financing activities | (3,500) |
| Net change in cash | 300 |
| Cash at the beginning of the year | 2,000 |
| Cash at the end of the year | 2,300 |
Free cash flow and warning signs
FCF shows the cash left after maintaining and expanding the asset base, available for repaying debt, paying dividends or buying back shares. In the example, the company generated MDL 3,500 thousand of FCF and used MDL 3,500 thousand for financing, keeping its cash position almost unchanged.
- Net profit rising while operating cash flow falls for several consecutive years.
- Dividends consistently funded by new borrowing rather than free cash flow.
- Receivables systematically growing faster than revenue.
- CAPEX below depreciation over the long term, which may indicate underinvestment.
Key takeaways
- Accounting profit and cash differ because of non-cash items and changes in working capital.
- Cash flows are split into operating, investing and financing activities; their sum is the net change in cash.
- Increases in receivables and inventories consume cash; an increase in trade payables keeps it in the company.
- FCF = operating cash flow − CAPEX shows the cash available to creditors and shareholders.
- Profit that does not turn into cash over the long term is a warning sign.
Educational material only. It does not constitute investment, legal or tax advice. Numerical examples are hypothetical.