Perhaps the most important information that can be derived from analysing the balance sheet is whether the company has good financial health. This is determined by how much cash or debt the company holds.
Needless to say, a company that has no debt will be better than one that has. But what is the optimal level of debt? The academic answer will involve corporate finance and things like WACC (pronouced as "whack" as in the sound that is made when you use a baseball bat and smash it on your broker's forehead) which I hope to touch on in future, but not now. For a rough gauge, perhaps we can look at two simple ratios.
- Net Debt to Equity ratio
- Cash to Market Cap ratio
For a company that has debt, we first subtract cash from its debt to get its net debt level. Next we simply divide its net debt by its shareholders' equity. E.g. Firm A has $100 Debt but $20 Cash and $80 Equity. Hence Net Debt to Equity = (100-20)/80 = 1. This means that Firm A employs as much debt as equity to finance its business. (Which is not very good lah, imagine your wife borrows from you $1000 for every $1000 she has to buy a Prada bag!)
In Singapore, a company with a Net Debt to Equity ratio of 1 or 100% is considered very bad since most listed companies here has no debt. This is especially true for the best companies around.
Now if the company has no debt, then how much cash is enough? The other ratio that people look at is the Cash to Market Cap ratio. This is simply taking cash that the company holds divided by its market capitalization. I would say that a ratio above 20% would be considered very good. This ratio rarely goes above 50% because if it does, essentially you are buying for the company's operations at a 50% discount. (i.e. your wife propose to sell her total net worth to you for $100,000, she has $50,000 in her bank and you get a cut of whatever she makes for the rest of her working life. Sounds good huh?)
To illustrate further, imagine that a company has a Cash to Market Cap ratio of 100%. Essentially, you bought the company for free, because its cash would have paid you the amount you forked out, plus you get the company's business which will continue to generate cashflow FOC.