A stock may look cheap, but if the company is drowning in debt or not generating cash, it can still destroy wealth. Even great businesses can fail if finances are mismanaged. This guide shows how to use the balance sheet, cash flow statement, and income statement to judge if a company can survive and grow.
By the end, you’ll know how to assess stability, profitability, and cash position using key ratios — and what they mean in the real world.
The Three Statements, Simply
- Balance Sheet: What the company owns (assets) and owes (liabilities) at a point in time.
- Cash Flow Statement: How much actual cash the business generates and where it goes.
- Income Statement: Whether the business is profitable and how margins are trending.
Think of your own finances: your bank balance (balance sheet), your salary vs. expenses (income statement), and cash left over after bills (cash flow). Together, they tell the full story.
Balance Sheet: Strength & Liquidity
A strong sheet = manageable debt, adequate assets, and room to maneuver.
Debt-to-Equity (D/E)
Total Debt ÷ Shareholder Equity. Lower is generally safer. Below 1 = stable; 2 = twice as much debt as equity (risky in rate hikes); 3–4+ can signal distress.
Current Ratio
Current Assets ÷ Current Liabilities. Measures ability to pay near‑term bills. Below 1 = potential strain; Above 3 may imply idle capital.
Cash Flow: Cash Is King
Operating Cash Flow (OCF)
Cash from core operations. Consistently positive OCF = healthy engine. Persistently negative = reliance on debt/equity just to survive.
Capital Expenditure (CapEx)
Spend on plants, equipment, tech. Good if growth‑accretive; risky if outpaces internal cash generation for long.
Free Cash Flow (FCF)
FCF = OCF − CapEx. Positive FCF funds expansion, dividends/buybacks, or debt reduction. Consistently negative can indicate cash burn.
Income Statement: Profitability & Efficiency
Net Profit Margin
Profit kept after all costs. Higher = better cost control/positioning; falling margins can flag pressure.
ROE
Return on shareholders’ equity. Tests management’s ability to compound owners’ capital.
ROCE
Return on total capital employed (equity + debt). Useful across capital structures.
Revenue Growth
Growth sustains relevance. Consistent growth suggests expanding demand/execution; falling revenue may imply share loss or industry headwinds.
Common Red Flags
- High debt combined with falling profits.
- Consistently negative free cash flow with no clear path to improvement.
- Declining revenue and shrinking margins.
- Unusual or frequent accounting adjustments, aggressive capitalization, or inventory build‑ups.
What’s Next
Financial health is the foundation — but investors must also judge profitability and growth durability. In the next chapter, we’ll dig into how to spot businesses that consistently generate strong returns.
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