Assets, liabilities, equity
The balance sheet shows a company's financial position at a point in time. Assets are what the company owns or controls — cash, receivables, inventory, property, intellectual property. Liabilities are what it owes — accounts payable, debt, pension obligations. The difference is shareholder equity.
The most important balance sheet metric for risk assessment is the debt load. Companies with high debt relative to earnings (measured by net debt / EBITDA) have less flexibility. If earnings fall, they can't just cut the dividend — they may struggle to service debt. This amplifies downside in economic contractions.
Cash position matters equally. A company with $5B in cash and $3B in debt has net cash of $2B — it can absorb a downturn, invest opportunistically, and return capital to shareholders. A company with $5B in debt and $500M in cash is vulnerable to refinancing risk when rates are high or credit markets tighten.
When a company acquires another at a premium to book value, it records "goodwill" on its balance sheet — the excess paid over fair value. Goodwill can be impaired (written down) if the acquisition underperforms, which is an instant hit to reported earnings. High goodwill relative to total assets is a risk to watch.
Debt structure and maturity
Not all debt is equally dangerous. Short-term debt (maturing within a year) must be refinanced regularly — a risk when credit markets seize up or rates spike. Long-term debt locks in financing costs for years, but at fixed rates that can become a burden if the business deteriorates.
Interest coverage ratio (EBIT / interest expense) measures a company's ability to service debt from operating earnings. A ratio below 2x is considered stressed — the company is generating barely twice its annual interest bill. Below 1x is critical.
Investment-grade companies (BBB- and above) have access to public bond markets at lower rates. High-yield (junk) companies pay more and are more vulnerable to credit market conditions. When high-yield spreads widen, these companies' financing costs rise and their stock typically sells off.
Reading the cash flow statement
Operating cash flow shows how much actual cash the business generates from operations — stripping out accounting choices, non-cash charges, and working capital movements. It's the most honest measure of underlying business health.
Free cash flow (FCF) is operating cash flow minus capital expenditures. It's what the company has left after maintaining and growing its asset base — available for debt paydown, dividends, buybacks, or acquisitions. FCF yield (FCF divided by market cap) is a practical valuation metric.
A company consistently earning profits but generating negative free cash flow is a red flag. It means the business requires continuous reinvestment just to maintain its earnings — and if growth slows, FCF may never materialize. SaaS companies before reaching scale often have this profile; evaluating when FCF breakeven occurs is crucial.