What is a clean balance sheet?
A healthy balance sheet indicates that a business has little or no debt. Healthy balance sheets typically combine healthy liquidity with minimal leverage, allowing financial flexibility to fund operations and meet financial obligations. Alternatively, a healthy balance sheet can also mean that all amounts are understandable, traceable and verifiable. It can also refer to a balance sheet that accurately reports healthy financial ratios.
Key points to remember
- A healthy balance sheet indicates that a business is in good financial health, but it can also mean that all the numbers are correct and verifiable.
- Firms with healthy balance sheets will have good asset and liquidity coverage ratios, as well as low debt ratios.
- Healthy balance sheets reduce downside risks, illustrating the financial flexibility to grow or cope with shocks and the ability to obtain loans on favorable terms.
Understanding a healthy balance sheet
The balance sheet, one of the three main financial statements used to value a business, lists the assets, liabilities, and equity of a business at a specific point in time. It provides a snapshot of a company’s financial condition, revealing what it owns and owes, as well as how much shareholders have invested.
Balance sheets can often be described as clean or dirty. To be qualified as clean, the capital structure of a company should be largely debt free and its balance sheet accurate and free from underperforming non-performing assets. Firms with healthy balance sheets will have good asset coverage and liquidity ratios, such as the current ratio, and low debt ratios, as measured by debt-to-equity, and various debt-to-earnings ratios, including including earnings before interest and taxes (EBIT) and earnings before interest, taxes, depreciation and amortization (EBITDA).
Management teams have several motivations for keeping their balance sheets clean. It can be pressure from investors, creditors or rating agencies, and a desire to increase flexibility to better compete or engage in mergers and acquisitions (M&A).
Healthy balance sheets are attractive to potential buyers, so a sudden cleanup can sometimes be a sign that a business is preparing for a potential sale. Many investors find companies with healthy balance sheets attractive because minimal leverage reduces downside risks.
Clean balance method
A highly indebted company may be advised to “clean up its balance sheet” in order to become more attractive to investors. This can be done by making sales of non-core assets or unprofitable divisions, by implementing cost reduction programs to free up cash flow, or sometimes by issuing shares.
Reducing accounts receivable (AR) balances, reviewing the book values of inventory and reducing them to their present value if necessary, as well as reducing the outstanding debt, also help to make a balance sheet more attractive.
A healthy balance sheet is difficult to maintain, especially for businesses that derive a significant percentage of their annual revenue from seasonal activities.
When talking about banks, balance sheet cleaning is a term used to describe the process of removing unprofitable loans through the sale and write-off of distressed assets, strengthening liquidity and reducing debt.
Another way to get a healthy balance sheet is to go through a bankruptcy or liquidation process. Companies can use a Chapter 11 reorganization to deleverage and negotiate new financing.
Under “fresh start” accounting rules, companies that experience a loss of control over their equity (existing holders control less than 50% of the common stock) and are technically insolvent are essentially allowed to start over.
This means that upon exiting the reorganization process, their existing assets are revalued to their fair market value (FMV) and their debts are renegotiated. Companies emerging from a reorganization usually trumpet their improved financial situation and “healthy balance sheet”.