Why The Balance Sheet Holds The Key To Profit Growth

What ASX companies have the strongest balance sheets?

| More on:
a woman

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

For many investors, all that matters is a company's profitability. After all, it is rising profitability which tends to cause an increase in share prices over a sustained period of time. However, the reality is that profitability and profit growth are only possible in the long run when a business has a sound balance sheet. If for whatever reason it does not, then this can cause its income statement to disappoint and investor sentiment to come under pressure.

Debt levels

 

The most important aspect of a balance sheet is debt. If a business is carrying too much debt then it can hamper its profitability, since all debt must be serviced. In recent years this has not been a major problem since interest rates have been at rock bottom. As a result, a number of companies have increased debt, knowing that because they can afford to make what are historically low interest payments, their profitability will not be affected.

However, the future interest rate is likely to be much higher as the world transitions away from the deflationary phase which has been a key feature of the last decade. A new US President and his more relaxed fiscal standpoint could cause global inflation to rise, which may mean that interest rates do likewise. Companies which have high amounts of debt on their balance sheets may find that their profitability is squeezed by higher interest costs, which could cause their share prices to disappoint.

Assets

 

On the asset side of the balance sheet, a healthy cash pile is crucial in order for all companies to operate. Without cash, it is not possible to continue as a going concern. While larger companies tend to have significant amounts of cash on hand as well as various credit lines with their lenders, smaller companies sometimes have insufficient cash with which to operate over the medium term.

That's especially the case if they are unprofitable, and this can lead to the requirement of a fundraising which could dilute an investor's holding. Even worse, insufficient cash could lead to a permanent lack of profitability if the company in question goes under.

Other assets to consider are debtors and stock levels. For the former, continually increasing amounts due from customers could indicate that the company in question is having problems collecting monies owed to it. In fact, it could mean that the debtors total needs to be written down in order to more accurately reflect the position of the business. Doing so, however, could hurt its overall valuation.

Similarly, stock levels which are continually rising or excessive indicate an inefficient business which is not making use of its cash resources. They could be better employed elsewhere in order to generate higher profitability.

The Foolish Takeaway

 

Although the balance sheet is merely a snapshot of a company's financial position at a specific moment in time, it indicates how successful a company will be in future. High debt levels, rising debtors and excessive stock levels show a company that is struggling to turn a profit and which could continue to do so in future.

Meanwhile, a business which has modest debt, stable debtors and sensible stock levels looks efficient, disciplined and is much more likely to be profitable and capable of delivering rising profitability in future.

Motley Fool contributor Motley Fool Staff has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

More on ⏸️ Investing

Close up of baby looking puzzled
Retail Shares

What has happened to the Baby Bunting (ASX:BBN) share price this year?

It's been a volatile year so far for the Aussie nursery retailer. We take a closer look

Read more »

woman holds sign saying 'we need change' at climate change protest
ETFs

3 ASX ETFs that invest in companies fighting climate change

If you want to shift some of your investments into more ethical companies, exchange-traded funds can offer a good option

Read more »

a jewellery store attendant stands at a cabinet displaying opulent necklaces and earrings featuring diamonds and precious stones.
⏸️ Investing

The Michael Hill (ASX: MHJ) share price poised for growth

Investors will be keeping an eye on the Michael Hill International Limited (ASX: MHJ) share price today. The keen interest…

Read more »

ASX shares buy unstoppable asx share price represented by man in superman cape pointing skyward
⏸️ Investing

The Atomos (ASX:AMS) share price is up 15% in a week

The Atomos (ASX: AMS) share price has surged 15% this week. Let's look at what's ahead as the company build…

Read more »

Two people in suits arm wrestle on a black and white chess board.
Retail Shares

How does the Temple & Webster (ASX:TPW) share price stack up against Nick Scali (ASX:NCK)?

How does the Temple & Webster (ASX: TPW) share price stack up against rival furniture retailer Nick Scali Limited (ASX:…

Read more »

A medical researcher works on a bichip, indicating share price movement in ASX tech companies
Healthcare Shares

The Aroa (ASX:ARX) share price has surged 60% since its IPO

The Aroa (ASX:ARX) share price has surged 60% since the Polynovo (ASX: PNV) competitor listed on the ASX in July.…

Read more »

asx investor daydreaming about US shares
⏸️ How to Invest

How to buy US shares from Australia right now

If you have been wondering how to buy US shares from Australia to gain exposure from the highly topical market,…

Read more »

⏸️ Investing

Why Fox (NASDAQ:FOX) might hurt News Corp (ASX:NWS) shareholders

News Corporation (ASX: NWS) might be facing some existential threats from its American cousins over the riots on 6 January

Read more »