The 12-Week MBA Chapter 5: The Balance Sheet Part 1 - What a Company Owns and Owes
Here is a question that sounds simple but trips up most people: how do you know if a company with $175 billion in debt is in trouble? The answer might surprise you. This is post 6 in my 12-Week MBA retelling series.
Debt Is Not Always a Bad Sign
The authors open Chapter 5 with a comparison of two real companies. Company T has around $175 billion of debt and pays about $7 billion a year just in interest. Company P has basically zero debt. Which one makes you nervous?
Most people would pick Company T. We have been taught that debt is scary. We think about credit card bills, student loans, and mortgages. Debt means you owe somebody money, and if you cannot pay, bad things happen.
But here is the twist. Company T is AT&T, one of the biggest and most stable companies in the US. Company P is Palantir Technologies, which at the time of writing had never made a profit in about twenty years of existence. AT&T has so much debt because lenders are fighting to give it money. Palantir has no debt because nobody wants to lend to it.
Debt can actually be a sign of strength. If a bank is willing to give you a huge loan, it means they trust you to pay it back. That is the first lesson of this chapter: do not judge a company by its debt alone.
The Balance Sheet Is a Snapshot
So what is a balance sheet? Think of it as a photograph of a company at one specific moment. It answers two questions:
- What does the company own? (These are called assets.)
- Who has a claim on those things? (These are liabilities and equity.)
The magic rule that never changes: Assets = Liabilities + Equity. Always. Every time. If this equation does not balance, somebody made a mistake.
The authors use a food truck example to walk us through this, and it is the clearest explanation of a balance sheet I have ever read. Let me retell it.
Building a Balance Sheet from Scratch
Imagine you and a friend decide to start a grilled cheese food truck. You put in $25,000 of your own savings and borrow another $25,000 from a bank. Now the company has $50,000 in cash sitting in the bank.
Here is your first balance sheet:
- Assets: Cash = $50,000
- Liabilities: Bank loan = $25,000
- Equity: Your money = $25,000
Both sides equal $50,000. It balances. That is literally why it is called a balance sheet.
Notice something important. The cash does not just exist in a vacuum. Two different groups have a claim on it. The bank is owed $25,000 (plus interest). And you, the owner, have a claim on whatever is left after the bank gets paid. Right now, that is $25,000.
Turning Cash into Stuff
You cannot sell sandwiches with just cash. You need ingredients and equipment. So you spend $5,000 on food and $40,000 on a truck and cooking gear. Now:
- Assets: Cash = $5,000, Inventory = $5,000, Equipment = $40,000
- Liabilities and Equity: Same as before ($25,000 + $25,000)
Total assets still equal $50,000. You just changed one type of asset (cash) into other types (food and equipment). Nothing changed on the right side of the balance sheet. The bank still has its claim, you still have yours.
But here is what changed emotionally. The bank is now a little worried. Before, the company had enough cash to cover the entire loan. Now there is only $5,000 in the bank, barely enough for one year of payments. If the business fails, the bank might have to seize a used food truck and some melted cheese. Not a great deal for them.
Your First Month of Selling
Good news: your first month goes well. You sell all your inventory for $20,000. After paying salaries and advertising ($5,000 in expenses), you have $10,000 in profit. Not bad for a food truck.
Now the balance sheet gets interesting. That $10,000 profit stays inside the company (assuming you do not take it out). The equity section splits into two pieces:
- Paid-in capital: The $25,000 you originally invested.
- Retained earnings: The $10,000 profit that the company earned and kept.
Total equity is now $35,000. Total liabilities are still $25,000. Assets total $60,000 (cash + equipment). Both sides balance.
Retained earnings is a term worth remembering. It is all the profits a company has ever made that the owners chose not to take out yet. As long as there are good opportunities to grow, smart owners leave money in the business and let it compound.
Paying Yourself: Dividends
After that good first month, you decide to reward yourself. You take $5,000 out of the company as a dividend. Cash goes down by $5,000 on the assets side, and retained earnings go down by $5,000 on the equity side. Both sides still balance at $55,000.
Dividends are just the company paying shareholders some of the profit they have a claim to. It reduces the size of the balance sheet but everything stays in balance.
A New Player Enters: Accounts Payable
Your food ran out, and you need more. But this time your supplier says: “You are a good customer. Take the ingredients now, pay me next month.” So you get $5,000 of inventory without spending any cash.
This creates a new type of liability called accounts payable. It is a bill you have not paid yet. Unlike the bank loan, there is no interest on it. But it is still a promise you have to keep.
Now your balance sheet has three parties with claims on the company: the bank (debt), the supplier (accounts payable), and you (equity). The left side went up by $5,000 (more inventory), and the right side went up by $5,000 (the supplier’s claim). Still balanced.
Fast Forward: One Year Later
The authors run the food truck for a full year. Each month, $20,000 in sales, $5,000 in cost of food, $5,000 in other expenses, $5,000 in dividends to the owners. Plus a loan payment (interest and principal). The equipment also loses $2,000 of value over the year because it wears out. That wear-and-tear cost is called depreciation.
After one year, the balance sheet looks healthy:
- Cash: $65,000
- Inventory: $5,000
- Equipment: $38,000 (original $40,000 minus $2,000 depreciation)
- Accounts Payable: $5,000
- Debt: $22,500 (paid down $2,500 in principal)
- Equity: $80,500 (paid-in capital + retained earnings)
The business generated enough profit to build up a nice cash pile, pay down some debt, and still pay the owners dividends every month. Both creditors and shareholders should feel pretty good at this point.
The Big Takeaway from Part 1
The balance sheet is not some boring accounting form that only accountants care about. It tells a story. It tells you where a company came from (who invested money), where that money went (what was bought), and how things stand right now.
Every business decision shows up on the balance sheet. Buying equipment? Cash goes down, equipment goes up. Making a sale? Inventory goes down, cash goes up. Taking a loan? Cash goes up, liabilities go up. Paying a dividend? Cash goes down, equity goes down.
And here is the most important thing: it always balances. Every dollar that comes in is claimed by somebody, whether that is a bank, a supplier, or the owners. Understanding this simple fact is the foundation of reading any company’s financial health.
Key Takeaway
A balance sheet is a snapshot showing what a company owns (assets) and who has a claim on those things (liabilities and equity). The two sides always equal each other. Every business transaction changes both sides in a way that keeps them balanced. Debt is not automatically bad. Sometimes it means everyone wants to lend you money because you are trustworthy. The real question is not “how much debt does a company have?” but “can it reliably pay that debt back?”
Book: The 12-Week MBA by Nathan Kracklauer & Bjorn Billhardt | ISBN: 978-0-306-83236-9
Previous: Chapter 4 - Risk
Next up: Chapter 5 - The Balance Sheet Part 2 - Going deeper into balance sheet mechanics.
Part of the 12-Week MBA retelling series