Lessons › Fundamentals and news › Debt, cash and cash flow
World 7 · Fundamentals and news · lesson 6 · level 3
Debt, cash and cash flow
A company with lots of debt and little cash can get into trouble even when it reports a profit.
In one line
A company with lots of debt and little cash can get into trouble even when it reports a profit.
Explained simply
Imagine a family that earns a good salary but has a huge loan and an empty wallet: one surprise bill could cause real trouble. Companies are the same. Profit on paper is not the same as cash in the bank, and heavy debt makes bad years much harder.
The lesson
The balance sheet lists what a company owns (assets) and what it owes (liabilities), and the debt-to-equity ratio compares its borrowing with its shareholders' money. The cash flow statement shows the cash that actually came in and went out, which can differ from reported profit. Companies with heavy debt are more exposed to rising interest rates and bad years. Free cash flow, operating cash flow minus spending on equipment and buildings, shows the cash left over for debts, dividends and growth.
A worked example
Illustrative example: a company owns assets of 400 and owes debts of 300, so shareholders' equity is 100 (400 minus 300) and debt-to-equity is 3 (300 divided by 100). If the interest rate on that debt rises from 5% to 8%, yearly interest grows from 15 (300 times 0.05) to 24 (300 times 0.08). Its operating cash flow of 40, minus 30 spent on equipment, leaves free cash flow of 10 (40 minus 30).
The same idea at four levels
- Beginner. A company can report a profit and still run short of cash.
- Foundation. The balance sheet balances: assets = liabilities + shareholders' equity.
- Intermediate. Debt-to-equity = debt ÷ equity, so 300 of debt against 100 of equity is 3, a heavily borrowed company.
- Advanced. Free cash flow = operating cash flow − spending on equipment and buildings, and a profit with weak cash flow deserves a closer look.
- Expert. Experts check how a company's interest bill would change if rates rose, and compare debt within an industry, since some industries normally borrow more.
Mistakes to avoid
- Looking only at profit and ignoring debt and cash flow.
- Assuming all debt is bad; some industries normally carry more.
- Forgetting that rising rates can push up a heavy borrower's interest bill.
Check yourself
What does a balance sheet list?
What a company owns and what it owes. Assets on one side, liabilities and equity on the other.
Can a company with a profit run short of cash?
Yes, profit on paper is not cash in the bank. Cash flow can differ from reported profit.
What does the cash flow statement show?
The cash that actually came in and went out. It tracks real cash.
Why is heavy debt risky?
Interest must be paid even in bad years. Fixed payments bite when business slows.
Assets are 400 and debts are 300. What is shareholders' equity?
100. 400 minus 300 is 100.
Goal of this lesson: Check a company's financial health using its debt, cash and cash flow.