What Is a Clean Balance Sheet?
A clean balance sheet indicates that a company has very little or no debt. Clean balance sheets typically combine healthy liquidity with minimal leverage, allowing for plenty of financial flexibility to fund operations, meet financial obligations and weather shocks or unexpected expenses.
- A clean balance sheet indicates that a company is in good financial health.
- Companies with clean balance sheets will have good asset coverage and liquidity ratios, as well as low debt leverage ratios.
- Clean balance sheets reduce downside risks, illustrating financial flexibility to expand or weather shocks and the ability to secure loans on favorable terms.
Understanding a Clean Balance Sheet
The balance sheet, one of three core financial statements used to evaluate a business, lists a company's assets, liabilities and shareholders' equity at a specific point in time. It provides a snapshot of the state of a company's finances, revealing what it owns and owes, as well as the amount invested by shareholders.
Balance sheets can often be described as clean or dirty. To qualify as clean, a company’s capital structure should be largely free of debt and its balance sheet easy to read, accurate and free of underperforming, non-productive assets. Companies with clean balance sheets will have good asset coverage and liquidity ratios, such as the current ratio, and low debt leverage ratios, as measured by debt to equity, and various debt to earnings ratios, including EBIT and EBITDA.
Management teams have several motivations to keep their balance sheets clean. These might include pressure from investors, creditors or rating agencies, and a desire to increase flexibility to better compete or engage in mergers and acquisitions (M&A).
Clean balance sheets are appealing to prospective acquirers, so a sudden tidy up can sometimes be a signal that a company is readying itself for a potential sale. Many investors find companies with clean balance sheets attractive because the minimal leverage reduces downside risks.
Clean Balance Sheet Method
A company that has a lot of debt may be advised to "clean up its balance sheet" in order to become more enticing to investors. This can be done by carrying out sales of non-strategic assets or unprofitable divisions, implementing cost reduction programs to free up cash flow, or at times through equity issuance.
Bringing down accounts receivables (AR) balances, reviewing inventory carrying value amounts and writing them down to current value where necessary, as well as reducing outstanding debt, are also all part of making a balance sheet more attractive.
A clean balance sheet is challenging to maintain, especially for businesses that derive a significant percentage of yearly revenues from seasonal activity.
When discussing banks, cleaning the balance sheet is a term used to describe the process of shedding unprofitable loans through distressed asset sales and write-offs, shoring up liquidity and slashing debt.
Under “fresh start” accounting rules, companies that experience a loss of equity control (existing holders control less than 50 percent of the common stock), and are technically insolvent are allowed to essentially start over.
That means when they exit the reorganization process their existing assets are revalued at their fair market value (FMV) and their debts are renegotiated. Companies emerging from reorganization typically trumpet their improved financial position and “clean balance sheet.”