What Is a Clean Balance Sheet?
A clean balance sheet typically combines healthy liquidity with minimal debt leverage. A clean balance sheet indicates a company has no significant debt during the statement period, allowing for plenty of financial flexibility to fund operations, meet financial obligations and weather shocks or unexpected expenses.
Understanding a Clean Balance Sheet
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 (for instance EBIT and EBITDA) ratios.
A company that has a lot of debt may be advised to "clean up its balance sheet" in order to become more attractive 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. Additionally, bringing down accounts receivables balances, inventory carrying value amounts and writing them down to current value where necessary, as well as reducing outstanding debt are all part of making a balance sheet more attractive.
Company management often has several motivations to do this. These might include pressure from investors, creditors or rating agencies, a desire to increase flexibility to better compete or engage in mergers and acquisitions (M&A). Sometimes, it is a signal that a company is readying itself for a potential sale.
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 bringing down their debt levels.
Challenges of a Clean Balance Sheet
A clean balance sheet is challenging to maintain, especially for businesses that derive a significant percentage of yearly revenues from seasonal activity. Many investors find companies with clean balance sheets attractive because the minimal leverage reduces downside risks.
Of course, one way to achieve a clean balance sheet is to undergo a bankruptcy or liquidation process. Companies can use a Chapter 11 reorganization to shed debt and negotiate new financing. Under “fresh start” accounting rules, companies that go through a Chapter 11 reorganization, a loss of equity control (existing holders control less than 50% 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 the fair market value and their debts are renegotiated. Companies emerging from reorganization typically trumpet their improved financial position and “clean balance sheet.”