BALANCE SHEET ANALYSIS
A balance sheet, also known as a "statement of financial position", reveals a company's assets, liabilities and owners' equity (net worth). The balance sheet, together with the income statement and cash flow statement, make up the cornerstone of any company's financial statements.
If you are a shareholder of a company, it is important that you understand how the balance sheet is structured, how to analyse it and how to read it.
How the balance sheet works
The balance sheet is divided into two parts that, based on the following equation, must equal (or balance out) each other. The main formula behind balance sheets is:
assets = liabilities + shareholders' equity
This means that assets, or the means used to operate the company, are balanced by a company's financial obligations along with the equity investment brought into the company and its retained earnings.
Assets are what a company uses to operate its business, while its liabilities and equity are two sources that support these assets. Owners' equity, referred to as shareholders' equity in a publicly traded company, is the amount of money initially invested into the company plus any retained earnings, and it represents a source of funding for the business.
It is important to note, that a balance sheet is a snapshot of the company's financial position at a single point in time.
Know the types of assets
Current assets
Current assets have a life span of one year or less, meaning they can be converted easily into cash. Such assets classes are: cash and cash equivalents, accounts receivable and inventory. Cash, the most fundamental of current assets, also includes non-restricted bank accounts and checks.
Cash equivalents are very safe assets that can be are readily converted into cash such as US Treasuries. Accounts receivable consists of the short-term obligations owed to the company by its clients. Companies often sell products or services to customers on credit, which then are held in this account until they are paid off by the clients.
Lastly, inventory represents the raw materials, work-in-progress goods and the company's finished goods. Depending on the company, the exact makeup of the inventory account will differ. For example, a manufacturing firm will carry a large amount of raw materials, while a retail firm caries none. The makeup of a retailers inventory typically consists of goods purchased from manufacturers and wholesalers.
Non-current assets
Non-current assets, are those assets that are not turned into cash easily, expected to be turned into cash within a year and/or have a life-span of over a year. They can refer to tangible assets such as machinery, computers, buildings and land.
Non-current assets also can be intangible assets, such as goodwill, patents or copyright. While these assets are not physical in nature, they are often the resources that can make or break a company - the value of a brand name, for instance, should not be underestimated.
Depreciation is calculated and deducted from most of these assets, which represents the economic cost of the asset over its useful life.
Learn the different liabilities
On the other side of the balance sheet are the liabilities. These are the financial obligations a company owes to outside parties. Like assets, they can be both current and long-term. Long-term liabilities are debts and other non-debt financial obligations, which are due after a period of at least one year from the date of the balance sheet.
Current liabilities are the company's liabilities which will come due, or must be paid, within one year. This is comprised of both shorter term borrowings, such as accounts payables, along with the current portion of longer term borrowing, such as the latest interest payment on a 10-year loan.
Shareholders' equity
Shareholders' equity is the initial amount of money invested into a business. If, at the end of the fiscal year, a company decides to reinvest its net earnings into the company (after taxes), these retained earnings will be transferred from the income statement onto the balance sheet into the shareholder's equity account.
This account represents a company's total net worth. In order for the balance sheet to balance, total assets on one side have to equal total liabilities plus shareholders' equity on the other.
Read the Balance Sheet
Below is an example of a balance sheet:
Source: https://www.edgar-online.com
As you can see from the balance sheet above, it is broken into two sides. Assets are on the left side and the right side contains the company's liabilities and shareholders' equity. It also can be seen that this balance sheet is in balance where the value of the assets equals the combined value of the liabilities and shareholders' equity.
Another interesting aspect of the balance sheet is how it is organized. The assets and liabilities sections of the balance sheet are organised by how current the account is. So for the asset side, the accounts are classified typically from most liquid to least liquid. For the liabilities side, the accounts are organized from short to long-term borrowings and other obligations.
Analyze the balance sheet with ratios
With a greater understanding of the balance sheet and how it is constructed, we can look now at some techniques used to analyze the information contained within the balance sheet. The main way this is done is through financial ratio analysis.
Financial ratio analysis uses formulas to gain insight into the company and its operations. For the balance sheet, using financial ratios (like the debt-to-equity ratio) can show you a better idea of the company's financial condition along with its operational efficiency. It is important to note that some ratios will need information from more than one financial statement, such as from the balance sheet and the income statement.
The main types of ratios that use information from the balance sheet are financial strength ratios and activity ratios. Financial strength ratios, such as the working capital and debt-to-equity ratios, provide information on how well the company can meet its obligations and how they are leveraged.
This can give investors an idea of how financially stable the company is and how the company finances itself. Activity ratios focus mainly on current accounts to show how well the company manages its operating cycle (which include receivables, inventory and payables). These ratios can provide insight into the operational efficiency of the company.
There are a wide range of individual financial ratios that investors use to learn more about a company.
Conclusion
The balance sheet, along with the income and cash flow statements, is an important tool for investors to gain insight into a company and its operations. The balance sheet is a snapshot at a single point in time of the company's accounts - covering its assets, liabilities and shareholders' equity.
The purpose of the balance sheet is to give users an idea of the company's financial position along with displaying what the company owns and owes. It is important that all investors know how to use, analyse and read one.
For companies, being able to meet short-term financial obligations is an integral part of maintaining operations and growing in the future. After all, if it's not able to meet today's debts, a company might not live to see another day! That's why it's essential for investors to know how to evaluate a company's short-term financial health. Here we take you through a few of the ratios that are the foremost tools for doing so.
The basics of liquidity
A large factor determining a company's short-term financial health is liquidity, the definition of which depends on context. In stock trading, liquidity is the degree to which the market is willing to buy a particular stock. As a characteristic of an asset, liquidity refers to the ease with which an asset can be converted into cash. This is the definition of liquidity we are interested in.
Let's compare two different kinds of assets: a building and a money market account. Even if these two assets are valued at $100,000 on a company's financial statement, their liquidities have different implications for the company's short-term health.
The money market account, an asset referred to as a cash equivalent, can be converted into cash within a day or two, if not immediately. The building, however, is very illiquid. For the company to get its cash, it must sell the building, which could take months, if not years.
Essentially, a company's short-term liquidity determines how well it can make its necessary payments (cash outflows) - which include employee wages, interest and supplier costs - given the revenue it generates (cash inflows). If a company has no cash equivalents, its inflows need to match or exceed cash outflows. So, if a company has a bad month and it has no supply of liquid assets like a money market account, it will be unable to make its necessary payments.
The current ratio:
The first ratio we will look at is the current ratio, which compares all of a company's current assets to all of its current liabilities. In general, the term "current" means less than one year. So, current assets include cash, accounts receivable, inventory, prepaid expenses and other assets that can be converted to cash within one year. Current liabilities include short-term debt, interest, accounts payable and any other outstanding liabilities that are due within a year's time.
When calculating this ratio, you are essentially trying to determine whether a company can meet its short-term obligations. It will likely be able to do so if the ratio is above 1; if the ratio is less than 1, the company is likely to fall short. We say "likely" because although a ratio of 1 or greater indicates that the company has more current assets than current liabilities, it may be inappropriate to judge certain industries by a rigid standard.
For industries that generally have a large portion of current assets tied up in inventory, a ratio of 1.5 or even 2 might be a better standard. When analyzing the current ratio, as when looking at any ratio, an investor should make comparisons between companies that operate in the same industry. Different industries have different business needs, so investors must modify their analyses accordingly.
Finally, bigger is not necessarily better in the case of the current ratio. A really high ratio, 10 for example, should probably sound some alarm bells, because it indicates that the company has a large amount of current assets that could - and probably should - be invested back into the company. Although a company with a very high current ratio may be stable in the short term, it probably has no means of sustaining its long-term growth and performance.
The acid test or quick ratio:
The acid test is a more rigorous version of the current ratio. It indicates whether a firm, without selling inventory, has enough short-term assets to cover its immediate liabilities. Companies with ratios of less than 1 cannot pay their current liabilities without selling inventories and should be viewed with extreme care. An acid test that is much lower than the current ratio signals that current assets are highly dependent on inventory - retail is a type of business in which this would occur. In general, a ratio of 1 is considered satisfactory, although, as with the current ratio, the acid test should be compared only within a similar industry.
Interest coverage:
Interest coverage indicates what portion of debt interest is covered by a company's cash flow. A ratio of less than 1 means the company is having problems generating enough cash flow to pay its interest expenses. Ideally, you want the ratio to be over 1.5.
A company with no long-term debt doesn't have any interest expense; this situation causes the current ratio to give enviable results. Companies with a poor interest coverage ratio can improve it by improving cash flow and/or lowering interest expenses by paying off debt.
This ratio is popular not only among investors, but also with creditors, who want to see that a company's short-term health is strong and that the company has sufficient cash flow to make principal and interest payments.
Another notable fact about the ratio is that sometimes different numerators will be used. For example, some analysts or creditors will use EBITDA in place of EBIT.
Activity ratios
There are a few different activity ratios, but essentially, their main function is to help determine the company's cash flow cycle, giving a picture of how efficiently assets are being used. Almost any current account can be analyzed in terms of this cycle, but the three most common activity ratios each measure one of the following:
· How long a company takes to collect receivables
· How long a company takes to sell inventory
· How long it takes to pay suppliers
The calculation of activity ratios is a little complex, but to give you an idea of how these ratios work, we'll look at the activity ratio dedicated to accounts receivable. Suppose that a company has total credit sales of $22 million. At the beginning of the year, accounts receivable is at $4.5 million, and at the end it's $1.5 million. By using the accounts receivable turnover ratio we can determine that the company's receivables turn over at a rate of approximately 7.3 times per year. This means receivables remain outstanding for an average of 50 days. Here the calculations are represented mathematically:
Although we only demonstrate one activity ratio calculation here, the others are calculated in a similar fashion. All it takes is some research into the company and some number crunching.
Let's look at an example to put this all into context. Suppose that the above company has to pay suppliers within 90 days of purchase and suppose that, by calculating another activity ratio, we find the company holds inventory for 80 days.
As the company's accounts receivable remain outstanding for 50 days, we find it has a cash cycle of 130 days (80+50). In other words, from the time it purchases its product from the supplier, the company takes approximately 130 days to collect payment from the customer.
The supplier, however, requires a payment within 90 days of the purchase. This 40-day discrepancy may create short-term liquidity problems for the company. This means investors should conduct more research to determine whether there is justification for this difference, and whether it is likely to cause hardship for the company.
Examining activity ratios and determining a company's cash flow cycle are important elements of determining a company's short-term health and should be analyzed in conjunction with the other short-term liquidity ratios.
Conclusion
By honing in on crucial aspects of a company's financial health, ratios shed light on how well a company will do in the short term. More importantly, they help investors determine whether a company has the stability to get through unexpected problems today. If a company cannot maintain operations in the short term, it will not have the ability to provide investors with any benefits in the long term.
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