How to analyze a balance sheet ?

The balance sheet has several purposes including telling you the assets a company has to protect shareholders, how efficiently management is using capital, the risk of bankruptcy, and how fast a business can grow.

To get balance sheet copy most of the time you can go onto a company’s website and find the Investor Relations link. From there, you should be able to either download the annual report in PDF form or documents that Securities Exchange Commission makes available to you online at the Edgar website give you all sorts of balance sheet information in the 10-Ks and 10-Qs. 10-K is reported annually and contains all financial statements as an annual report has. 10-Q is similar is a quarterly filing that a company makes with SEC that also tracks balance sheet throughout the year. 10-Q is critical because if a company wants to change some policies, they may report it in 10-Q which may not be available in 10-K.

Current Assets

One of major component of the balance sheet is Current Assets, which are assets that a company has at its disposal that can be easily converted into cash within one operating cycle. An operating cycle is the time in which company takes to sell a product and collect cash from the sale. It can last anywhere from 60 to 180 days. Current assets are important because company depends for funds for its ongoing, day to day operations on current assets. There are five main kinds of current assets – Cash & Equivalents, Short – Long term Investments, Accounts Receivable, Inventories and Prepaid Expenses.

Cash & Equivalents are assets that are money in the bank, literally cold, hard cash or something equivalent, typically complete liquid assets.

Investments come into play when a company has so much on hand that it can afford to tie some of it up in bonds with durations of less than a year. This money cannot be immediately liquefied, but it does earn higher returns to strengthen cash position of company.

Accounts Receivable is the money currently owed to a company by its customers. Looking at the growth in accounts receivable relative to the growth in revenues is important. If receivables are up more than revenues, you know that lot of sales for that period have not been paid yet.

Inventories are the components and finished products that a company has currently stockpiled to sell to customers. Inventories should be viewed somewhat skeptically by investors as an asset. First, because of real liquidation compared to accounting value, the value of inventories is often overstated on the balance sheet. Second, money blocked in inventories cannot be used to sell it. Companies that have inventories growing faster than revenues or that are unable to move their inventories fast enough are sometimes disasters waiting to happen.

Prepaid Expenses are expenditure that the company has already or over paid to its suppliers. Although this is not completely liquid, but having bills already paid is definite plus. It means less amount has to be paid for that expense and more of the revenues will flow to the bottom line and become liquid assets.

Current Liabilities

These are short-term debts that normally require that the company convert some of its current assets into cash in order to pay them off. As well as simply being a bill that needs to be paid, liabilities are also a source of assets. Any money that a company pulls out of its line of credit or gains the use of because it pushes out its accounts payable is an asset that can be used to grow the business. There are four main categories of current liabilities; Accounts Payable, Accrued Expenses, Short-Term Notes Payable and Long-Term Debt Payable.

Accounts Payable are basic costs of doing business that a company, for whatever reason, has not paid off yet. One company’s accounts payable is another company’s accounts receivable, which is why both terms are similarly structured. A company has the power to push out some of its accounts payable, which often produces a short-term increase in earnings and current assets.

Accrued Expenses are bills or services that the company has racked up but it has not yet paid. These are normally contracted, utility expenses and taxes subject to withholding that are billed on set schedule and have not yet come due. Although subject to withholding,

Short-Term Notes Payable is the amount that a company has drawn off from its line of credit from a bank or other financial institution that needs to be repaid within next one year. The company also might have a portion of its Long Term Debt come due with the year, which is why this gets counted as a current liability even though it is called long-term debt.

Debt & Equity

The remainder of the balance sheet is taken up by assets that cannot be easily converted into cash or liabilities that will not come due for more than a year. Specifically, these are main categories – Fixed Assets, Long-Term Liabilities, Equity and Retained Earnings.

Fixed Assets are assets are not liquid, but that are kept on a company’s books for accounting purposes. Much of this is actually subject to an accounting convention called depreciation for tax purposes, meaning that the stated value of the total assets and the actual value or price paid might be very different.

Long Term Liabilities are normally loans from banks or other financial institutions that are secured by various assets on the balance sheet, such as inventories. Most companies will tell you in a footnote to this item when this debt is due and what interest rate the company is paying.

Equity & Retained Earnings are more than a little bit confusing and does not always add all that much value to the analysis. Equity can be capital introduced by owner plus par value of stock issued that is recorded purely for accounting purposes and has no real relevance to the actual value of company’s stock. Retained earnings simply measures the amount of earnings a company has generated and decides that earnings should be retained. These have to account for on the balance sheet under shareholder equity. This allows investors to see how much money has been generated through business over the years.

Balance sheet – Checklist
  • Bank Reconciliation – review bank in books including a copy of the bank statement.
  • Petty Cash Reconciliation – ensure the amounts reimbursed balance with the nominal balance to be held.
  • Debtor’s Accounts – include any amounts not contained in aged debtors report. This will also include analysis of amounts outstanding greater than 30 days with reports on action taken.
  • Fixed Asset Reconciliation – examine fixed asset to ensure all items of capital are included. Ensure there are no obsolete items being depreciated (e.g. obsolete computer hardware/ upgraded software applications).
  • Pre-paid Expenses – ensure pre-paid expenses relate to future periods are accounted e.g. Rent paid in advance, Taxes & Insurance, Legal & Contractual expenses.
  • Income Accrual – ensure income, which is due but has not been invoiced or received, is raised as accrued income e.g. interest income, accounts receivable, rent receivable.
  • Expense Accrual – ensure all accrued expenses i.e. interest payable, Taxes payable, Wages payable, Goods/ Services received for which no supplier invoice has yet been received is reflected in the accounting records.
  • Pre-paid Income – ensure pre-paid income is accounted for properly
  • Creditor’s Accounts – review the creditors report to ensure all expenses are current and credit notes have been processed where applicable.
  • Accrued Expenses – ensure all expenses are included as accrued expenses if the amounts have not been included in the accounts payable ledger. Examine accrued expenses to ensure liability had arisen at balance date
  • Contingent Liabilities – ensure all contingent liabilities are raised including necessary compliance requirements.
  • Payroll Liabilities – examine payroll reports to substantiate wages/deductions/ superannuation and taxation balances.
Balance sheet – Analysis

After knowing all the terms of balance sheet now you are ready to analyze and judge actual position of company through balance sheet. With the help of below stated ratios you can easily get an idea about company’s financial position.

Current Ratio is a measure to know how much liquidity a company has, the formula for calculating a company’s current ratio is:

Current Ratio = (Current Assets/ Current Liabilities)

 

As a general rule, a current ratio of 1.5 or greater is normally sufficient to meet near term operating needs. A current ratio is too high can suggest that a company is hoarding assets instead of using them to grow the business; not the worst thing in the world, but potentially something that could impact long-term returns. But certain industries have their own norms as far as which current ratios make sense e.g. in the auto industry a high current ratio makes a lot of sense if a company does not want to go bankrupt during the next recession. Because, if a company (like auto industry) has a lot of its liquid assets tied up in inventory, it is very dependent on the sale of that inventory to finance operations. If a company is not growing sales very quickly, this can turn into an albatross that forces company to issue stock or take on debt.

Quick Ratio, because of above, it pays to check quick ratio. The formula for calculating a company’s current ratio is:

Quick Ratio = (Current Assets – Inventory)/Current Liabilites

 

By taking inventories out of the equation, you can check and see if a company has sufficient liquid assets to meet short-term operating needs. Most people look for a quick ratio in excess of 1.0 to ensure that there is enough cash on hand to pay the bills and keep on going. The quick ratio can also vary by industry. As with the current ratio, it always pays to compare this ratio to that of peers in the same industry in order to understand what it means in context.

Market Capitalization is the value of all the shares of stock currently outstanding plus any long term debt or preferred shares that the company has issued. The reason you add long-term debt and preferred shares to the market capitalization is because if you were to buy the company, not only would you have to pay the current market price but you would also have to incur the responsibility for the debt as well.

Market Capitalization = Current Stock Price * Shares Outstanding + Long Term Debt/ Preferred Stock

 

If you take a company’s working capital and measure it against a company’s market capitalization, you can find some decent percentage. You can compare working capital to market capitalization by dividing working capital by that market capitalization. This calculation will give you how much percentage of the market valuation is backed up by working capital. If you are dealing with a company where 50% or more of the capitalization is backed up with working capital, you have a company that has ample funds to get itself going. Also, you might want to net out the inventories from working capital and check that percentage just to make sure that the number is not all that different, especially for retailers and clothing manufactures.

Price-to-Book Ratio by using the aggregate market capitalization of the company divided by the current shareholder’s equity. You have to also use Enterprise Value, which is market capitalization minus cash and equivalents plus debt. The reason you subtract cash and equivalents from market capitalization is because if someone were to actually buy the company, they would get all the cash the company currently has, meaning it would effectively be deducted from the cost after the transaction was closed. The Enterprise Value (EV) to Shareholder’s Equity (SE) looks like this, then;

EV=Shares Outstanding*Price + Debt – Cash\

SE Shareholder’s Equity

 

If this number is below 1.0, then it means that the company is selling below book value and theoretically below its liquidation value. Some value investors will shun any companies that trade above 2.0 times book value or more.

Days Sales Outstanding is a measure of how many days’ worth of sales the current accounts receivable (A/R) represents. It is a way of transforming the accounts receivable number into a handy metric that can be compared with other companies in the same industry to determine how company is managing its receivable collection better. To figure out DSO, you first have to figure out Accounts Receivable Turnover.
This is:

Accounts Receivable Turnover= Net Credit Sales/ Average Accounts Receivable.

 

This ratio tells you how many times in a year a company turns its accounts receivable. By “Turn” we mean the number of times it completely clears all of the outstanding credit. For this number, HIGHER is better. To turn this number into days sales outstanding, you do the following:

DSO = (Accounts Receivable/Credit Sales) * Number of Days

 

This tells you roughly how many days’ worth of sales are outstanding and not paid for at any given time. As you might have expected, the lower this number is, the better it is for the company. By comparing DSOs for various companies in the same industry, you can get a picture of which companies are managing their credit better and getting money in faster on their sales. This is crucial edge to have because money that is not tied up in accounts receivable is money that can be used to grow the business.

Inventory Turnover Ratio, Inventory management actually is bottleneck for growth if it is not efficient enough, tying up a lot of working capital that could be better used elsewhere. If you can find out a company’s DSO and Inventory turns relative to its peers, you will have an incredible view into how well the company can fund its own growth going forward, allowing you to make better investments.

The formula for inventory turnover:

Inventory turnover = Cost of Goods Sold/ Average Inventory

 

Return on Equity, measures the rate of return for ownership interest (shareholders’ equity) of common stockowners. It measures the efficiency of a firm at generating profits from each unit of shareholder equity. The ROE is useful for comparing the profitability of a company to that of other firms in the same industry.

The formula for Return on Equity:

ROE= Net Income/Shareholder Equity

 

Return on Investment, measure, per period, rates of return on money invested in an economic entity in order to decide whether or not to undertake an investment. The project with best ROI is prioritized. As a performance measure, ROI is used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments.

The return on investment formula:

ROI = (Gain from Investment – Cost of Investment)/ Cost of Investment