Wednesday, 21 April 2010

Balance Sheet Analysis: What Information Does it Reveal?

We mentioned in the last post that much information about the financial position of a company can be obtained by analyzing its balance sheet. Let us now look at the kind of information such analysis reveals.

Balance sheets are analyzed by comparing two items in that document. A simple example is the working capital computation we did in the last post. We deducted total current liabilities from total current assets and both these values were obtained from the Balance Sheet. Instead of deducting one item from another, the analysis often involves finding the ratio between two items.

Working Capital

If the working capital is negative, it can indicate that the company's short-term financial position is not safe. The business might not be able to meet its day-to-day payments comfortably. In practice, working capital adequacy also depends on the industry in which a company is engaged in.

A retail establishment that sells merchandise for cash can have a lower working capital and yet be able to meet its obligations without difficulty. It can accumulate the cash takings to meet any heavy cash outflows expected.

On the other hand, an aircraft manufacturing company will take years to complete an order, and even with part advance payments from customers, it will need substantial working capital to meet its day-to-day obligations such as payroll and other expenses, as well as paying its suppliers, during the period when the aircraft is being manufactured.

Two widely-used ratios related to working capital are the Current Ratio and Quick Ratio.

The Current Ratio is computed by dividing the total current assets by total current liabilities. In the example balance sheet, current ratio is 122078 / 78399 = 1.56 for 2009 and 109550 / 76134 = 1.44 in 2008. A ratio above one indicates a positive working capital. The computation also shows that the working capital position has improved during the latest year.

The Quick Ratio recognizes the fact that items like Inventories included in current assets might not be quickly convertible into cash and thus capable of being used for immediate payments. This ratio is computed by subtracting inventory from total current assets and dividing the net amount by total current liabilities. In the balance sheet above, the total current assets of 122078 for 2009 includes inventories of 45854 and when it is deducted, we get 76224 as "quick" assets. Dividing quick assets by total current liabilities of 78399 we get a quick ratio of 0.97. The ratio indicates that, provided the quick assets do not include significant amounts of "bad" items (such as unrecoverable debtors), the company can meet its current obligations without difficulty.

Long-Term Financial Soundness

While the working capital amount and related ratios give an insight into the company's short-term financial position, it is the Debt-Equity Ratio that reveals its longer-term financial strength. This ratio is computed by dividing long and short term debt by shareholders' equity. In the example balance sheet, long-term liabilities amount to 73945 and current portion of long-term debt amounts to 22337. By dividing the resultant total of 96282 by total shareholders' equity of 133783, we get a Debt-Equity Ratio of 0.72.

Generally, a debt-equity ratio of 1 or less is considered sound in the U.S. However, this can vary from industry to industry and the ratio is typically compared with other businesses in the same industry.

Inventory and Receivables Management

Managing inventories and receivables well is critical for good financial management. Inventories are managed by keeping it to as low as possible while ensuring that sales opportunities are not lost for want of materials. Receivables are managed by extending credit only to customers with good credit rating, and collecting the dues in a timely manner.

The effectiveness of managing inventories and receivables are sought to be assessed by computing two "turnover" ratios, inventory turnover and receivables turnover. The turnover ratios are computed by dividing inventories or receivables by total revenue (or cost of revenue) for the year. The ratios can then be used to work out the number of days' sales represented by inventories or receivables.

The total revenue amount will have to be obtained from the Income Statement. In the case of the company whose balance sheet has been illustrated, total revenue for the latest year was 713950 and cost of revenue was 432744. Corresponding amounts for the previous year were 739211 and 426916 respectively.

Inventory turnover: For inventory turnover, it is better to use cost of sales because inventory is valued at cost.  In the example above, we divide the cost of sales, 432744, with inventory, 48854  and get 8.86, representing 365 / 8.86 = 41 days worth of (cost of) sales.

Receivables turnover: 713950 / 11335 = 63, or 365 / 63 = 5.79 days worth of sales. This particular company did most of its sales on the Web against immediate payment, and hence the low receivables outstanding.

Turnover rates, and days of sales in inventory and receivables, differ from industry to industry. Hence, these values for a particular business become meaningful only when compared with those of other businesses in the same industry.

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