Balance Sheet Analysis

Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is the Balance Sheet Analysis?

Balance sheet analysis is the analysis of the assets, liabilities, and owner’s capital of the company by the different stakeholders to get the correct financial position of the business at a particular point in time.

The following Balance Sheet Analysis outlines the most commonly used by investors and financial analysts to analyze a company. It is a complete analysis of items on the balance sheet at various intervals of time, like quarterly or annually, and is used by shareholders, investors, and institutions to understand the company’s exact financial position. It is impossible to provide a complete set of analyses that addresses every variation in every situation since there are thousands of variables.

In this article, we have divided our analysis into two parts –

  • #1 -Analysis of Assets
  • #2 – Analysis of Liabilities
Balance-Sheet-Analysis

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Let us discuss each one of them in detail –

Key Takeaways

  • Balance sheet analysis refers to the company’s assets, liabilities, and owner’s capital analysis. It is performed by various stakeholders to obtain an accurate financial business position at a specific period.
  • It is a comprehensive analysis of the items on the balance sheet at different intervals, such as quarterly or annually.
  • Shareholders, investors, and institutions may utilize it to know the company’s financial position. Still, it is challenging to enable comprehensive analyses that address every variation in every situation, as there are thousands of variables.

#1 – How to do Analysis of Assets in the Balance Sheet?

Assets include fixed assets or Non-current assets and current assets.

A) Non-Current Asset

Non-current assetsNon-current AssetsNon-current assets are long-term assets bought to use in the business, and their benefits are likely to accrue for many years. These Assets reveal information about the company's investing activities and can be tangible or intangible. Examples include property, plant, equipment, land & building, bonds and stocks, patents, trademark.read more include the items of fixed assets like property plant & equipment (PPE). The fixed-assets analyses calculate the assets’ earning potential, use, and useful life. The fixed asset efficiency can be analyzed by calculating the ratio of the fixed asset turnover.

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Fixed Assets Turnover Ratio

This ratio is of more significance to the manufacturing industry than the other industries as there is a substantial purchase of property, plant & equipment in the manufacturing concern to get the required output.

The Formula of Fixed Asset Turnover RatioFormula Of Fixed Asset Turnover RatioThe fixed asset turnover ratio formula determines the ability of a business entity to generate revenue by employing its fixed assets. It is computed as the fraction of net sales and average net fixed assets.read more

Fixed Assets Turnover Ratio = Net sales/Average Fixed Assets

Where,

  • Net sales are sales less returns and discounts
  • And average fixed assets = (opening fixed assets + closing fixed assets) / 2

For example, Tricot Inc. reported its sales for the financial year 2018-19 as $400,000, and out of these sales returned were $4,000. Also, it reported its total property, plant, and equipment (PPE) as of 31st March 2019 as $200,000. The balance of PPE as of 1st April 2018 was $160,000.

So, Fixed Asset Turnover Ratio will be –

balance sheet analysis example 1

This ratio reflects how efficiently the company’s management uses its substantial fixed assets to generate revenue for the firm. The higher the ratio, the higher the efficiency of the fixed assets.

B) Current Assets

Current assetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more are such assets that are likely to be converted into cash within a year. The current assets include cash, account receivable, and inventories.

The ratios which help in the analysis of current assets are

Current Ratio
Liquidity - Current Ratio

It is a liquidity ratio that measures the ability of the company to pay off its short-term debts.

The formula for the current ratio is:

Current Ratio = Current Assets/Current Liabilities

Where

Quick Ratio
Liquidity - Quick Ratio

It is a liquidity ratio that measures the company’s short-term liquidity position by calculating the company’s ability to pay off its current liabilities with the use of its most liquid assets.

The formula of Quick Ratio

Quick Ratio = Quick Assets/ Current Liabilities

Example: Microsoft Inc. is a manufacturing concern which reported the following items in the balance sheet:

balance sheet analysis example 2

Now the Total current assets = $10,000 + $6,000 + $11,000 + $3,000 = $30,000

So, Quick Ratio will be –

balance sheet analysis example 3

Quick ratio = $21,000/$15,000 = 1.4:1

C) Cash

Investors are more attracted towards the company who is having plenty of cash reported on their balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more

as the cash offers security to the investors because it can be used in tough times. Increasing cash year to year is a good sign, but diminishing cash can be considered a sign of trouble. But if plenty of cash is retained for many years, investors should see why the management is not putting it into use. The reasons for maintaining a considerable amount of cash include management’s lack of interest in the investment opportunities, or maybe they are short-sighted, so they do not know how to utilize the cash. The company does even the cash flow analysis to determine its source of cash generation and its application.

D) Inventories

Inventory Turnover Ratio Analysis - Colgate

Inventories are the finished goods accumulated by the company for selling to its customers. The investor will see how much money is tied up by the company in its inventory. To analyze the inventory, a company calculates its inventory turnover ratioCalculates Its Inventory Turnover RatioInventory Turnover Ratio measures how fast the company replaces a current batch of inventories and transforms them into sales. Higher ratio indicates that the company’s product is in high demand and sells quickly, resulting in lower inventory management costs and more earnings.read more, which is calculated as below:

Inventory Turnover Ratio = Cost of goods sold / Average inventory

Where,

This ratio calculates how fast the inventory is converted into sales. A higher inventory ratioInventory RatioInventory ratio or inventory turnover ratio is an activity ratio that depicts the frequency of replacing the stocks sold by the company in a certain period. It is evaluated as the proportion of the cost of goods sold to the average inventory.read more shows that the goods are sold quickly by the company and vice versa.

E) Accounts Receivables

Accounts Receivables Turnover Ratio

Accounts receivable is the money due to the debtors of the firm. By analyzing accounts receivable, a company analyzes the speed at which the amount is collected from the debtors.

For this, the company calculates the Accounts receivable turnover ratio, which is calculated as below:

Accounts Receivable Turnover Ratio = Net credit sales/Average accounts receivable

Where,

This ratio calculates the number of times the company collects the average accounts receivable over a given period. The higher the ratio, the higher the company’s efficiency in collecting it debtorsDebtorsA debtor is a borrower who is liable to pay a certain sum to a credit supplier such as a bank, credit card company or goods supplier. The borrower could be an individual like a home loan seeker or a corporate body borrowing funds for business expansion. read more.

Video Explanation of Balance Sheet

 

#2 – How to Analyze Liabilities on the Balance Sheet?

Liabilities include current liabilities and non-current liabilities. Current liabilities are obligations of the company to be paid within a year, whereas non-current liabilities are the obligations that are to be paid after a year.

A) Non-Current Liabilities

Pepsi Capital Gearing - Debt and Equity

It can be done by the debt to equity ratioDebt To Equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. read more. The formula for the same is:

Debt to equity ratio =Long term debts/ Shareholders equity

For example, Mania Inc. has its equity share capital amounting to $100,000. Its Reserves and surplusReserves And SurplusReserves and Surplus is the amount kept aside from the profits that are to be used either for the business or for the shareholders to pay out dividends. Reserves and surplus is reflected under shareholders funds in the balance sheet.read more are $20,000, and the long term debts are $150,000

Therefore the debt to equity ratio = $150,000 / ($100,000 + $20,000) = 1.25:1

This ratio measures the proportion of the debt fund as compared to equity. It helps to know the relative weights of the debts and the equity.

B) Current Liabilities

The current liabilities can also be analyzed with the help of the current ratio and the quick ratioQuick RatioThe quick ratio, also known as the acid test ratio, measures the ability of the company to repay the short-term debts with the help of the most liquid assets. It is calculated by adding total cash and equivalents, accounts receivable, and the marketable investments of the company, then dividing it by its total current liabilities.read more. Both ratios are discussed above in the current assets section.

C) Equity

The amount of capital contributedAmount Of Capital ContributedContributed capital is the amount that shareholders have given to the company for buying their stake and is recorded in the books of accounts as the common stock and additional paid-in capital under the equity section of the company’s balance sheet.read more by the shareholders is represented by the Equity and is also called shareholder’s equity. Equity is calculated by subtracting total liabilities from the total assets.

Equity = Total Asset – Total Liabilities

There are various ways in which equity can be analyzed.

ROE
Pepsi vs Coca Cola ROE

Return on equityReturn On EquityReturn on Equity (ROE) represents financial performance of a company. It is calculated as the net income divided by the shareholders equity. ROE signifies the efficiency in which the company is using assets to make profit.read more  is an important determinant that shows the company how the company is managing shareholders’ capital. It is calculated by dividing the net income by the shareholder’s equity. Higher the ROE, the better it is for shareholders.

For example, XYZ had $20 million net income last year and shareholders’ equity of $40 million last year, then.

ROE = $20,000,000/$40,000,000 = 50%

It shows that XYZ generated $0.50 profit for every $1 of shareholders’ equity with an ROE of 50%.

Debt to Equity Ratio
Debt to Equity Starbucks

Another ratio that helps analyze equity is the debt-equity ratio. The same is explained in the case of non-current liabilities, where Mania Inc has a debt-equity ratio of 1.25. The company has a higher debt-equity ratio as the company’s debt is more than the equity. A lower debt-equity ratio implies more financial stability. Companies having a higher debt-equity ratio, like in the present example, are considered riskier to the investors and the creditors of the company.

Frequently Asked Questions (FAQs)

What is comparative balance sheet analysis?

A comparative balance sheet refers to a side-by-side comparison of a current and previous accounting period’s whole balance sheet report. For example, business owners or investors may compare a date-to-date company to understand financial performance trends.

How important is balance sheet analysis?

The balance sheet analysis is essential as it enables details about the company’s resources, such as assets, and the sources of capital, such as equity, liabilities, or debt. Such information helps an analyst examine a company’s capability to pay for near-term operating requirements, satisfy forthcoming debt obligations, and distribute to owners.

What are the types of balance sheet analysis?

Balance sheet analysis comprises three types: comparative balance sheets, vertical balance sheets, and horizontal balance sheets

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