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 for the purpose of getting the correct financial position of the business at a particular point in time.
It is a complete analysis of items on the balance sheet at the various intervals of time like quarterly, annually and is used by shareholders, investors and institutions to understand the company’s detailed financial position. The following Balance Sheet Analysis provides an outline of the most common used by investors and financial analysts to analyze a company. It is impossible to provide a complete set of analysis that addresses every variation in every situation
In this article, we have divided our analysis into two parts –
- #1 -Analysis of Assets
- #2 – Analysis of Liabilities
Let us discuss each one of them in detail –
#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 assets include the items of fixed assets like property plant & equipment (PPE). The analyses of fixed assets involve not only the calculation of the assets’ earning potential and its use but also the calculation of its useful life. The efficiency of fixed assets can be analyzed by calculating the fixed asset turnover ratio.
Fixed Assets Turnover Ratio
This ratio is of more significance to the manufacturing industry as compared to the other industries as there is a substantial purchase of property, plant & equipment in the manufacturing concern to get the required output.
- 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 on 31st March 2019 as $200,000. The balance of PPE as on 1st April 2018 was $160,000.
- Now net sales = $400,000 – $40,000 = $360,000
- Average fixed assets =($160,000 + $200,000)/2 =$180,000
So, Fixed Asset Turnover Ratio will be –
This ratio reflects how efficiently the management of the company is using its substantial fixed assets in generating the revenue of the firm. Higher the ratio, higher is the efficiency of the fixed assets.
B) Current Assets
Current assets are such assets which 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
It is a liquidity ratio which measures the ability of the company to pay off its short term debts.
The formula for the current ratio is:
- Current assets = Cash & Cash equivalents + Inventories + Accounts receivable + other assets that can be converted into cash within a year.
- Current Liabilities = Accounts payable + short term debt+ current portion of long term debt
It is a liquidity ratio which measures the short term liquidity position of the company by calculating the ability of the company to pay off its current liabilities with the use of its most liquid assets.
- Where, quick assets = Cash & cash equivalents + Accounts receivable + other short term assets
- Current liabilities = Accounts payable + short term debt + current portion of long term debt
Example: Microsoft Inc. is a manufacturing concern which reported the following items in the balance sheet:
Now the Total current assets = $10,000 + $6,000 + $11,000 + $3,000 = $30,000
- Quick assets = $10,000+ $11,000 = $21,000
- Total current liabilities = $8,000 + $7,000 = $15,000
- Therefore, current ratio = $30,000/$15,000 = 2:1
So, Quick Ratio will be –
Quick ratio = $21,000/$15,000 = 1.4:1
Investors are more attracted towards the company who is having plenty of cash reported on their balance sheet as the cash offers security to the investors because it can be used in the tough times. Increasing cash year to year is a good sign but diminishing cash can be considered as a sign of trouble. But if plenty of cash is retained for many years then investors should see why the management is not putting it into use. The reasons for maintaining huge amount as cash includes 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. Even the cash flow analysis is done by the company to determine its source of cash generation and its application.
Inventories are the finished goods accumulated by the company for selling them 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 ratio which is calculated as below:
Inventory Turnover Ratio = Cost of goods sold / Average inventory
- Cost of goods sold = Opening stock + purchases – Closing stock
- Average inventory = (Opening inventory + Closing inventory) / 2
This ratio calculates how fast the inventory is converted into sales. Higher inventory ratio shows that the goods are sold quickly by the company and vice versa.
E) Accounts Receivables
Accounts receivable is the money due from the debtors of the firm. By analyzing accounts receivable a company analysis the speed at which the amount is collected from the debtors.
For this the company calculates Accounts receivable turnover ratio which is calculated as below:
Accounts Receivable Turnover Ratio = Net credit sales/Average accounts receivable
- Net credit sales = Sales – Sales return – discounts
- Average accounts receivable = (Opening accounts receivable + closing accounts receivable) / 2
This ratio calculates the number of times, the average accounts receivable is collected by the company over a given period of time. Higher the ratio higher is the efficiency of the company to collect its debtors.
#2 – How to do Analysis of 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 which are to be paid after a year.
A) Non-Current Liabilities
It can be done by debt to equity ratio. The formula for the same is:
- Where long term debts = debts to be paid off after a year
- Shareholders equity = Equity share capital + preference share capital + accumulated profits
For example, Mania Inc. has its equity share capital amounting to $100,000. Its Reserves and surplus 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 the 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 Current ratio and the quick ratio. Both the ratios are discussed above in the current assets section.
The amount of capital contributed by the shareholders is represented by the Equity and is also called as shareholder’s equity. Equity is calculated by subtracting total liabilities from the total assets
There are various ways in which equity can be analyzed.
Return on equity an important determinant which shows that company how the company is managing the capital of shareholder. Higher the ROE, better it is for shareholders. It is calculated by dividing the net income by the shareholder’s equity.
For example, XYZ has $20 million net income last year and shareholders’ equity of $40 million last year, then
ROE = $20,000,000/$40,000,000 = 50%
This shows that XYZ generated $0.50 profit for every $1 of the equity of shareholders with ROE of 50%.
Debt to Equity Ratio
Another ratio which is helpful in analyzing equity is the debt-equity ratio. The same is explained in case of non- current liabilities where Mania Inc, is having a debt-equity ratio of 1.25. The company has a higher debt-equity ratio as a debt of the company is more than the equity. A lower debt-equity ratio implies more financial stability. Companies having a higher debt-equity ratio like in present example are considered to be more risky to the investors and the creditors of the company.
This has been a guide to Balance Sheet Analysis. Here we discuss step by step how to analyze balance sheet assets, liabilities, and equity along with examples and explanations. You may learn more about accounting from the following articles –