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- 1 – Introduction to the Income Statement
- 2 – Beginning Income Statement Analysis
- 3 – Introduction to the Balance Sheet
- 4 – Beginning Balance Sheet Analysis
- 5 – Introduction to the Cash Flow Statement
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Transcript for the video:
In the prior video, we provided an overview of the Balance Sheet. In this video we are going to explain some easy ways to analyze the balance sheet. We are going to focus on three key areas: liquidity, financial strength, and how well the business is being managed.
The first area we are going to look at is liquidity. This is essentially how easily can the company pay from existing assets for its ongoing expenses, including payroll, inventory, and investments in capital equipment.
As with the income statement, the easiest way to analyze a balance sheet is to look at ratios. The first ratio we are going to look at is called the current ratio, and sometimes is referred to as the working capital ratio. It is very easy to calculate. It is simply current assets divided by current liabilities. In this example, that means $6,670,000 of current assets divided by $1,839,000 of current liabilities gives you a number of 3.63. The accounting textbooks will tell you that a current ratio 2.0 or higher is an indicator of the company having sufficient liquidity. This is one of the key measures of liquidity.
The next ratio we’re going to look at is the quick ratio. This excludes some of the current assets that cannot easily be turned into cash, such as inventory. So it’s more like extremely liquid current assets, and then this amount is divided by current liabilities. So in this example, the assets that would qualify as liquid current assets include cash, marketable securities, and accounts receivable, and we then divide that by current liabilities and we get a ratio of 1.91. The accounting textbooks basically say a ratio of 1.0 or higher shows adequate liquidity for most companies.
DEBT TO EQUITY RATIOS
After evaluating liquidity the next thing to look at is financial strength. The most common ratios to look at here are a couple different debt-to-equity ratios. The first one is long term debt divided by equity, and the other ratio is total debt divided by equity. When we talk about debt here, we are talking about interest bearing debt—that means loans and bank revolving lines of credit. We’re not talking about non interest-bearing liabilities, which are also debts, such as accounts payable. And equity, as you recall, is the amount of money that shareholders have invested in the company plus net income that has been earned and retained over the years. When evaluating company strength using debt to equity ratios, the smaller the ratio, the better, as a company is financially stronger the less debt it has compared to equity. However, in many industries, it is normal for debt to be several times the amount of equity, although as that ratio gets higher and higher it begins to be known as ‘junk debt’ rather than at investment grade. So you can see in the first example the $2,332,000 of long-term debt is divided by shareholders equity of $4,203,000 and we get a ratio of .55, which is excellent. When we look at total debt, we’ve got the short term debt (the current portion of long term debt) at $1,021,000 and we add that to the $2.3 million of long-term debt and divide that by the same total equity, and this time the ratio is higher—it’s 0.8—but it’s still well below 1.0, so the financial strength of this company looks solid.
Another indicator of financial strength is interest coverage, also sometimes referred to as times interest earned. Essentially this is operating profit divided by interest expense. Neither of these items is on the balance sheet, they’re actually from the income statement. But when you talk about debt-to-equity ratios and the company’s debt, it’s also important in evaluating financial health to look at the company’s current operating profit versus the amount of interest it has to pay its debt holders. Clearly we want the ratio to be above 1 to indicate that operating profit is more than interest expense, and usually something at 5 to 7 is considered very healthy. For this company they have very little interest expense and quite a bit of operating profit, so their interest coverage ratio is extremely healthy.
RETURN ON EQUITY
Next we are going to measure how efficiently management is running the company. The first ratio we’ll look at is return on equity. This is a measure of the company’s earnings on the equity that the shareholders have invested. We simply take the net income and divide it by shareholders equity. In this example, $397,000 of net income divided by $4,203,000 of shareholders equity gives us a return on equity of 9.45%. In today’s market with low inflation and high risk, people are very happy with that 9% return. As with other ratios, it would be
good to compare this return on equity to other companies in the same line of business to get a better idea of how well this management team is generating a profit compared to its peers. We discuss how to get information on other companies in the same industry in the Financial Statement Analysis series.
RETURN ON ASSETS
The next efficiency ratio is very similar, but it is return on total assets instead of just shareholders equity. This is a measure of profit on all capital invested in the business which was used to acquire assets. To calculate this, we simply take net income and divide it by total assets. In this example, the net income of $397,000 is divided by total assets of $8,374,000 and we get a return on assets of 4.74%. The return on equity ratio is impacted by the debt to equity ratio of the specific company. The return on assets ratio eliminates the impact of the source of financing, regardless if it is debt or equity, to measure management efficiency, and that is why it is good to look at both ratios when comparing companies.
There are three other efficiency ratios that we can look at to get an idea of how well management is actually managing a few specific very important company assets. The first is inventory turnover. It shows how well they are managing their inventory. One way to calculate this is to simply take costs of goods sold and divide that by ending inventory. In this example, we divide costs of goods sold of $9,905,000 by ending inventory of $2,936,000 and the result of 3.73 means that the company sells its inventory 3.73 times a year. Some people prefer to look at this as the number of days that something is in inventory, so to see that we divide 365 days by the 3.73 times inventory turns, and the result 108 days. This means that it takes on average 108 days to sell all inventory. There are several other ways to modify this calculation which is discussed in the financial statement analysis series. The best way to understand if the resulting number is good or bad is to compare with other companies in the industry.
ACCOUNTS RECEIVABLES DAYS OUTSTANDING
Another efficiency ratio is Accounts Receivable days outstanding also know as days sales outstanding, which is frequently referred to as DSO. This measures how well management turns sales in to cash and represents how long it takes to collect on sales. The longer it takes, the more working capital is needed to finance the company and it could lead to debt collection problems. It may also be an indicator that management is not focusing on keeping accounts receivable in line, or that they are having to give longer terms or sell to riskier, slower paying customers in order to get sales. To calculate this we simply take the Accounts Receivable balance at the at the end of the period and divide it by sales for the past year and then multiply that by 365 days. So in this example, we have $1,667,000 in Accounts Receivable on the balance sheet and divide that by total sales of 11,892,000 and multiply that number by 365. This gives us a result of 51.5 days. For this company, it takes an average of 51 1/2 days to collect on its sales.
ACCOUNTS PAYABLES DAYS OUTSTANDING
The final efficiency ratio going to look at is the accounts payable days outstanding. This is an indication of how fast the company pays its bills. For companies thinking about doing business with this company, this is a very important ratio as you want to know how fast you will get paid. To calculate it we simply take the accounts payable balance and divide it by the cost of goods sold and then multiply that by 365 days. The reason we use cost of goods sold instead of sales in this calculation is that payables are associated with costs, not revenues. For companies where costs of goods sold is a small portion of total operating expenses, it may be better to use costs of goods sold plus operating expenses as the denominator in the equation. To calculate the standard ratio for this company, they had $625,000 in accounts payable outstanding and we divide that by cost of goods sold of $9,905,000 and then multiply that by 365, and it shows that their days payables outstanding was only 23 days. This means they are a very fast payer. Companies who are thinking about providing credit to this business should feel very comfortable with this number.
The next video in this series is Introduction to the Cash Flow Statement. Remember, you can download the Financial Statement Analysis eBook, which includes over 50 definitions and ratio calculations. It also includes an Excel spreadsheet that will calculate key ratios when you input financial data. If you need debt collection assistance, we are specialists in large business-to-business claims, and we can refer you to other agencies if your needs do not fit with our expertise. Just fill out the Request A Quote form or give us a call.