How to read and understand a company’s Balance Sheet
Balance Sheet is the true starting point for understanding a company’s financial position. It shows how much a business it owns (its assets), owes (its liabilities), and how much equity is leftover for the owners at a specific point in time.
Reading the Balance Sheet
In this article we have tried to capture few basic points which must be kept in mind whilst reading any company’s balance sheet, which will help the reader assess the company’s financial position.
Liquidity and Solvency
Liquidity is a company’s ability to meet its short-term obligations, such as its working capital needs and its debt obligations. Solvency is a measure of the company’s ability to sustain its activities over a longer period of time. In order to assess liquidity, one key ratio is used, namely current ratio, which is company current assets divided by current liabilities. Current assets include cash, cash equivalents, securities, accounts receivable, inventory, and any other assets that can be converted into cash or used up within the current period. Current liabilities are what a company needs to pay off over the coming year. A good ratio varies from industry to industry.
For example, in the banking industry, an ideal current ratio would be 2:1. That is, the company should have twice as many current assets as liabilities. In order to assess solvency, one has to look at the level of total debt relative to the equity used to capitalize a business by its owners. This ratio is known as debt-equity ratio and varies from industry to industry.
Tangibles versus Intangible assets
This is seen to understand what would happen if the company is forced to liquidate an asset. Hence, one must analyze whether a company’s assets are tangible or intangible. Tangible assets are physical in nature and include cash, inventory, buildings, equipment and accounts receivable. Intangible assets are items like patents and trademarks. One has to ascertain that if the company has made excess payments in terms of fair value of its assets and if things went bad it would not be able to recover adequate cash against the same.
Other key ratios for assessing inventory and receivables
• Inventory Turnover = Cost of Goods Sold divided by Average Inventories
• Receivables Turnover = Sales divided by Average Accounts Receivable
• Total Asset Turnover = Sales divided by Average Total Assets
One can compare assets, liabilities and equity as a percentage with total assets. These percentages should be compared over a period of three years to spot changes. If inventory was 10 per cent of total assets last year and 12 per cent of total assets this year, one now knows that inventory grew faster than total assets and can then investigate why that is so. Another area to look at closely is receivables. If they’re increasing faster than revenue, that may be a signal that the company has a problem with collections and whether it is increasing its allowance for doubtful accounts at a fast enough pace.
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