How to analyze a balance sheet
Financial analysts try to see the secret behind the numbers of financial statements. Is this company healthy, is it performing better or worse this year compared to previous years or competitors. Comparing financial statements among competitors faces several problems. On the one hand the difference in size of companies (eg Ford /Toyota) makes it cumbersome to compare numbers. The first approach to standardizing financial statements is to express them as a percentage. Balance sheet positions are going to be listed as a percentage of total assets, income statement positions will be listed as a percentage of total sales, cash flow positions will be listed as a percentage of total sources of cash or total uses of cash.
A further help in comparing financial statements may be to choose a base year and reflect changes to it in percentage points. Nevertheless, this does not yet address the matter of financial statements denominated in different currencies.
Fiancial ratios are generally simple in concept: take two numbers from financial statements, divide them and give the result a name. This has lead to and endless choice of ratios (pick your ratio) which I categorize as follows:
1) Liquidity measures (ability of a company to pay its bills)
2) Asset management measures (how efficiently does this company use its asset to build sales)
3) Profitability measures (how efficiently does the company manage its operations)
4) Market Value measures (does the stock price reflect the actual value of the company).
Liquidity measures
The best known ratios are the current ratio (current assets/current liabilities) and the “Quick (or Acid-Test) Ratio” ((current assets – Inventory)/Current liabilities). The higher the ratio the more a company will be able to meet its current obligations.
The Acid Test takes into consideration that inventory might be difficult to sell, hence the exclusion of inventory from the ratio.
The total debt ratio ((Total Assets – Total Equity)/Total Assets) is concerned with the long term viability of a company. Being concerned about bankruptcy one hopes to get a low total debt ratio. However,
debt might be used to utilize the company’s assets better and create higher profits.
Asset Management measures
Inventory Turnover or Days Sales in Inventory is calculated as inventory turnover = (Cost of Goods Sold)/ Inventory. The resulting quotient then is utilized as follows: (365 days/Inventory turnover)= Days’ sales in inventory. This number will indicate the amount of days on average inventory sits before it is sold.
Similarly, you can calculate how long it takes a company to collect on its receivables (so-called: Receivalbes Turnover). In the first step you divide: Sales /Accounts Receivable which gives you the Receivables turnover. In a second step you calculate the Days’ sales in receivables: 365 days/Accounts Receivables.
Profitability Measures
The most famous profitability measure is the profit margin which divides Net Income/Sales to show how much profit a corporation makes for every $ sold. As much as everyone likes an increased profit margin, some companies become more successful lowering their prices and selling more at a lower margin (think Walmart).
Return on Assets (ROA=Net Income/Total Assets) explains how well our assets contributed to your profits. ROE (Return on Equity=Net Income/Total Equity) explains how much cash was generated through the shareholders’ investment.
Market Value Measures
Price-Earnings Ratio is defined as: price per share/earnings per share. The PE ratio is widely used to show that the dot com era overvalued shares. At the height of the Dot-com bubble P/E had risen to 32. The collapse in earnings caused P/E to go up to 46. 50 in the following year: 2001. Historically the PE ratio had been around 15 %.
A PE between 0-10 might indicated that company stock is undervalued, 17 and above might show that the
company stock is overvalued.
Accountants and additionally financial analysts have addressed their original question: how to compare different companies. Nevertheless, even though we may well compare financial data now better than before, the real question: -is the copmany over or undervalued? – is unanswered. Ratios that make sense for one industry,
seem extravagant in another kind of business (eg compare the financial industry and manufacturing). Geographic position also influences the ratios without anyone knowing why. Maybe the thought that mathematics may not determine the value of a company is comforting. After all, we would not want to exchange Warren Buffett’s genius for a spreadsheet.
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