Balance Sheet Analysis: Beginner's Guide 2016 South Universi

Balance Sheet Analysis Beginners Guide 2016 South Universitypage 2

Balance Sheet Analysis - Beginners Guide © 2016 South University Financial Management of Healthcare Organizations ©2016 South University 2 Balance Sheet Analysis - Beginners Guide 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 the 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 and gives us a number of 3.63. The accounting textbooks will tell you that a current ratio of 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 are going to look at is the quick ratio, this excludes some of the current assets that can't 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 then we divide that sum by the total of 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.

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, when we are talking about interest-bearing debt, that means loans and bank revolving lines of credit. We are 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 more financially strong, 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 investment-grade. So you can see in the first example that the $2,332,000 of long-term debt is divided by shareholders’ equity of $4,203,000, and we get a ratio of 0.55, which is excellent. When we look at total debt, we have the short-term debt, which is the current portion of long-term debt, that is $1,021,000, and we add that to the $2.3 million of long-term debt and divide that sum by the same total equity amount, resulting in a ratio of 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 called times interest earned. Essentially, this is operating profit divided by interest expense. Neither of these items is on the balance sheet; they are from the income statement. But when you talk about debt equity ratios in a company’s debt, it’s also important to evaluate the company’s current operating profit relative to its interest obligations. To look at this ratio, we take the operating profit and divide it by interest expense. Ideally, this ratio should be above one, indicating operating profit exceeds interest payments. Usually, a ratio of 5 to 7 times is considered very healthy.

In this example, the company has very little interest expense and quite a bit of operating profit. Therefore, their interest coverage ratio is extremely healthy, indicating the company can comfortably meet its interest obligations from operating earnings.

Next, assessing management efficiency involves evaluating ratios like return on equity (ROE), which measures the company's earnings relative to shareholders' invested capital. To calculate ROE, net income is divided by average shareholders' equity. In the example, net income of $397,000 divided by shareholders’ equity of $4,203,000 results in an ROE of approximately 9.45%. Given current market conditions characterized by low inflation and risk, a 9% return is generally acceptable for investors. Comparing this ratio with peer companies provides insight into management performance in generating profits from shareholder investments.

Similarly, return on total assets (ROA) assesses how efficiently the company utilizes all assets to generate earnings. Calculated by dividing net income by total assets, it offers a measure independent of the company's financing structure. In this case, net income of $397,000 divided by total assets of $8,374,000 yields an ROA of approximately 4.74%. Comparing ROE and ROA helps analyze whether the company's leverage is effectively amplifying returns, or if operations could improve.

Furthermore, inventory turnover ratio indicates management's efficiency in managing inventory. It is calculated by dividing the cost of goods sold by ending inventory. Here, with a cost of goods sold of $9,905,000 and ending inventory of $2,936,000, the ratio is 3.37, meaning inventory turns over approximately 3.37 times annually. The reciprocal gives the average days in inventory; dividing 365 days by 3.37 results in approximately 108 days. Comparing this figure across industry peers helps determine if inventory management is optimized.

Accounts receivable turnover measures how effectively the company collects sales revenue. Calculated by dividing accounts receivable by total sales and multiplying by 365 days, this company’s accounts receivable of $1,667,000 and sales of $11,892,000 produce a DSO (Days Sales Outstanding) of about 51.5 days. A lower number indicates quicker collections, reducing working capital needs, whereas a higher DSO could point to collection issues or lenient credit terms.

Finally, accounts payable turnover indicates how swiftly the company pays its bills. It is calculated by dividing accounts payable by cost of goods sold, then multiplying by 365 days. With accounts payable of $625,000 and COGS of $9,905,000, the payable days outstanding are roughly 23 days, reflecting prompt payments and favorable credit terms from suppliers. For vendors or credit providers, understanding this ratio informs risk assessments and credit decision-making.

Paper For Above instruction

Balance sheet analysis is an essential practice for financial professionals and business managers to assess an organization’s financial health, liquidity, operational efficiency, and management effectiveness. This comprehensive evaluation involves various ratios derived from the balance sheet and income statement to provide insights into different facets of the company's functions and strategic position. Analyzing these ratios collectively enables stakeholders to make informed decisions regarding investment, credit, and management strategies.

Among the primary measures of liquidity, the current ratio and quick ratio are fundamental. The current ratio, calculated as current assets divided by current liabilities, indicates the company's capacity to meet short-term obligations with its liquid assets. A current ratio of 2 or higher, as suggested by accounting textbooks, generally signifies adequate liquidity, though industry-specific benchmarks are also pertinent. Conversely, the quick ratio refines this measure by excluding inventory—an asset that might not be easily converted into cash—highlighting the company's ability to satisfy immediate liabilities. A quick ratio above 1 typically indicates sufficient liquidity for most firms, emphasizing the importance of liquid asset management for operational stability.

Assessing financial strength involves analyzing debt levels through debt-to-equity ratios. The long-term debt-to-equity ratio and total debt-to-equity ratio offer insights into leverage and risk. A lower ratio represents a stronger financial position with less reliance on borrowed funds. For example, a long-term debt of $2,332,000 against shareholders' equity of $4,203,000 yields a ratio of 0.55, indicating conservative leverage and a solid financial structure. High debt levels, especially when exceeding industry norms, may signal elevated risk, potentially leading to junk debt status if ratios surpass acceptable thresholds.

Interest coverage ratio serves as a vital indicator of debt management health. It is derived from operating profit divided by interest expense, with higher ratios signifying better capacity to service debt. A ratio above 1 confirms that operating income is sufficient to cover interest obligations, and ratios of 5 to 7 are viewed as very healthy. Given the low interest expenses and substantial operating profits in the example, the company's interest coverage ratio indicates excellent debt management and low financial risk.

Operational efficiency is better understood through ratios such as return on equity (ROE) and return on assets (ROA). ROE measures net income relative to shareholders' equity, reflecting the profitability of investments made by shareholders. An ROE of 9.45% suggests moderate profitability; however, peer comparison is necessary to determine management effectiveness. ROA, meanwhile, considers total assets, providing a broader view of asset utilization. A 4.74% ROA in the example demonstrates reasonable efficiency in generating profit from total assets.

Asset management ratios, including inventory turnover and days in inventory, reveal how well management controls stock levels. A turnover ratio of 3.37 indicates inventory is sold approximately 3.37 times annually, translating to about 108 days in inventory. These figures inform inventory optimization strategies. Similarly, accounts receivable turnover and DSO highlight management's effectiveness in collecting receivables. A DSO of 51.5 days reflects relatively efficient receivables collection, reducing working capital strain.

Lastly, accounts payable turnover and payable days provide insight into payment practices and supplier relations. A payable period of 23 days suggests prompt payments, which can foster favorable credit terms but may also indicate limited financial slack. Balancing payables and receivables ratios enables a comprehensive understanding of the company's cash flow cycle and operational resilience.

In conclusion, debt and liquidity ratios, operational efficiency metrics, and management effectiveness indicators are integral to comprehensive balance sheet analysis. These ratios, when contextualized within industry standards, inform stakeholders about the company's financial stability, risk profile, and management quality. Regular and thorough analysis supports strategic decision-making, ensuring the organization's long-term sustainability and growth.

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