The basic approach is to compute certain ratios between two different items and to extract certain net values. For example, we compare the liabilities of the company with its equity (shareholder funds) to assess financial soundness. We deduct current liabilities from current assets to check whether the company has a positive or negative working capital.
The Balance Sheet
Let us briefly summarize what the typical balance sheet shows.
The balance sheet shows the ASSETS employed by the company for carrying on its business. These assets can be CURRENT ASSETS such as inventory, customer receivables and cash that are constantly turned over in the course of business, i.e. inventory and receivables are converted into cash and cash is converted into inventory and receivables.
The assets can also be LONG-TERM (or FIXED) ASSETS such as land, building, plant, furniture, vehicles and more that are not meant for conversion into cash. Instead, these are facilities used to carry on the business' operations.
The balance sheet also shows the LIABILITIES of the company. These can be LONG-TERM LIABILITIES such as mortgages that are used to create the long-term facilities such as plant and machinery. Or they can be CURRENT LIABILITIES that finance the current assets such as inventory and receivables.
By deducting total liabilities from the total assets, we get SHAREHOLDERS' EQUITY. This equity is typically built up with original shareholder capital contributions plus undistributed profits made by the company. If the company is incurring losses, these would in effect be financed with the original shareholder contributions and the equity can become negative.
For a more detailed look into the items that go under each of the above categories, refer to the previous articles mentioned earlier.
Analyzing the Balance Sheet
Working Capital Computation
You compute the working capital available to a company by deducting the total current liabilities from total current assets. In an earlier article, we had included a balance sheet example that showed total current assets of 29167 and total current liabilities of 2747. The working capital of this company is 29167 minus 2747, i.e. 26420.
Working capital is the funds available to the company for day-to-day operations. For example, by converting receivables and inventory into cash, the company gets the cash needed to pay its creditors and employees. Generally, a negative working capital is a danger signal. However, in the case of companies that sell for cash, such as retail stores, low working capital might not be a problem.
Businesses like heavy equipment manufacturers that take a long time to convert their inventory and receivables into cash, however, will need substantial working capital.
Current and Quick Ratios
Current Ratio is computed by dividing total current assets by total current liabilities. If current assets are more than current liabilities, the ratio will be higher than 1. In the illustrative balance sheet mentioned above, the current ratio is 27167/2747, i.e. 10.62. It might be noted that a current ratio higher than one indicates positive working capital and a ratio of less than one indicates negative working capital.
The Quick Ratio is computed by dividing (current assets minus inventories) by current liabilities. Inventories are not included in current assets for this computation because inventories typically take longer to be converted into cash. Inventories can also include items that are no more saleable. Hence a better indication of a company's ability to meet its current liabilities is given by the quick ratio. In the illustrative balance sheet, the current assets total of 27167 does not include any inventory, and hence the quick ratio is the same as current ratio, viz. 10.62.
Debt Equity Ratio
Debt Equity Ratio is computed by dividing long-term and short-term debt by shareholders' equity. In the illustrative company balance sheet, the total long and short term debt is 1745 and shareholders' equity is 36005. Debt Equity Ratio is hence 0.048.
What is an acceptable Debt Equity Ratio depends on the company's profitability and what local investors consider acceptable. A company that is earning a higher return on its funds than what it pays as interest to lenders can have a higher debt equity ratio. Generally, a 1:1 ratio is considered acceptable in the U.S. However, this can vary from industry to industry.
The above are only the main ratios to illustrate how they are used. In practice, the analysis goes deeper into smaller details. For example, the inventory and receivables can be compared to the company's yearly sales to find out how well the company is managing these assets. If the inventory represents several months' sales, it might be a sign that it includes non-moving merchandise, for example.
Ratios have no absolute value in themselves and become meaningful when similar ratios are compared over several periods, or among businesses in the same industry. Incidentally, the illustrative balance sheet we used in this article is not that of a typical company, but of an extremely successful, cash rich company.
