Are you the one who is eager to understand company valuations? Do you wish to start investing in stocks? Well, if yes, the first thing that might come to your mind is knowing all the aspects you should be aware of while analyzing a company. From the basic balance sheet to the cashflow statements and other financial profiling, you should first understand their outcome to invest appropriately.
We have already listed the skills to develop while planning to start trading in our previous article, “Master These Finance Skills To Excel In The Field Of Finance Today!” One of the skills was financial reporting, and the balance sheet is a part of it. So, without much delay, let us start with the right steps of analyzing the balance sheets. Also, let us understand what exactly a balance sheet is all about.
Understanding A Balance Sheet
What is a balance sheet? In the simplest terms, the balance sheet is a record of the assets and liabilities of a company at any point in time. It is usually created at the financial year end and reflects the company’s financial health to the internal and external stakeholders.
The structure of the balance sheet is predefined. The left side of the sheet is dedicated to all the liabilities, while the right is reserved for all the assets. Sometimes the balance sheet is created by adding liabilities at the top followed by assets at the bottom. In the end, the assets and liabilities side of the balance sheet should tally, which means they should be equal.
To understand the structure of the balance sheet, one must first understand the 3 important parts as follows:
It is the section where all the assets owned by the business are listed. The significant assets include cash in hand, cash at the bank, bills receivables, property, machinery, plant, and debtors. Now, there are two parts to the assets in every balance sheet, as discussed below:
These assets have an accounting life of under a year. They include inventories, cash and financial equivalents, advances, and accounts receivable. The company’s working capital is built mainly on its current assets. Usually, this section is linked to the current liabilities regarding the analysis. The main ratios that are calculated using this include current ratio, cash ratio, outstanding sales ratio, and others.
These are resources that have a longer life than a year. They include things like land, buildings, machinery, and goodwill. They are the company’s assets employed to produce income and power the main line of business. You should read this section in conjunction with the notes for details on topics like deprivation. A company’s total assets may include a sizable amount of goodwill. This intangible asset is primarily the result of acquisitions. The main ratios calculated using this include asset turnover, capital expenditure, fixed, and others.
For every business to run, there are some obligations in monetary terms, usually referred to as liabilities. Liabilities are the obligations to be paid off by the business depending on the tenure of the contract or valuation. There are again two sections in the liabilities:
These debts have a maturity date of less than a year. Accounts like accounts payable, unearned income, the current portion of outstanding loan ratio, and others.-term debt is included in the area of current liabilities. The business’s working capital comprises current liabilities on the other end. They are the debts that must be paid off with the help of other funding sources and the cash flows from current assets. The ratios that can be calculated using it are quick ratio, payable ratio and others.
Long Term Liabilities
These liabilities have a longer than one-year accounting life. Long-term debt and leasing commitments are sometimes included in the long-term liabilities section. The balance sheet’s long-term debt figure is an average that includes all the debt the company has issued. The notes section, which breaks down the debt by issuance, contains more information about the figure. The main ratios that can be calculated using this include debt-to-equity ratio, debt-to-capital ratio, and others.
3] Shareholder’s Equity
Mentioned with the liability side only, shareholder’s equity is another significant part of understanding the balance sheet. The value that the company’s equity holders receive is outlined in this section. It contains accounts such as contributed surplus, retained earnings, cumulative other comprehensive income, and paid-up capital through various classes of stock, such as common and preferred stock. The balance sheet does not contain many financial assets that support other revenue. Instead, they are explained in the notes. The specifics of such financial vulnerabilities must be understood. The shareholders’ equity portion can be examined using the price-to-book ratio as a statistic.
So, with a basic understanding of the balance sheet, you can now look into the steps to be followed while analyzing the balance sheet to conclude an understanding of the financial health and value of the company.
How To Read Balance Sheet?
Analyzing a balance sheet is about calculating these ratios, which can help you estimate a company’s financial position. Since a balance sheet shows the company’s financial position, calculating the ratios will help you to identify the current position and estimate the expected future position in quantitative terms. The primary outcomes usually drawn by calculating the balance sheet ratios include liquidity, efficiency, and the company’s financial structure.
Now, multiple ratios can be used, but let us look at the most important ones that can help you analyze. These ratios use the information from the balance sheet to reflect the position or health of the company.
1] Current Ratio
It is the ratio of the current assets to the current liabilities. The ideal ratio is 2:1. When the current assets are double the current liabilities, the ratio is satisfactory, and the company is in a good position. If the ratio is too high, the assets are not appropriately used to generate revenue. While if the ratio is too low, the liabilities are too high to be paid off, generating a negative impact. The representation of the formula is as follows:
Current Ratio = Current Assets / Current Liabilities
2] Quick Ratio
This describes a company’s capacity to utilize its liquid assets effectively while satisfying its immediate obligations. The acid test ratio is another name for it. The quick ratio calculates current liabilities by cash, cash equivalents, short-term investments, and current receivables. The suggested ratio should be 1:1 to ensure that the company performs in all stakeholders’ best interests. The representation of the formula is as follows:
Quick Ratio = (Current Assets – Current Inventory) / Current Liabilities
3] Debt-to-Equity Ratio
This ratio divides the business’s total liabilities by the owner’s equity. It aids bankers or investors in determining whether to lend money to the company. It is an unmistakable sign of a company’s long-term potential to make enough money to make payments and pay off debts. The debt-to-equity ratio is a measure of financial stability. Investors and creditors view businesses with a high debt-to-equity ratio as riskier.
Debt-to-Equity Ratio = Total Liabilities / Total Shareholder Equity
4] Return On Equity Ratio
Return on equity ratio is another name for proprietary ratios. It connects the capital or net assets and the proprietors’ finances. This ratio determines how successfully a firm manages its debts and funds its asset requirements. A corporation should aim for an equity ratio of roughly 0.5, or 50%, meaning that there is more outright ownership in the company than in debt. In other words, the corporation itself owns more than its debtors do.
Return On Equity Ratio = Shareholder’s funds / Capital or Total Assets
5] Assets Turnover Ratio
You can learn how effectively a company uses its assets by looking at its asset turnover ratio. A company’s ability to produce revenue from its assets is assessed by contrasting net sales with its average total assets. A more excellent asset turnover ratio shows that the company’s assets are effectively used to produce sales and profit. If the company has a reduced asset turnover, it may not be effectively using its assets.
Asset Turnover = Net Sales / Total assets
6] Inventory Turnover Ratio
This ratio reveals the frequency a business sells and then buys back its stock over a specific period. High inventory turnover indicates that the business is doing well and that its items are still in demand. A low inventory turnover value suggests less market for the company’s goods, leading to fewer sales.
Inventory Turnover = Cost of Goods Sold / Average Inventory
7] Accounts Receivable Turnover Ratio
The receivable turnover ratio shows how quickly a business can collect its receivables from its clients. A high percentage of accounts receivable to total revenue shows that the number of creditors is high. However, considering the length of the credit period offered to creditors differs by industry, receivable turnover must be examined compared to the company’s rivals in the same sector.
Receivable Turnover = Net Sales / Average Receivables
8] Accounts Payables Turnover Ratio
The payables turnover ratio reveals how quickly a business can settle its debts. It is obtained by dividing purchases by creditors as of the balance sheet date. It shows whether a business is paying its vendors on time or not. Low payables turnover is a sign that the business is not taking advantage of the longer credit time from its suppliers.
Payables Turnover = Purchases / Creditors Outstanding
9] Net Working Capital Turnover Ratio
The Net Working Capital Ratio shows how well the company’s working capital has been used in driving sales. Working capital turnover, sometimes referred to as net sales to working capital, gauges the connection between the resources required to finance a business’s operations and the revenues a business needs to earn to stay in business and make a profit.
Net Working Capital = Net Sales/ Net Working Capital
10] Debt Service Coverage Ratio (DSCR)
The DSCR Ratio shows a company’s capacity to pay off debt commitments. It is a common standard for assessing an entity’s capacity to generate enough income to pay off its debts. This ratio determines the operating revenue to debt servicing costs for interest, principal, and lease payments. However, a DSCR of 1.25 is typically seen as “strong,” whereas ratios below 1.00 could signify the company’s financial issues.
DSCR = (Profit after tax + Depreciation + Interest) / (Interest Payments Or Principal Payments + Lease Payments)
Analyzing the balance sheet is crucial when you wish to invest. It gives you an idea about the business’s financial soundness and helps you make a better decision. Simultaneously, the internal stakeholders also read balance sheet of a company to know the position of the business in the industry. Though most of the information can be obtained by just glancing at the balance sheet, deeply analyzing using the ratios makes the understanding even better.