📊Financial Information Analysis Unit 3 – Balance Sheet Analysis

What's a Balance Sheet?

• Financial statement that provides a snapshot of a company's financial position at a specific point in time
• Reports the company's assets, liabilities, and shareholders' equity
• Helps investors, creditors, and other stakeholders assess the company's financial health and stability
• Prepared using the accrual basis of accounting, which recognizes transactions when they occur rather than when cash is exchanged
• Typically prepared at the end of a company's fiscal year or quarter
• Audited by an independent certified public accountant (CPA) to ensure accuracy and compliance with accounting standards
• Used in conjunction with other financial statements (income statement, cash flow statement) to provide a comprehensive view of a company's financial performance

Key Components of a Balance Sheet

• Assets: Resources owned by the company that have economic value and are expected to provide future benefits
  • Current assets: Assets that are expected to be converted to cash within one year (cash, accounts receivable, inventory)
  • Non-current assets: Assets that are expected to provide benefits for more than one year (property, plant, and equipment, intangible assets)
• Liabilities: Obligations or debts owed by the company to external parties
  • Current liabilities: Obligations that are due within one year (accounts payable, short-term loans)
  • Non-current liabilities: Obligations that are due beyond one year (long-term debt, deferred tax liabilities)
• Shareholders' equity: The residual interest in the company's assets after deducting liabilities
  • Contributed capital: Funds invested by shareholders through the purchase of stock
  • Retained earnings: Accumulated profits that have not been distributed to shareholders as dividends

Balance Sheet Equation and Structure

• The balance sheet equation: Assets = Liabilities + Shareholders' Equity
• This equation must always balance, as the total value of a company's assets must equal the sum of its liabilities and shareholders' equity
• Assets are typically listed in order of liquidity, with the most liquid assets (cash) appearing first and the least liquid assets (long-term investments) appearing last
• Liabilities are typically listed in order of maturity, with current liabilities appearing first and non-current liabilities appearing last
• Shareholders' equity is typically divided into contributed capital and retained earnings
• The balance sheet structure allows users to quickly assess a company's liquidity, solvency, and overall financial health

Analyzing Asset Quality

• Asset quality refers to the likelihood that a company's assets will generate future economic benefits
• High-quality assets are those that are easily convertible to cash, have a low risk of obsolescence, and generate consistent cash flows
• Analyzing the composition of a company's assets can provide insights into its liquidity, efficiency, and risk profile
• The current ratio (current assets / current liabilities) measures a company's ability to meet its short-term obligations
• The quick ratio ((current assets - inventory) / current liabilities) provides a more stringent measure of liquidity by excluding inventory, which may be difficult to convert to cash quickly
• The age and condition of a company's property, plant, and equipment can indicate the need for future capital expenditures and potential obsolescence risk

Evaluating Liabilities and Debt

• Liabilities represent a company's obligations to external parties and can impact its financial flexibility and risk profile
• The debt-to-equity ratio (total debt / total shareholders' equity) measures the extent to which a company relies on debt financing relative to equity financing
• A high debt-to-equity ratio may indicate increased financial risk and potential difficulty in meeting debt obligations
• The interest coverage ratio (earnings before interest and taxes (EBIT) / interest expense) measures a company's ability to make interest payments on its debt
• Analyzing the maturity profile of a company's debt can provide insights into its short-term and long-term liquidity needs
• Off-balance sheet liabilities (operating leases, contingent liabilities) should also be considered when evaluating a company's total debt burden

Interpreting Shareholders' Equity

• Shareholders' equity represents the residual interest in a company's assets after deducting liabilities
• The book value per share (total shareholders' equity / number of outstanding shares) provides a measure of the intrinsic value of a company's stock
• Analyzing changes in retained earnings over time can provide insights into a company's profitability and dividend policy
• The return on equity (ROE) ratio (net income / average shareholders' equity) measures the efficiency with which a company generates profits for its shareholders
• A high ROE may indicate a company's competitive advantage or efficient use of capital
• Comparing a company's ROE to its industry peers can provide insights into its relative performance and profitability

Common Balance Sheet Ratios

• Financial ratios derived from the balance sheet can provide quick insights into a company's liquidity, solvency, and efficiency
• Liquidity ratios: Current ratio, quick ratio, cash ratio
• Solvency ratios: Debt-to-equity ratio, debt-to-assets ratio, interest coverage ratio
• Efficiency ratios: Inventory turnover, days sales outstanding, fixed asset turnover
• Profitability ratios: Return on assets (ROA), return on equity (ROE), gross profit margin
• Comparing a company's ratios to its historical performance, industry averages, and competitor benchmarks can provide context for its financial health and performance

Real-World Balance Sheet Analysis

• When analyzing a company's balance sheet, it's important to consider the broader context of its industry, business model, and macroeconomic environment
• Comparing a company's balance sheet to its peers can help identify strengths, weaknesses, and potential red flags
• Analyzing trends in key balance sheet items (accounts receivable, inventory, debt) over time can provide insights into a company's growth, efficiency, and risk management
• Qualitative factors, such as the quality of a company's management team, its competitive position, and its growth prospects, should also be considered alongside balance sheet analysis
• Real-world events, such as mergers and acquisitions, changes in accounting standards, and economic downturns, can significantly impact a company's balance sheet and should be factored into the analysis
• Ultimately, balance sheet analysis is just one component of a comprehensive financial analysis and should be used in conjunction with other financial statements, ratios, and qualitative factors to make informed investment decisions