The balance sheet has been the go-to tool for financiers since money began changing hands. However, this complex document is more than it seems. The balance sheet must not be read as a series of individual statements but as a sum of its parts. For instance, an income statement may report a large sale to a new customer, while the balance sheet shows the sale as an accounts receivable. Reading an ageing receivables report may reveal that the account has been unpaid for quite some time. Reading all of a company’s statements and reports deepens the understanding of this financial story. The balance sheet gives a clear picture as to whether the company has achieved its ultimate goal – profitability.
To use this tool effectively and improve financial performance, the major balance sheet components need to be evaluated – assets, liabilities, and equity. Assets, such as cash, equipment, and property, are owned by the company for one reason – to increase the business’s profitability and future wealth. One way to look at the effectiveness of assets is to evaluate how well they are generating profits by focusing on the return on assets (ROA). Periodic review of business ROA trends enables comparison with industry averages.
Balance sheet benchmarks
Most financial ratios are derived from two financial statements, the balance sheet and the income statement. When analysing the balance sheet it is important to understand that one measure doesn’t tell the entire story. The best approach involves calculating several ratios and looking for trends in the data. When calculating financial ratios, the evaluation is usually benchmarked against other companies. The best comparisons include:
- Market averages: these are market-wide averages or financial ratio ‘rules of thumb’ that apply to ‘generic’ companies.
- Industry averages: a better comparison than market averages, here the benchmark is against companies in the same or similar industries.
- Same company: ratio analysis can be done using historical, current, as well as forecasts or projections for the same company.
The following financial ratios are the key metrics that can be calculated using only the balance sheet.
The ‘current’ or ‘liquidity’ ratio is a measure of the solvency of the business. For a potential investor, this ratio highlights the company’s ability to cover current liabilities with available resources. A high current ratio indicates that the company would be prepared to cover its short-term liabilities using available, or liquid, cash. A low score – below 1.0 – can be used as a benchmark, indicates that the business may not be able to meet its short term obligations.
An alternative calculation of liquidity, known as the quick ratio, measures the company’s ability to cover short term obligations as well. The difference in this particular measurement is the removal of some of the less liquid assets from the equation. This is a more aggressive test of financial strength. As with the current ratio, a high score reflects financial strength.
Another indication of the financial strength of a company is the leverage ratio. Also known as the debt-to-equity or debt-to-worth ratio, this calculation gives a potential investor an idea of whether or not the company is healthy enough to pay creditors and obtain sustainable and long-term funding. It should be noted that this indicator can vary by industry. However, throughout industries, a general benchmark is that the ratio should not exceed 2:1, liability to shareholder equity.
These calculations provide a measure of how healthy a company’s assets are – in short, how likely it is that the company can convert its assets into cash or sales. Activity financial ratios such as these can demonstrate to shareholders and investors how financially fit a business is.
Financial metrics aren’t just for the company, but also measure the people behind the business and how well they are doing their job. A few key indicators are:
- Days Sales Outstanding (DSO)
DSO calculates receivables over revenue per day. A high DSO score indicates that the business collects its accounts receivables in a timely manner, whereas a high DSO number shows that the company allows its product to be sold on credit, and therefore takes longer to collect on its accounts.
- Days Inventory Outstanding (DIO)
This financial ratio is used to measure the average number of days a company holds inventory before selling it. This ratio is industry specific and should be used to compare competitors.
- Days Payable Outstanding (DPO)
The Days Payable Outstanding equation reveals the number of days that a business has to meet its credit obligation. This calculation also reveals how long the cash will be available to the company before it needs to pay back its creditors.
The cash conversion cycle can be calculated with the below equation:
Cash Conversion Cycle = DIO + DSO – DPO
This conversion cycle gives a holistic overview of company effectiveness and is a clear indicator of where a company stands in the market.
The receivables turnover ratio is categorised as an activity ratio because it measures the company’s effectiveness in collecting its credit sales. Inventory turnover is important for companies with physical products and is best used to compare against peers.
Another useful ratio in determining the quality of the potential product is intangibles to book value. With the exception of organisations that retain a great deal of intellectual property or widely known brands, intangible assets should be kept to a minimum.
An inventory to sales ratio is an excellent tool when tracking budgets on a yearly or quarterly basis. Its aim is to shed light on the manner in which inventory is being managed. This ratio is intended to reveal issues with cash flow in trends in inventory flow.
Debt to equity ratios is evaluated to understand whether the company is in a difficult situation or not. A company that is working with a high level of leverage, as well as a high debt ratio may seem like an issue. However, the actual cause for concern is when an organisation has a low debt ratio and that debt ratio changes suddenly.
Comparative balance sheets
A comparative balance sheet presents simultaneous information about an entity’s assets, liabilities, and shareholders’ equity as of multiple points in time. It could be in long range – three years – or short – three months. The aim is to highlight the company’s financial health over time, by developing a trend line analysis through individual snapshots of the financial history. One can use vertical analysis – a linear look at the actual figures – or horizontal analysis, which means analysing trends and fluctuations, along with comparative balance sheets to get a complete picture.
Between the lines
Understanding the different types of financial documents and the information each contains helps you analyse your financial position and make more informed decisions about your practice. Balance sheet ratios are an excellent tool in the determination of key financial factors including the ability to meet financial obligations and effective credit usage.
The ratios determined by the balance sheet allow for a comparative view of reporting periods. One should pay attention to changes in assets, debts and investments. Using the ratios, CFOs can determine the overall past, present and future health of the business.