Assets – Liabilities = Equity
Assets are broadly classified as fixed assets and current assets. Liabilities are classified into debt and equity. Debt can be further classified as long-term debt and current liabilities. While assets represent investments in the business, liabilities reflect the sources of financing. Proportion of liabilities and equity financing the investments have a significant impact on the return on investment.
Analysis of balance sheet helps assess the liquidity, return on investment (ROI) and leverage of a firm. Liquidity refers to the ability of the firm to pay its bills when due. Ideally, the current liabilities – payments to be made to firm’s suppliers and other day-to-day operating costs – should match the inflows of current assets; primarily arising from the credit sales. However, this is a rare possibility in practice for obvious reasons.
Readily realizable assets the firm has on hand, after paying its current liabilities is a measure of the liquidity of the firm. Current assets divided by current liabilities called, as current ratio is one such indicator computed using the information from the balance sheet and used in assessing the liquidity of the firm.
While the suppliers of the firm would always favor higher ratio, it indicates that firm is not using its liquidity to grow. In other words, firm with higher current ratio would have investments in assets which are not the primary revenue-earning assets. The other key aspect to be observed, in addition to the current ratio, is the composition of current assets. Cash – considered to be the most liquid of all assets – is what percent of the total current assets? While higher amount of cash is always better, excess of it indicates unproductive use. Days the credit sales are outstanding and firm’s ability to collect them on time are also some of the other indicators to be looked into before interpreting the current assets. Finally, the computed current ratio should be compared against the firm’s nearest competitor or industry average and also with its own previous years’ values.
ROI measures the returns the firm provides to its investors i.e. shareholders. It is computed by dividing the Net Income by shareholders’ equity.
For instance, an ROI of 10% indicates that for every 100 units of investment, investors get 10 units of returns. However, ROI would vary owing to firm and industry characteristics. Shareholders’ equity is observable from the balance sheet; Net Income is taken from the income statement.
Leverage – a measure of how a firm’s assets are financed- is computed by dividing debt (usually only long-term debt is taken into consideration for the computation of leverage ratio) by shareholder’s equity.
The level of debt a firm has on its balance sheet is a crude indicator of the bankruptcy risk the firm is likely to face. Higher the leverage number, the more risky the firm’s position is. This is so because debt involves interest payments that cannot be delayed. At higher debt levels firm should earn enough profits to honor interests payments when due. While it is not rare to find firms with no debt, some level of debt is always preferable given the tax bias against equity. However, there exists no universal theory that provides clear answer to what is an optimal ratio despite four decades of empirical and academic research. Observing the leverage ratio across industries one would find it varying from 0 to 1.2 or even higher. A useful comparison for the sake of analysis would be an industry average or nearest competitor (in the same line of business).
Balance sheet is a key part of a firm’s financial statements but does not provide a complete picture of the firm. The complete picture emerges only after looking into income statement, cash flow statement and management’s discussion & analysis including balance sheet. Though a valuable source of information, informed investment decisions could be taken only after supplementing the information in balance sheet with analysis of other financial statements. In the next article we would discuss the utility of financial ratios as tools of analysis.