Balance Sheet

Introduction to the Balance Sheet

The Balance Sheet is one of the principal accounting tables that form the numerical foundation of an organization's financial report.  It lists the calculated or estimated values, on a given day and in a given currency, for the organization's Assets, Liabilities, and Net Worth (also known as Shareholders' Equity).  Typically, one column identifies these figures for the last day of the fiscal quarter or year and another column includes the same numbers for the last day of the previous fiscal year.  This arrangement makes it easy to see how each Balance Sheet item changed during the year.

By definition:

    Assets minus Liabilities equals Net Worth;

or, as it is usually expressed,

    Assets = Liabilities plus Net Worth.


Assets

The liquidity of an Asset is an indication of how quickly the item can be sold or exchanged for Cash.  When assessing an organization's finances and creditworthiness, it is useful to distinguish between those Assets that are relatively more liquid and those that are relatively less liquid.

The first category -- the more liquid assets -- are referred to as Current Assets.

Current Assets include Cash, Short-term Investments, Accounts Receivable, Inventory, and a few other items.  While one can be reasonably sure of a bank or money market account balance, valuing Receivables and Inventory is more difficult.  The sale of these items to a third party will not necessarily return the cash value listed on the Balance Sheet.

Non-Current Assets is the second of the two categories of Assets.  Non-Current Assets include relatively illiquid items such as Property, Plant, and Equipment, Long-term Investments, and Intangible Assets.


Liabilities

The Liabilities section of the Balance sheet is also arranged by the effect of the item on the organization's liquidity.

Current Liabilities, such as Accounts Payable, are obligations that must be paid in cash within a year or some other designated time in the near future.  Interest and tax payments due are other examples of Current Liabilities.

The most significant Non-Current Liability is usually Long-term Debt.


Net Worth (Shareholder's Equity)

Net Worth consists of the proceeds from stock sales plus Retained Earnings and certain adjustments.  Retained Earnings are the company's cumulative profits over its existence, less amounts paid out as dividends.


Invested Capital

Companies finance their operations by selling common and preferred equity shares and by taking on debt.  The total amount raised and retained is the company's Capitalization.

We refer to Invested Capital as Capitalization less the amount held as Cash or Short-term investments.  The subtraction is made because these funds haven't been invested in the company's operations.

     Invested Capital = Shareholders' Equity + Debt - Cash - Short-Term Investment.


Please note that there are various other definitions of Invested Capital.

When assessing the efficiency and profitability of a company, we compare various aspects of its earnings and cash flow to the Invested Capital.



Balance Sheet Example

There are as many forms of the Balance Sheet as there are companies.  Some are very detailed with many line items, and others condense the entries into a smaller number of items.  Nevertheless, most Balance Sheets follow a similar pattern. 

We concocted the example below to illustrate what can be learned from the Balance Sheet.

GCFR Corp., Inc. (Millions of $)			30 June 2006	31 December 2005
Assets
	Current assets:
		Cash & equivalents	$10	$8
		Short-term investments	$11	$9
		Net accounts receivable (Accounts receivable - doubtful accounts)	$12	$10
		Total inventories (Raw materials + Work in process inventories + Finished goods)	$13	$11
		Deferred tax assets	$14	$12
		Other current assets	$15	$13
		Total current assets	$75	$63
	Non-current assets:
		Property, plant, and equipment (Purchase cost - Accumulated depreciation)	$50	$40
		Long-term investments	$60	$50
		Other assets	$70	$60
		Total non-current assets	$180	$150
	Total assets		$255	$213
Liabilities
	Current Liabilities
		Accounts payable	$6	$5
		Accrued liabilities	$7	$6
		Deferred items	$8	$7
		Notes payable (ST debt)	$9	$8
		Taxes payable	$10	$9
		Other current liabilities	$1	$1
		Total current liabilities	$41	$36
	Non-current liabilities:
		Long-term debt	$60	$50
		Deferred items	$10	$10
		Minority interest & other	$10	$10
		Total non-current liabilities	$80	$70
Net worth (Stockholders' Equity)
	Common and preferred stock (paid-in capital)		$40	38
	Retained earnings		$100	75
	Accumulated adjustments		$(6)	$(6)
	Total stockholders' equity		$134	$107
Liabilities + Net worth			$255	$213

What Can be Learned from the Balance Sheet?

The Balance Sheet can reveal a lot about an organization's financial strength.  To evaluate that sturdiness, financial analysts compute ratios with data extracted from the Balance Sheet, other financial statements, and the supporting Notes.  These analysts look at how a set of ratios change over time and how the numbers compare with other companies in the same industry.

Analysts have invented a seemingly infinite number of ratios involving Balance Sheet data.  The importance of any one of these ratios to an evaluation depends on factors such as the size, type, and condition of the company.  For example, ratios indicating a company's creditworthiness are more useful to an examination of a small or struggling company than a healthy blue-chip firm.

GCFR uses the following ratios derived from Balance Sheet data:


Current Assets/Current Liabilities

This ratio, known as the Current Ratio, is one indication of how well a company is positioned to pay the bills that will come due during the next year.  It presupposes that the company can and will liquidate its Current Assets to make the required payments; managing cash flow is certainly more complicated.  Companies were once expected to keep their Current Ratio above 2.0, but lower values seem to be the norm these days.  We get concerned if the ratio falls below 1.5, decreases inexplicably, or rises above 4.0.  Why would a high Current Ratio be a concern?  It suggests that the company is tying up too much of its resources in short-term assets instead of long-term investments with greater earnings power.

In the example above, GCFR Corp.'s Current Ratio was 75/41 = 1.83 in June, up from 63/36 = 1.75 the previous December.


Liquid Assets/Current Liabilities

This "Acid Test" ratio

    (Cash + Short-term Investments + Accounts Receivable, net) / Current Liabilities

is similar to the Current Ratio; the difference is that the numerator is limited to the most liquid Current Assets.  Since it covers fewer assets, the Acid Test ratio will always be lower than the Current Ratio at a given time.  We rest easier when the Acid Test is greater than 1.0.

The mythical GCFR Corp.'s Acid Test Ratio was (10+11+12)/41 = 0.80 in June and (8+9+10)/36 = 0.75 six months earlier.


Cash/Total Assets

The Cash-to-Assets Ratio

    (Cash & Cash equivalents + Short-term Investments) / Assets

is normally expressed as a percentage.

For GCFR Corp., the ratio increased to (10+11)/255 = 8.24% from (8+9)/213 = 8.0%.


Working Capital / Market Capitalization

We learned about this ratio, expressed as percentage, from the Motley Fool.

    Working Capital / Market Capitalization
= (Current Assets - Current Liabilities) / (Market Value + Debt)
= (Current Assets - Current Liabilities) / [(Shares Outstanding * Share Price) + (Long-term Debt + Short-term Debt)]

Market Capitalization, since it includes Debt, approximates the cost of acquiring the company.  Higher values of Working Capital, as a percentage of this acquisition cost, would presumably make the company more attractive to an acquirer.

The number of common shares outstanding may be found on the Balance Sheet or a supplemental table.  We use the average value that is denominator of Earnings per Share.

GCFR Corp. had a Working Capital of $75 - $41 = $34 million on 30 June 2006.  If it had 5 million shares outstanding, and if these shares were selling for $10 each on 30 June 2006, its Market Value on that date equaled $50 million.  We add $9 million of Short-term debt and $60 million of Long-term Debt to the Market Value to find that the Market Capitalization was $119 million.  Therefore, the ratio of Working Capital to Market Capitalization was 34/119 = 28.6 percent.


Working Capital/Invested Capital

= (Current Assets - Current Liabilities) / (Shareholders' Equity + Debt - Cash - Short-Term Investment)


Note that the denominator is the Invested Capital defined above.


GCFR Corp. had a Working Capital of $75 - $41 = $34 million on 30 June 2006. 

Its Invested Capital on that date was $134 + ($60 + $9) - $10 - $11 = $182 million. 

Therefore, the ratio of Working Capital to Invested Capital is 34/182 = 18.7 percent.


Long-Term Debt/Stockholders' Equity

This ratio is one way to measure the extent to which a company is financially leveraged.  If the ratio is too high (e.g., close to, or over, 100 percent), hefty interest payments could become burdensome if business conditions worsen.

This ratio for GCFR Corp. was 60/134 = 44.8 percent in June and 50/107 = 46.7 percent six months earlier


Net Debt Ratio

This Debt measurement includes an adjustment for the cash on hand to pay off the debt

    (Total Debt - Cash and Equivalents) / Assets
= [(Long-term Debt + Short-term Debt) - (Cash + Short-term Investments)] / Assets

For GCFR Corp., the Net Debt Ratio was [(60+9)-(10+11)]/255 = 18.8 percent in June.



Debt/Cash Flow from Operations

The ratio gives a different view of the leverage implied by the company's financial structure. It indicates how many months or years of incoming Cash Flow are required to pay off the company's Short-term and Long-term Debt.

GCFR Corp's total debt was $60 + $9 = $69 million on 30 June 2006.  If we assume its Cash Flow from Operations (found on the Statement of Cash Flows) was $25 million in the first six months of 2006, then 69/(25/6) = 16.6 months of Cash Flow to cover the existing debt.


Inventory/Cost of Goods Sold

Inventory consists of the raw materials, work in process, and unsold finished goods owned by the company. There are many different ways to estimate the Inventory's value, and these alternatives can yield substantially different results. The company will select an approach and disclose its choice in the Notes to the financial statements. The independent analyst should be aware that the Inventory might not be worth the value calculated by the company, but the analyst will almost never have enough information to compute a different value.

This ratio, and the two ratios that follow, shed light on whether the company is holding too much Inventory, which saps its cash.  More importantly, excessive Inventory could signal that customers have slowed their purchases of the company's products.  It's not unusual to learn that a company declared a substantial loss attributed to an Inventory write-down. This is less likely to happen when the company keeps its inventories lean.

A few facts will make this ratio more understandable. Cost of Good Sold (CGS) (a/k/a Cost of Revenue), found on the Income Statement, is how much the company spent, over a quarter or year, to acquire and fabricate the items it sold during that period. If we divide this expense by the number of days in the quarter or year, we get the cost per day. Finally, if we divide the Inventory value by the CGS per day, we get a quantity that is a number of days. To be specific, it is how many days of expenses are represented by the current Inventory. Clearly, lower values are better.

Let's assume GCFR's Income Statement for the second quarter of 2006 shows a Cost of Good Sold of $39 million.  We divide $39 by the quarter's 90 days to get a CGS/day of $0.433 million.  Therefore, the Inventory/CGS ratio = $13/0.433 = 30 days.

The value of this ratio is not as important as how it has changed over time. If the company normally holds 30 days of Inventory, we would be happy to see the time reduced to 27 days because Sales were probably higher than management expected. Similarly, an increase to 33 days would tell us that Sales were slower than expected, causing inventory to back up.


Inventory/Revenue (days)

This ratio is almost identical to the previous figure, except that Revenue per day, instead of CGS per day, is used to compute how many days worth of Inventory are held. This effectively relates the Inventory to its value at retail prices.

Assume GCFR's Revenue, from its Income Statement (not included here), in the second quarter of 2006 was $52 million.  We divide $52 by the quarter's 90 days to get a Revenue per day of $0.5778 million.  Therefore, the Inventory/Revenue ratio = $13/0.433 = 22.5 days.


Finished Goods/Inventory

The final Inventory ratio provides insight into what percentage of the Inventory consists of finished goods.  If this percentage is increasing, it hints that the company's products are selling slower than expected. The company might have to cut production or take back unsold goods from wholesalers. On the other hand, if the percentage is decreasing, it suggests either faster sales than expected or that the company is ramping up production in anticipation of future sales.

Of GCFR Corp.'s $13 million Inventory on 30 June 2006, let's assume $3 million was raw material, $4 million was work in process, and $6 was finished goods.  Therefore, 6/13 = 46 percent of the total Inventory was composed of finished goods.


Accounts Receivable/Revenue
[Days of Sales Outstanding]

In this ratio, we take the Accounts Receivable, net value from the Current Assets section of the Balance Sheet and divide it by the Revenue per day derived from the Income Statement. The result indicates whether other parties are quick or slow to pay their bills to the company. Rapid collection is a sign of efficiency because the payments received can be re-invested sooner.

Slow collections can be a real risk for a small company, especially one that does business with unreliable partners.

GCFR Corp. had $12 million of Receivables on 30 June 2006.  We assumed above that GCFR's Revenue, from the Income Statement, in the second quarter of 2006 was $52 million (Revenue per day = $0.5778 million). Therefore, the ratio of Receivables/Revenue =  12/0.5778 = 20.8 days (of sales outstanding)


Accounts Payable/Cost of Goods Sold (days)
[Days of Payables Outstanding]

In this ratio, we take the Accounts Payable value from the Current liabilities section of the Balance Sheet and divide it by the CGS per day derived from the Income Statement.

For fictional GCFR Corp., the ratio on 30 June 2006 equaled $6 million/($39 million/90 days) = 13.85 days.

An alternative for the numerator is the average Accounts Payable over the measurement period (e.g., a quarter or year) for the CGS. An alternative for the denominator is to add the increase in Inventories to the CGS.

The result indicates how long the company waits on average before paying for purchases. It can be interesting to compare the value of this ratio with the value for Accounts Receivable/Revenue to see the relative leverage among the company, its customers, and its suppliers in holding on to Working Capital.


Cash Conversion Cycle (CCC) Time

This one is a little complicated, but it is well explained in an Investopedia article by David Harper.  The key point is that Short CCC times indicate that the company is using its Working Capital efficiently.

The CCC Time, in days, 
= Days of Inventory plus Days of Sales Outstanding, minus Days of Payables Outstanding.
= [Inventory/(CGS/day)] + [Accounts Receivable, net/(Revenue/day)] - [Accounts Payable/(CGS/day)]

Note that the first two terms indicate how long the company ties up Working Capital for Inventory and Sales for which it hasn't yet been paid. The subtracted term represents how long the company can preserve its Working Capital by deferring bill payments.

For GCFR Corp., using the made-up numbers above, the CCC Time as of June 2006 was 30 days + 20.8 days - 13.85 days = 37 days.