We use a sample Balance Sheet to introduce some of the many ratios an analyst might want to calculate using Balance Sheet and other data from the financial statements.
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.
Assets minus Liabilities equals Net Worth;
or, as it is usually expressed,
Assets = Liabilities plus Net Worth.
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.
For reasons explained below, GCFR pays a lot of attention to Inventory figures for manufacturers and retailers. We get less information from the Inventory figures, if any, for service companies.
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.
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.
Working Capital is the value of the liquid assets a company would have left after satisfying all its short-term obligations. It is found by subtracting Current Liabilities from Current Assets.
Companies generally need to have enough liquid assets to pay their bills on time, keep the shelves and warehouses well stocked, and maintain an orderly flow of business. The minimum amount of Working Capital for a given company depends on the size of the business and on the industry. One would usually expect that companies in the same industry would have similar Working Capital/Revenue ratios.
Higher amounts of Working Capital can be evidence of a company's creditworthiness. However, much more Working Capital than needed can be a sign that the company is not deploying its capital efficiently. Capital unnecessarily tied up as low-yielding Working Capital is not necessarily a positive sign. The company could be missing out on opportunities use its capital to make long-term investments that would ultimately benefit its shareholders more profitably.
If a weak company has negative Working Capital, it could be indicative of impending failure. However, in a very strong company with rapid cash flows, low or negative Working Capital can signify extremely efficient use of cash.
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.
Inventory consists of the raw materials, work in process, and unsold finished goods owned by a company. There are many different ways to estimate the Inventory's value, and these alternatives can yield substantially different results. Each company will disclose its valuation methods in the Notes to its financial statements. A thorough analyst will realize that the Inventory value reported by a company is an estimate based on assumptions that might not reflect current conditions in the marketplace. Unfortunately, analysts will rarely have enough information to recompute the Inventory value under a different set of assumptions.
An evaluation of how well a company is managing its Inventory can be very informative. For example, a bloated Inventory indicates the company spent more than was really necessary to acquire or produce the Inventory. In addition, depending on the product, older items in the Inventory can diminish in value as these items become more difficult or even impossible to sell. While everyone knows that fresh foods have to be sold quickly or thrown away, the same principle can apply to other products. Technology-based products and fashionable items, for example, tend to get supplanted by a new or improved version on a regular basis.
When a company recognizes that the worth of its Inventory has decreased, it has to write-down the value. The amount written off, which can be very substantial, reduces the company's earnings and can turn a profitable quarter into a losing period. When announcing a write-down charge, the company may try to diminish its significance by claiming it is a non-cash expense for accounting purposes only. In fact, the cash was spent earlier and the write-down formally indicates that the expense was for naught.
Companies that keep their inventories lean should experience fewer and less severe write downs.
Big changes in the total Inventory level or in its Finished Goods component can be very significant. If they increase, it hints that the company's products may have sold slower than management expected. In this case, the company might have to cut production or take back unsold goods from wholesalers. On the other hand, if Inventory is decreasing, it could suggest faster sales than expected or that the company has chosen to ramp up production in anticipation of future sales.
Other explanations are possible, so the careful analyst will consider whether seasonal factors, new product launches, changing commodity prices, or any of a host of other circumstances are driving the company's Inventory management.
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|
|Cash & equivalents||$10||$8|
|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|
|Property, plant, and equipment (Purchase cost - Accumulated depreciation)||$50||$40|
|Total non-current assets||$180||$150|
|Notes payable (ST debt)||$9||$8|
|Other current liabilities||$1||$1|
|Total current liabilities||$41||$36|
|Minority interest & other||$10||$10|
|Total non-current liabilities||$80||$70|
|Net worth (Stockholders' Equity)|
|Common and preferred stock (paid-in capital)||$40||38|
|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.
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%.
We mentioned this ratio above as measure of whether a company has too much or too little Working Capital. The company should have enough Working Capital, relative to its Revenue, to ensure the smooth running of the business. The amount of Working Capital that is "enough" is usually different for different industries.
Low Working Capital could be a sign the company will have trouble paying its bills; however, if that's not the case, it might actually demonstrate the company's efficient use of cash.
A company with excessive Working Capital won't have problems with creditors, but its shareholder might suffer low returns because capital isn't being used efficiently.
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 12 million shares outstanding, and if these shares were selling for $4.17 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
This ratio is one that can shed light on how well the company is managing its Inventory. For reasons explained above, GCFR pays a lot of attention to Inventory figures for manufacturers and retailers. We get less information from the Inventory figures, if any, for service companies.
The Balance Sheet, as described above, lists an estimated value of the company's inventory. The value is in dollars, as assumed here, or another currency. With the Inventory/CGS ratio, we have a way to express Inventory in terms of a number of days.
Cost of Goods Sold (CGS) (a/k/a Cost of Revenue), found on the Income Statement, is how much the company spent, over a given period of time, to acquire and fabricate the items it sold during that period. Dividing the expense by the number of days in the periods results in a cost per day. Dividing the Inventory value in dollars by the dollar cost per day yields an Inventory level in days.
In other words, it measures how many days of expenses are represented by the current Inventory. Clearly, lower values are better.
When making these calculations, it is best to use the average Inventory value over the period represented by the Cost of Goods Sold.
GCFR's sample Income Statement for the second quarter of 2006 shows a Cost of Good Sold of $39.1 million. We divide $39.1 by the quarter's 91 days to get a CGS of $0.43 million per day. The sample Balance Sheet above lists GCFR's Inventory value on 30 June 2006 at $13 million. Let's further assume that the Inventory value at the beginning of the quarter was $12 million, resulting in an average Inventory value over the quarter of $12.5 million.
With these figures, the Inventory/CGS ratio would equal
$12.5 million / $0.43 million/day = 29 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.
GCFR's sample Income Statement for the second quarter of 2006 shows Revenue of $52.2 million. We divide $52.2 by the quarter's 91 days to get Revenue of $0.574 million per day. Therefore, the Inventory/Revenue ratio equals
$12.5 million / $0.574 million/day = 21.8 days.
This is the last ratio attempting to shed light on how well the company is managing its Inventory. For reasons explained above, GCFR pays a lot of attention to Inventory figures for manufacturers and retailers. We get less information from the Inventory figures, if any, for service companies.
We're now focused on the finished goods percentage of the total Inventory. As mentioned above, declines in the percentage can be a positive development for the company.
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.
[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 $52.2 million (Revenue per day = $0.574 million). Therefore, the ratio of Receivables/Revenue = 12/0.574 = 20.9 days (of sales outstanding)
To be more precise, the average Accounts Receivable over the given period should be used.
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/($39.1 million/91 days) = 14.0 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 29 days + 20.9 days - 14.0 days = 35.9 days.
This article was last modified on 30 December 2009.