2. Balance Sheet Analysis 1

8/2/2019 2. Balance Sheet Analysis 1

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S5 Finance GestionS5 Finance Gestion FinancialFinancial

DiagnosticDiagnostic

2. Balance Sheet2. Balance Sheet

AnalysisAnalysis

EMLV 2011/2012


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S5 Finance Gestion FinancialFinancial

DiagnosticDiagnosticJill Tynan Wantz

Contents:Contents:

1.Introduction

1.1.Balance Sheet AnalysisBalance Sheet Analysis

LiquidityLiquidity && RatiosRatios

Operating cycle - Asset managementOperating cycle - Asset management

Working capital - Financial structureWorking capital - Financial structure

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S5 Finance Gestion Financial DiagnosticFinancial Diagnostic

2. Balance Sheet Analysis2. Balance Sheet Analysis

We look briefly at the balance sheet:We look briefly at the balance sheet:

The balance sheetis a summary of the assets,

liabilities, and equity of a business at aparticular point in timeusually the end of

the firm's fiscal year.

Assetsare the resources of the business. They are

used to generate future benefits. If a firm ownsplant and equipment that will be used to producegoods for sale in the future, the firm can expect

these assets (the plant and equipment) to

generate cash inflows in the future.EMLV 2011/2012


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Liabilitiesare obligations of the business.They represent commitments to creditors

in the form of cash outflows. When a firm

borrows, say, by issuing a long-termbond, it becomes obligated to payinterest and principal on this bond as

promised.

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Equity,also called shareholders' equityor stockholders' equity, reflects

ownership.

The equity of a firm represents the part of its valuethat is not owed to creditors and therefore is leftover for the owners. In the most basic accountingterms, equity of an organization is the difference

between what the firm ownsits assetsand

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Liquidity -Liquidity -

The firms ability to meet itsshort-term obligations usingusing

those assets that are mostthose assets that are most

readily converted into cashreadily converted into cash.

Can the firm pay its bills ?Can the firm pay its bills ?

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Can the current assets pay for the currentCan the current assets pay for the current

liabilities ?liabilities ?

Long-term Assets Property, Plant & E

Intangible assetsInvestment

Balance sheet

Long-term Liabilities

Shareholders Equity

Degree of liquidityDegree of liquidity DegreeDegree ofofdemanddemand

High dHigh d

Low dLow d

High dHigh d

Low dLow d

Current AssetsCashAccounts receivable

Invertory

Current LiabilitiesAccounts payableTax payable

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How much liquidity the companyHow much liquidity the companyneeds depends on theneeds depends on the Operating

cycle

The operating cycle is theduration from when cash is

invested in goods to the time

when the sale of goodsproduces cash.

Goods and services bought ..transformed....Sold .......cash received from customers

This cycle can also be called This cycle can also be called CCashash CConversiononversion CCycle ycle

Operating cycle

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The operating cycle:

Four phases :Four phases :

1.1. Purchase raw material, merchandise,Purchase raw material, merchandise,produce goodsproduce goods

2.2. Sale of goodsSale of goods

3.3. Extend credit creating accounts receivableExtend credit creating accounts receivable

4.4. Collect accounts receivable, generatingCollect accounts receivable, generatingcashcash

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S5 Finance Gestion Financial DiagnosticFinancial Diagnostic2. Balance Sheet Analysis -2. Balance Sheet Analysis - Liquidity -Liquidity -

EMLV 2008/2009

Short-term Assets

Long-term Assets

Balance sheetBalance sheet

Short-term Liabilities

Long-term Liabilities

Shareholders Equity

< 1 year< 1 year

> 1 year> 1 year

Operatingcycle(-1 year)

How much liquidity the company needsHow much liquidity the company needsdepends on itsdepends on its Operating cycleOperating cycle

InvestingInvesting&&

FinancingFinancing+1 year


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The operating cycle concernsaccounts of day-to-day activity

such as :

cash, receivables, inventory, payables, andcash, receivables, inventory, payables, andaccrualsaccruals

Current Assets

CashAccounts receivable

Invertory

Liquidity RatiosLiquidity Ratios indicate how liquid each of theseindicate how liquid each of theseaccounts are. Liquidity expressed in days.accounts are. Liquidity expressed in days.EMLV 2008/2009

Current LiabilitiesAccounts payableTax payable


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Liquidity Ratios indicate:Liquidity Ratios indicate:

1.1.The turnover of inventory in nbr. ofThe turnover of inventory in nbr. of

daysdays

2.2.The number of days credit the firmThe number of days credit the firm

allows its clientsallows its clients

3.3. Average purchases daysAverage purchases days

4.4.The net operating cycle in daysThe net operating cycle in days5.5. Current ratio, the proportion of currentCurrent ratio, the proportion of current

assets to current liabilitiesassets to current liabilities

6.6. Net working capital to sales ratioNet working capital to sales ratioEMLV 2008/2009


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Liquidity RatiosLiquidity Ratios :: 1. The turnover of1. The turnover ofinventoryinventory ininnbr. of daysnbr. of days

1.1.The turnover of inventory in nbr. ofThe turnover of inventory in nbr. ofdays.days.

The number of days the company tiesThe number of days the company ties

up funds in inventories, is calculatedup funds in inventories, is calculatedby using:by using:

the total amount of money represented inthe total amount of money represented in

inventoryinventory EMLV 2011/2012


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Liquidity RatiosLiquidity Ratios 1. The turnover of1. The turnover ofinventoryinventory inin

nbr. of daysnbr. of days

The average days cost of goods sold =The average days cost of goods sold =

Cost of goods sold* / 365 daysCost of goods sold* / 365 days

**cost of goods sold is found in the income statementcost of goods sold is found in the income statementEMLV 2011/2012


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Liquidity Ratios : 1. The turnover ofLiquidity Ratios : 1. The turnover ofinventoryinventory inin

nbr. of daysnbr. of days

Number of days of inventory =Number of days of inventory =

The total amount of money represented inThe total amount of money represented ininventoryinventory

How many days worth of goods is this ?How many days worth of goods is this ?

amount of inventory on handamount of inventory on handaverage days cost of goods soldaverage days cost of goods sold

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Liquidity Ratios :Liquidity Ratios : 2. The number of2. The number ofdays creditdays credit the firmthe firm

allows its clients:allows its clients:

number ofnumber ofdays credit =days credit = Accounts receivableAccounts receivable

Credit sales per dayCredit sales per day

Credit sales per day* =Credit sales per day* =

Number ofNumber ofdays credit =days credit =

Credit sales*365 days

*We presume that all sales are on credit

Accounts receivableAccounts receivable

Credit sales per dayCredit sales per day

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Liquidity RatiosLiquidity Ratios :: 3.3. average days purchasesaverage days purchaseson crediton credit..

We also need to look at theWe also need to look at the liabilitiesliabilities on theon thebalance sheet to see how long it takes thebalance sheet to see how long it takes the

firm to pay its short-term debts.firm to pay its short-term debts.

FirstFirst we need to determine how manywe need to determine how manyaverage days purchasesaverage days purchaseson credit.on credit.

Average days purchases* =Average days purchases* =

Number of days of purchases =Number of days of purchases =

*We assume that all purchases are on credit

PurchasesPurchases

365 days365 days

Accounts payableAccounts payableaverage days purchasesaverage days purchases

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Liquidity Ratios : 4. TheLiquidity Ratios : 4. The netnet operating cycleoperating cycle

in daysin days

We now know how long it takes the firm to turn currentWe now know how long it takes the firm to turn current

assets into cash and to pay its short-term debts.assets into cash and to pay its short-term debts.

We can calculate theWe can calculate the net operating cyclenet operating cycle ::

Number ofNumber of

days ofdays of

inventoryinventory

Number ofNumber of

days of creditdays of creditNet Operating cycleNet Operating cycle == ++ --

By not paying for its purchases immediatly the firm reduces its liquidity needs.By not paying for its purchases immediatly the firm reduces its liquidity needs.

The longer the net operating cycle the greater the liquidity requiredThe longer the net operating cycle the greater the liquidity required

Number ofNumber of

days ofdays of

purchasespurchases

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Application 1 :Application 1 :

Given the balance sheet and the incomestatement of the company , calculate ,for 2007:

1- the Average days cost of goods sold2- the The turnover of inventory in nbr. of

days

3- the Credit sales per day

4- Number of days credit

5- Average days purchases

6- Number of days of purchases

7- Net Operating cycleEMLV 2008/2009


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FICTIOUS Corporation, BALANCE SHEET2007 2006

In thousands $

SSETS

Cash 400 200

Marketable securities 200 -0-Accounts receivable 600 800Inventories 1,800 1,000Total current assets 3,000 $ 2,000

Gross lant and e ui ment 11,000 10,000Less: Accumulated depreciation 4,000 3,000

Net plant and equipment 7,000 7,000

Intangible assets 1,000 1,000Total assets $ 11,000 $ 10,000

LIABILITIESAND SHAREHOLDERS' EQUITY

Accounts ayable $ 500 $ 400Other current liabilities 500 200Lon -term debt 4,000 5,000

Total liabilities 5,000 5,600

Preferred stock (12.5%; $100 par value)800 800

Common stock: ($1 ar value 1,500 1,200Additional aid-in ca ital 1,500 800Retained earnings 2,200 1,600

Total shareholders' equity 6,000 4,400

Total liabilities and shareholders' equity$ 11,000 $10,000


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Income Statement

2 0 0 7 2 0 0 6

I n t h o u s a n d s

Sales $10,000 $9,000Less: Cost of goods sold 6,500 6,000

Gross profit 3,500 3,000

Less: Lease expense 1,000 500

Administrative expenses 500 500Earnings before interest and taxes (EBIT) 2,000 2,000

Less: Interest 400 500

Earnings before taxes 1,600 1,500Less: Taxes 400 500

Net income 1,200 1 , 0 0 0

Less: Preferred dividends 1 0 0 1 0 0Earnings available to common shareholders 1 , 1 0 0 9 0 0

Less: Common dividends 500 4 0 0

Retained earnings $ 600 $ 500


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1.1. average days cost of goods sold =average days cost of goods sold =

In other words the firm has $ 17 808 ofIn other words the firm has $ 17 808 of

cost of goods per day cost of goods per day

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$ 6 500 000$ 6 500 000

365365

= $ 17 808 per day= $ 17 808 per day



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2- Number of day of inventory =

= 101 days

In other words the firm has aboutIn other words the firm has about

101 days of goods in stock at the end101 days of goods in stock at the endof the year. If sales continue at theof the year. If sales continue at the

same pace it would take the firm 101same pace it would take the firm 101

days to run out of stock.days to run out of stock.EMLV 2008/2009

$ 1 800 000$ 17 808 per day



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3-3- Credit sales per day =

= $27 397 per day

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$ 10 000 000365 days



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4- Number of days credit =

= 22 daysThis means that it takes the firm 22This means that it takes the firm 22

days to collect the money owed bydays to collect the money owed by

customers.customers.

In other words 22 days are neededIn other words 22 days are needed

for Sales to become cashfor Sales to become cash..EMLV 2008/2009

$ 600 000$ 600 000

$27 397 per day$27 397 per day



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TheThe operating cycleoperating cycle in days:in days:

It takes 101 + 22 days to turnIt takes 101 + 22 days to turninventories and credit sales intoinventories and credit sales into

cash.cash.

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5- Average days purchases=Average days purchases=

== $17 808 per day$17 808 per day

*We assume that cost of good sold = purchases

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$ 6 500 000*$ 6 500 000*365 days365 days



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7- Number of days of purchases =7- Number of days of purchases =

= 28 days

This means it takes the firm 33 daysThis means it takes the firm 33 days

to pay for its purchases.to pay for its purchases.

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$ 500 000$ 500 000$17 808$17 808 per dayper day



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8- Net Operating cycle = 101+22-28

= 95 days

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Liquidity Ratios : 5.Liquidity Ratios : 5. Current ratiosCurrent ratios

The Ratio that assesses the financialThe Ratio that assesses the financial

structurestructure

to make sure theto make sure the current assetscurrent assets paypay

for thefor the current liabilitiescurrent liabilities is :is :

the Current ratioCurrent ratio ::

The result must be > than 1, that means thatthe current assets can pay for the short-termdebts.

Current AssetsCurrent Liabilities

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Liquidity Ratios : 5.Liquidity Ratios : 5. Current ratiosCurrent ratios

Current ratioCurrent ratio == == = 3.0= 3.0

This indicates that the firm has 3 times asThis indicates that the firm has 3 times as

mush as it needs to cover obligationsmush as it needs to cover obligationsdurnig the year.durnig the year.

An alternative current ratio is the quick ratio:An alternative current ratio is the quick ratio:

Quick ratioQuick ratio == ==

= 1.2= 1.2

This indicates that without inventories the

Current assets Current assets inventoriesinventories

Current liabilitiesCurrent liabilities

Current AssetsCurrent Liabilities

$ 3 000 000$ 3 000 000

$ 1 000 000$ 1 000 000

$ 1 200 000$ 1 200 000

$ 1 000 000$ 1 000 000

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ssets 2004 2005


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ssets 2004 2005urren asses :Cashandshort -terminvestmentsAccounts receivableInventories

Total currentassets

Noncurrent assets:Property, plant andequipment,Equityandother invest mentsOther assets

Total noncurrentassets

Total assets

17,2362,245752

20,233

1,61114,372

94016,923

37,156

$23,7983,2501,552

28,600

1,90317,7262,213

21,842

50,442a esan oc oers quy

Current liabilities :Accounts payableIncometaxes payableAccruedcompensationUnearnedrevenueOther

Total currentliabilitiesNoncurrent liabilities (loans, bonds)Stockholders' equity:

ConvertiblepreferredstockPaid-incapitalRetainedearnings

Total shareholders' equityTotal liabilitiesandshareholders' equity

8741,607396

4,2391,602

8,718-

98013,84413,61428,438

37,156

1,083583557

4,8162,714

9,753-

022,51618,17340,689

50,442

Exercise:

Calculate the

current ratiocurrent ratiofor both yearsand comment.

MicrosoftCorporation

Balancesheet

In $ millions

2004 : 2.32005: 2.9

Good result andimproving from

2004 to 2005.In 2005 CA arealmost 3 timesgreater than CL



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DiagnosticDiagnostic Microsoft CorporationStatement of Income(millions except earnings per share)

For the Year Ended June 30

2004 2005et revenuesCost of revenuesGross profitOperating expenses:

General and administrative

Research and developmentSales and marketingOther expenses

Total operating expensesOperating incomeOther income (expense)

Income before income taxesProvision for income taxesNet incomePreferred stock dividendsNet income available for commonshareholders

689

2,9703,231115

7,005

,-2,81416,93

-7,0059,921,963

11,891-4,1067,78

-28

7,75

1,009

3,7754,14192

9,017

, -3,00219,95

-9,01710,9373,338

14,275-4,8549,421

0

9,421

Earnings per share 1.54 1.81


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Liquidity Ratios : 6.Liquidity Ratios : 6. Net working capital Net working capital

to salesto sales ratioratio

Another way to measure the firms ability to satisfyAnother way to measure the firms ability to satisfy

short term obligations is theshort term obligations is the NetNet working working

capital to salescapital to salesratioratio

which compares net working capital (current assets current liabilities)which compares net working capital (current assets current liabilities)

to sales.to sales.

thethe NetNet working capital working capital is the cash availableis the cash available

for daily operations of the companyfor daily operations of the company..

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Liquidity Ratios : 6.Liquidity Ratios : 6. Net working capital Net working capital

to salesto sales ratioratio

Net working capital to salesNet working capital to sales ==

==

== == 0.20.2 oror

20%20%

The ratio tells us that for every dollar of sales theThe ratio tells us that for every dollar of sales the

firm has 20 cents of working capital to support. Orfirm has 20 cents of working capital to support. Or

Working capital represents 20% of sales.Working capital represents 20% of sales.

Net working capitalNet working capital

SalesSales

current assets current liabilitiescurrent assets current liabilities

SalesSales$ 3 000 000 - 1 000 000$ 3 000 000 - 1 000 000

$ 10 000 000$ 10 000 000

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Asset management - How well assets areAsset management - How well assets are

used.used.

Activity ratios or Turnover ratios (slightly different from Liquidity ratios)Activity ratios or Turnover ratios (slightly different from Liquidity ratios)

To evaluate the benefits produced by the totality of the firms assets.To evaluate the benefits produced by the totality of the firms assets.

A.A. Inventory managementInventory management

B.B. Accounts receivable managementAccounts receivable managementC.C. Overall Asset managementOverall Asset management

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A.A. Inventory management Inventory management

How well the firm uses stock to generateHow well the firm uses stock to generate

sales.sales.

Inventory turnover ratio =Inventory turnover ratio =

is a measure of the number of timesinventory is sold or used in a time periodsuch as a year

Cost of goods soldCost of goods sold

InventoryInventory

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used.used.


Inventory turnover ratio =Inventory turnover ratio =

== = 3.61= 3.61

times per yeartimes per year

This tells us that the firm turns over its stocks 3.6This tells us that the firm turns over its stocks 3.6

times a year.times a year.

Check with liquidity ratio number of days 101 =Check with liquidity ratio number of days 101 =

3.6 times per year3.6 times per year

Average Cost of goods soldAverage Cost of goods sold

Average InventoryAverage Inventory

$ 6 500 000$ 6 500 000

$ 1 800 000$ 1 800 000

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used.used.


A low turnover rate may point toA low turnover rate may point tooverstockingoverstocking,, obselesenceobselesence oror

deficienciesdeficienciesin the product line or marketingin the product line or marketingeffort.effort.

However, in some instances a low rate may beHowever, in some instances a low rate may be

appropriate, such as where higher inventory levelsappropriate, such as where higher inventory levelsoccur in anticipation ofoccur in anticipation ofrapidly rising pricesrapidly rising prices ororshortagesshortages. A high turnover rate may indicate. A high turnover rate may indicateinadequate inventory levelsinadequate inventory levels, which may lead to a, which may lead to aloss in business.loss in business.

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used.used.

B. Accounts receivable managementB. Accounts receivable management

How efficiently the firm is using credit extended toHow efficiently the firm is using credit extended to

customerscustomersAdvantage : rise sales,Advantage : rise sales, sales would not happen without credit.sales would not happen without credit.

Disadvantage :Disadvantage : Customer might not pay when promised.Customer might not pay when promised.

Accounts receivable turnover ratio =Accounts receivable turnover ratio =

==

= 16.67 times per year= 16.67 times per year

This means that there is almost 17 times a year , aThis means that there is almost 17 times a year , a

Net credit salesNet credit sales

Accounts receivableAccounts receivable

$ 10 000 000$ 10 000 000$ 600 000$ 600 000

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used.used.

B. Accounts receivable managementB. Accounts receivable management

A high ratio implies either that a companyA high ratio implies either that a companyoperates on a cash basis or that its extension ofoperates on a cash basis or that its extension of

credit and collection of accounts receivable iscredit and collection of accounts receivable is

efficientefficient..

A low ratio implies the company should re-assessA low ratio implies the company should re-assess

its credit policies in order to ensure the timelyits credit policies in order to ensure the timely

collection of imparted credit that is not earningcollection of imparted credit that is not earning

interest for the firm.interest for the firm.

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used.used.

C. Overall Asset managementC. Overall Asset management

For a more general picture of the productivity of theFor a more general picture of the productivity of the

firm we can compare firm we can compare

Total assetsTotal assets

to the to the

SalesSales they produce. they produce.

This tells us how many times a year the value of theThis tells us how many times a year the value of the

firmsfirms (total assets)(total assets) is generated in sales.is generated in sales.

Total assets turnover ratio =Total assets turnover ratio = ==

Net salesNet sales

Total AssetsTotal Assets$ 10 000 000$ 10 000 000

$ 11 000 000$ 11 000 000

Balance Sheet Income statement

TotalAssets

X

SalesX



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used.used.

C. Overall Asset managementC. Overall Asset management

See also See also FixedFixed assetsassets compared to the compared to the

SalesSales

they produce. they produce.

This tells us how many times a year the value of theThis tells us how many times a year the value of the

firmsfirms total assetstotal assets is genrated in sales.is genrated in sales.

FixedFixed assets turnover ratio =assets turnover ratio = ==

= 1.43= 1.43

Net salesNet sales

Fixed AssetsFixed Assets$ 10 000 000$ 10 000 000

$ 7 000 000$ 7 000 000

Balance Sheet Income statement

FixedAssets

SalesX



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used.used.

From these Ratios we can see that:From these Ratios we can see that:

Inventory flows in and out almost 4 times a yearInventory flows in and out almost 4 times a yearor every 101 daysor every 101 days

All receivables are collected every 22 days or 17All receivables are collected every 22 days or 17

times a yeartimes a year

We cannot see:We cannot see:The number of sales not made because of theThe number of sales not made because of the

credit conditions are too stringentcredit conditions are too stringent

How much credit sales are not collectedHow much credit sales are not collected

Which assets contribute most to salesWhich assets contribute most to sales



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