BALANCE SHEET ANALYSIS

HOW WE CAN READ A BALANCE SHEET

A balance sheet is divided into three main parts:

• Assets: Anything having value that the company owns

• Liabilities: the opposite of assets. Anything that costs the company money

• Shareholder’s Equity: what is left for the shareholders after the debt is paid

A balance sheet must balance:

• Assets= Liabilities + Shareholder’s Equity

A SAMPLE OF A BALANCE SHEET

Coca-Cola CompanyConsolidated Balance Sheet - January 31, 2001

Current Assets Dec. 31, 2001 Dec. 31, 1999

Cash & Equivalents $1,819,000,000 $1,611,000,000

Short Term Investments $73,000,000 $201,000,000

Receivables $1,757,000,000 $1,798,000,000

Inventories $1,066,000,000 $1,076,000,000

Pre-Paid Expenses $1,905,000,000 $1,794,000,000

Total Current Assets $6,620,000,000 $6,480,000,000

Long Term Assets $8,129,000,000 $8,916,000,000

Property, Plant, & Equipment $4,168,000,000 $4,267,000,000

Goodwill $1,917,000,000 $1,960,000,000

Total Assets $20,834,000,000 21,623,000,000

Current Liabilities

Accounts Payable $9,300,000,000 $4,483,000,000

Short Term Debt $21,000,000 $5,373,000,000

Total Current Liabilities $9,321,000,000 $9,856,000,000

Long-Term Liabilities

Long-Term Debt $835,000,000 $854,000,000

Other Liabilities $1,004,000,000 $902,000,000

Deferred Long Term Liability Charges $358,000,000 $498,000,000

Total Liabilities $11,518,000,000 $12,110,000,000

Shareholders' Equity

Common Stock $870,000,000 $867,000,000

Retained Earnings $21,265,000,000 $20,773,000,000

Treasury Stock ($13,293,000,000) ($13,160,000,000)

Capital Surplus $3,196,000,000 $2,584,000,000

Other Stockholder Equity ($2,722,000,000) ($1,551,000,000)

Total Stockholder Equity $9,316,000,000 $9,513,000,000

CURRENT ASSETS

Assets that easily can be converted into cash. They are also called liquid assets. Current assets are typically made of:

• Cash & cash equivalent• Short term investment• Receivables• Inventory• Pre-paid expenses

CASH AND CASH EQUIVALENT

Cash and Cash Equivalent is the amount of money the company has in bank accounts, savings, certificates of deposit, ….

It tells you how much money is available to the business immediately

Generally speaking, the more cash on hand the better: pay dividends, repurchase shares, pay debt, …

SHORT TERM INVESTMENTS

Investments that the company plans to sell shortly or can be sold to provide cash.

Short term investments are not as liquid as money in a checking account, but they provide added cushion if needed.

Short Term Investments become important when a company has so much cash. The company can use some of its cash to buy treasury bills (bonds having a maturity of less than 1 year).

ACCOUNTS RECEIVABLE

It is money that is owed to a company by its customers. When for instance the company sells its products on credit, this is recorded under ‘‘accounts receivable’’ in the balance sheet

Generally a company that sells a product on credit sets a term for its accounts receivable. The term is the number of days customers must pay their bill before they are charged a late fee or turned over to a collection agency (most terms are, 30, 60 or 90 days).

While accounts receivable are good, they can bring serious problems to the company if they are not managed properly.

ACCOUNTS RECEIVABLE TURNOVER

Credit Sales ÷ Average Accounts Receivables

This ratio tells how long it takes to the firm to collect its receivables. In other terms, how long it takes to convert its sales into dollars

The sooner the better!

The company can put the cash in the bank and earn interests, pay down debt, or make investment

ACCOUNTS RECEIVABLE TURNOVER:EXAMPLE

H.F. Beverages is a major manufacturer of soft drinks and juice beverages. It sells to supermarkets and convenience stores across the country on a 30 day term

In 2009, H.F. Beverages reported credit sales of $15,608,300 and had $1,183,363 in receivables and in 2008, $1,178,423. Is the firm managing well its receivables ?

INVENTORY

Inventory consists of merchandise a business ownsbut has not sold. It is classified as a current assets because investors assume that inventory can be sold in the near future, turning it into cash.

The Risks of Too Much Inventory:

1- the risk of obsolesce2- the risk of spoilage

INVENTORY TURNOVER

Cost of Goods Sold ÷ Average Inventory for the period

Coca Cola reported in 2000 cost of goods sold of $6,204,000,000. The average inventory value between 1999 and 2000 is $1,071,000,000. The average inventory turnover for the industry is 4.8.

1-What is the inventory turnover of Coca Cola in 20002- What is the number of days Coca Cola needs on average to sell its inventory

IMPORTANT POINT ABOUT INVENTORY

When analyzing a balance sheet, it is very important to look at the percentage of current assets inventory represents.

If 70% of a company's current assets are tied up in inventory and the business does not have a relatively low turnover rate (less than 30 days), it may be a signal that something is seriously wrong and the company may have liquidity problems

McDonald's vs Wendy’s

Which company is better managing inventory?

McDonald's

2000 1999

Inventory on Balance Sheet $99,300,000 $82,700,000

Cost of Goods Sold on Income Statement $8,750,100,000

Wendy's

2000 1999

Inventory on Balance Sheet $40,086,000 $40,271,000

Cost of Goods Sold on Income Statement $1,610,075,000

PREPAID EXPENSES

Sometimes companies decide to prepay taxes, salaries, utility bills, rent. This is recorded in the balance sheet under ‘‘pre-paid expenses’’

In general, this item is not important when it comes to balance sheet analysis

CURRENT LIABILITIES

These are short term Liabilities (less than 1 year)

Current liabilities are essentially made of:

- Accounts payable- Short term debt

ACCOUNTS PAYABLE

Accounts payable is the opposite of accounts receivable. It arises when a company receives a product or service before it pays for it.

Accounts payable is one of the largest current liabilities a company will face because they are constantly ordering new products or paying suppliers.

Really well managed companies attempt to keep accounts payable high enough to cover all existing inventory, meaning that the vendors are paying for the company's shelves to remain stocked, in effect.

SHORT TERM DEBT

These current liabilities are sometimes referred to as notes payable. They represent the payments on a company's loans that are due in 1 year.

Is Borrowing money a sign of financial weakness? Think about leverage and financial distress

If, on the other hand, the notes payable has a higher value than the cash, short term investments, and accounts receivable combined, you should be seriously concerned. Unless the company operates in a business where inventory can quickly be turned into cash

WORKING CAPITAL

Current Assets - Current Liabilities = Working Capital

Poor working capital usually leads to financial pressure on a company, increased borrowing, and late payments to creditor - all of which result in a lower credit rating. A lower credit rating means banks charge a higher interest rate, which can cost a company a lot of money over time

So, even a business that has billions of dollars in fixed assets will quickly find itself in bankruptcy if it can't pay its monthly bills! -Liquidity versus solvency-

NEGATIVE WORKING CAPITAL

Companies that have high inventory turns and do business on a cash basis (such as a grocery store) need very little working capital.

Since cash can be raised so quickly, there is no need to have a large amount of working capital available.

A company that makes heavy machinery is a completely different story. Because these types of businesses are selling expensive items on a long-term payment basis.

Think about McDonald’s and Boeing

CURRENT RATIO

Current assets/Current liabilities

It calculates how many dollars in assets are likely to be converted to cash within one year in order to pay debts that come due during the same year.

In general if the company has a current ratio exceeding 1 has no liquidity issues

Companies that have ratios around or below 1 should only be those which have inventories that can immediately be converted into cash. If this is not the case and a company's number is low, you should be seriously concerned.

QUICK TEST RATIO

Quick assets/Current liabilities

Quick Assets = Current Assets - inventory

This ratio is also called Acid Test or Liquidity ratio

The Quick Test ratio does not apply to companies where inventory is almost immediately convertible into cash (such as McDonalds, Wal-Mart, etc.) Instead, it measures the ability of the average company to come up quickly with cash. Since inventory is rarely sold that fast in most businesses, it is excluded

LONG TERM ASSETS

Assets a company owns but cannot be used to fund day to day operations

Examples of long term assets include:

- Long term investment- Fixed assets

LONG TERM INVESTMENTS

Investments a company intends to hold for more than one year. They can consist of stocks and bonds of other companies

They also include stock in company’s affiliates and subsidiaries

FIXED ASSETS

Assets such as buildings, real estate, office furniture are called fixed assets

They are also referred to as PP&E (Plant, Property & Equipment)

INTANGIBLE ASSETS

Companies often own things of value that cannot be felt.

These consist of patents, trademarks, brand names, franchises, and economic goodwill.

Economic goodwill consists of the intangible advantages a company has over its competitors such as an excellent reputation, strategic location, etc.

When analyzing a balance sheet, ignore the amount assigned to intangible assets. They may be worth a huge amount in real life, but it is the income statement, not the balance sheet, that gives investors insight into the value of these intangible items

ACCOUNTING GOODWILL

Goodwill is the difference between market and book value when buying a business

It is the "premium" a company pays when it acquires another, the amount it pays is called the purchase price.

Accountants take the purchase price and subtract it by a company's book value. The difference is recorded in the balance sheet under Goodwill.

SHAREHOLDER’S EQUITY

It is the money of shareholders

The following items are components of the Shareholder’s Equity:

- Capital- Retained Earnings - Reserves- Treasury stock (an item that reduces equity)

LONG TERM DEBT

Liabilities that have a maturity exceeding 1 year

- Bank loans (more than 1 year)- Bonds

Debt to Equity ratio =

Short and long term debt/ Shareholder’s Equity