Analysis of the Balance Sheet. The balance sheet
can help us evaluate a company's liquidity and solvency,
and as we saw with the income statement, here again,
we look at Common Size Analysis and the Balance Sheet
Ratios. With common size analysis, all balance sheet
items are expressed as a percentage of total sales.
With the income statement, all items were expressed
as a percentage of sales, here all items are expressed
as a percentage of total assets. What you are looking
at here is a time series analysis, and note that cash
17%, means that for the year ending 2005, the cash
amount is 17% of total assets, accounts receivable
is 21% of total assets and so on. Similarly, total
current liabilities are 7% of total assets. If you
do a simple analysis here, between 2004 and 2005, it looks
like the cash position is improving but accounts
receivable position is deteriorating, because
the accounts receivable amount is going up, 21% of
total assets. So, that seems to be a substantial increase
from the previous year. Property, plant and equipment
is a smaller percentage of total assets. Now you
need to get into the details to understand how bad
this is or what are the reasons for these changes,
but effectively looking at these percentages and
how they change over time is called Time Series Analysis.
The curriculum gives an example of Cross Sectional
Analysis where you are looking at these percentages
or ratios for a given period across different companies.
So, if you have companies A, B and C, and you see a cash
percentage of 10% here, 20% here, and 5% here, and for accounts
receivable, you might see 20%, 17%, and 4%. This is telling
you about how these companies are managing
themselves. Again, to really understand what is
good or bad, you can look at industry averages, within
the industry, you can look at numbers or ratios
for the best in class or the best players in the industry,
and then decide whether the company you are evaluating
is doing well or not. Let's look at some important
ratios now. There are two broad categories the liquidity
ratios, which we look at here, and solvency ratios
on the next slide. Liquidity ratios, tell us about
a company's ability to meet current liabilities.
There are three important liquidity ratios that
you need to know. The one that is quoted most often
is the current ratio. This is all current assets
divided by current liabilities. Now, you might
say that perhaps inventory is not too current, you might have
a concern that the inventory might not be sold so
easily, then you can look at a slightly more conservative
ratio, which is the quick ratio or the asset test.
This looks at the major current assets minus the
inventory, so cash marketable securities and receivables
divided by all liabilities. In some finance textbooks, you might
actually see current assets minus inventory, but
the CFA program curriculum gives us this formula.
Now, here again you might say that receivables are not very liquid
for a particular company, and then you can go to the
most conservative ratio, which is cash & marketable
securities divided by current liabilities. If these ratios are relatively
high and by relative, I mean relative to other companies
in the industry, that means that the company has
enough liquid assets to cover liabilities. In other
words, its liquidity position is good, short-term
obligations will be made. If the ratio is extremely
high, then that might imply that the company is not
managing its assets very efficiently. Coming now
to solvency ratios, these ratios help us evaluate
a company's ability to meet long-term and other
liabilities. These ratios also help us evaluate
a company's financial risk and leverage. Here are
some of the commonly referenced solvency ratios,
long-term debt to equity. So let's say you have a
company with the following balance sheet, let's say,
assets are equal to a 100, and on the right hand
side you have liabilities. For liabilities, let's say
short-term debt is equal to 10, long-term debt is
equal to 30, and equity is equal to 60. So, long term
debt to equity ratio is going to be 30 over 60. The
total debt to equity ratio is going to be 40 over 60. This is total
debt to assets ratio, which is equal to 40 divided by 100, and
financial leverage ratio is the total assets divided
by total equity. So, in this particular example, the total
assets are 100 divided by total equity, which is 60, this will give
us the financial leverage ratio. In general, low
ratios means that the company is safer. In other words, in general
you'll notice that debt is in the numerator. So, if the
debt number is relatively low compared to either asset
or equity, then that means that the leverage is low.
Leverage is a measure of how much debt a company has
taken on. If the amount of debt is high then the financial
risk is high, because high debt means that a company
will have to make interest payments and those interest
payments need to be made no matter what the operating
income is. If a company in a given period generates very
low operating income, but the debt level is high
and the interest expense is high, then obviously
the company faces a major financial risk. This last
ratio deserves a few more words, notice that we are
dividing assets by equity, so you might think that
we don't have any mention of debt over here. To understand
this, let's look at a simple example; say you have
two companies A and B, both have assets worth a 100.
For company A, the debt is 20 and equity is 80. Whereas,
for company B, the debt is 80 and the equity is 20.
If you look at the financial leverage ratio for A,
it is assets, 100, divided by equity, so this would be 100 over 80. Whereas,
for Company B it is going to be a 100 divided by 20, which
is equal to 5. So, notice that debt is automatically
considered, this ratio of 5 is much higher than the
ratio of 1.25 over here. A high leverage ratio means
a very high level of debt and hence high financial
risk. A few General Remarks now about Ratio Analysis.
Ratio analysis requires judgment; for example,
we've talked about the current ratio, which is only
a rough measure of liquidity. You might come up with
current assets over current liabilities equal to 1.2,
and you might conclude naively that we have enough
assets to cover liabilities. However, on deeper analysis
you might realize that both the inventory and accounts
receivables are not really very liquid. So, the point
here is that you need to do more analysis and rely
on some judgment to really understand whether this
ratio is safe or not, and you need to evaluate ratios
in the context of the company's industry as well
as the particular situation of that particular
company. We should also recognize that ratios are sensitive to end of period financing
and operating decisions. Obviously, ratios are
created based on numbers on the balance sheet, balance
sheet numbers are reported based on the last day
of operating period. Now, if a few days before that last day
a company sends a major piece of equipment and cash
goes up. Now, the company has sold a long-term asset, cash
has gone up, so it might seem that the current ratio
has become a whole lot better, but perhaps the company
has compromised its ability to generate cash flow
in the future or a company might have done a major
financing operation which increases long-term
liabilities and short-term cash, or increases cash that
might make your liquidity ratios look much better
than they might have been for most of the year. So,
as an analyst, you need to understand exactly what's
going on. There is more on this material in reading
that we will be covering soon. So, I would suggest
that the ratio related examples that you see in
this reading should be covered briefly now, but
again in detail after you've done the reading on
financial analysis techniques. So that brings
us to the end of this reading. A brief summary, you
need to understand the major current and non-current
assets. One of the most important items to understand
is the categorization of financial assets, the held
for trading, held to maturity, and AFS. You need
to understand that unrealized gains are shown on
the income statement across the board. For held for trading
and AFS, the financial assets are shown
at current fair value on the balance sheet. Unrealized
gains are shown on the income statement. For held
for trading, unrealized gains are shown as part
of OCI in equity, if the asset is classified as AFS.
For held to maturity, unrealized gains are not recorded.
You need to understand the major current and non-current
liabilities. Understanding all the components
of equity is important; the three major ones that
you must know, are the contributed capital or the stock,
the retained earnings, and other comprehensive
income. Within other comprehensive income, there are
four sub-categories, the most important one for you
at this stage is the unrealized gains with available for sale
assets, and finally analysis of the balance sheet.
You need to understand the common sized balance sheets,
recognize that all numbers are expressed as a percentage
of total assets. You can do both--a time series analysis,
which is looking at changes for a given company over
a time period, or you can do a cross sectional analysis,
which is looking at multiple companies over the
same period, and finally you need to be on top of ratio analysis.
You need to know all the liquidity ratios and we talked
about three of them, and you need to know all the solvency
ratios which essentially deal with debt and assets.
As always, read the summary, review the learning objectives, do the
examples to whatever extent possible. If the example
seems very long, don't get hung up over the examples.
The questions on the exam tend to be shorter. Spend
a lot of time on the practice problems, they are very
good, but as always not quite enough, so if you can
do practice questions from other sources, that
will be very good for you. That is it.