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IFT Notes for Level I CFA® Program

R18 Understanding Balance Sheets

Part 4


 

15. Common Size Analysis of Balance Sheet

Balance sheet analysis can help us evaluate a company’s liquidity and solvency. A balance sheet can be used to analyze a company’s capital structure and ability to pay liabilities.

In a vertical common-size balance sheet, all balance sheet items are expressed as a percentage of total assets. Common-size statements are useful in comparing a company’s balance sheet composition over time (time-series analysis) and across companies in the same industry. An example of a common-size balance sheet is shown in the figure below for Everest Inc.

ASSETS20152014
  Cash and cash equivalents10.81%13.12%
  Short-term marketable securities1.24%0.62%
  Other financial assets1.24%1.21%
  Accounts receivable7.50%4.80%
  Inventory25.32%25.97%
  Other current assets3.37%2.14%
  Property, plant and equipment38.76%40.06%
  Investment property6.18%6.22%
  Intangible assets0.22%0.35%
  Deferred tax assets0.11%0.08%
  Goodwill0.91%1.09%
  Long-term loans4.32%4.32%
  Other non- current assets0.03%0.02%
Total100.00%100.00%
EQUITY and LIABILITIES
  Short-term borrowing0.46%0%
  Accounts payable6.49%6.22%
  Accrued expenses4.22%3.38%
  Deferred revenue1.30%1.21%
  Other current liabilities24.29%24.42%
  Long-term borrowings0.23%0.31%
  Deferred tax liabilities4.01%4.20%
  Other long-term liabilities0.12%0.13%
Stockholder’s equity58.88%60.13%
Equity and Liabilities100.00%100.00%

16. Balance Sheet Ratios

Balance sheet ratios are those involving balance sheet items only. Liquidity ratios tell us about a company’s ability to meet current liabilities, while solvency ratios tell us about a company’s ability to meet long-term and other obligations. They also help us evaluate a company’s financial risk and leverage. The following table summarizes some liquidity ratios. The last column shows the relevant ratios for Everest Inc. for 2015.

Liquidity RatiosCalculationRatios for Everest Inc. for 2015
CurrentCurrent assets ÷ Current liabilities
1.35
Quick (acid test)(Cash + Marketable securities + Receivables) ÷ Current liabilities
0.53
Cash(Cash + Marketable securities) ÷ Current liabilities
0.33

Solvency ratios help to evaluate:

  • a company’s ability to meet long-term and other liabilities.
  • a company’s financial risk and leverage. The following table summarizes some solvency ratios:

 

Solvency RatiosCalculationRatios for Everest Inc. for 2015
Long-term debt-to-equityTotal long-term debt ÷ Total equity0.004
Debt-to-equityTotal debt ÷ Total equity0.012
Total debt-to-assetsTotal debt ÷ Total assets0.007
Financial leverageTotal assets ÷ Total equity1.69

It is important for analysts to remember that ratio analysis requires judgment. For example, current ratio is only a rough measure of liquidity. In addition, ratios are sensitive to end of period financing and operating decisions that can potentially impact current asset and current liability amounts. Analysts should also evaluate ratios in the context of a company’s industry. This requires an examination of the entire operations of a company, its competitors, and the external economic and industry setting.