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IFT Notes for Level I CFA® Program

R22 Understanding Balance Sheets

Part 4


 

7.  Analysis of the 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.

7.1. Common-Size Analysis of the Balance Sheet

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.

ASSETS 2015 2014
  Cash and cash equivalents 10.81% 13.12%
  Short-term marketable securities 1.24% 0.62%
  Other financial assets 1.24% 1.21%
  Accounts receivable 7.50% 4.80%
  Inventory 25.32% 25.97%
  Other current assets 3.37% 2.14%
  Property, plant and equipment 38.76% 40.06%
  Investment property 6.18% 6.22%
  Intangible assets 0.22% 0.35%
  Deferred tax assets 0.11% 0.08%
  Goodwill 0.91% 1.09%
  Long-term loans 4.32% 4.32%
  Other non- current assets 0.03% 0.02%
Total 100.00% 100.00%
EQUITY and LIABILITIES
  Short-term borrowing 0.46% 0%
  Accounts payable 6.49% 6.22%
  Accrued expenses 4.22% 3.38%
  Deferred revenue 1.30% 1.21%
  Other current liabilities 24.29% 24.42%
  Long-term borrowings 0.23% 0.31%
  Deferred tax liabilities 4.01% 4.20%
  Other long-term liabilities 0.12% 0.13%
Stockholder’s equity 58.88% 60.13%
Equity and Liabilities 100.00% 100.00%

7.2. 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 Ratios Calculation Ratios for Everest Inc. for 2015
Current Current 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 Ratios Calculation Ratios for Everest Inc. for 2015
Long-term debt-to-equity Total long-term debt ÷ Total equity 0.004
Debt-to-equity Total debt ÷ Total equity 0.012
Total debt-to-assets Total debt ÷ Total assets 0.007
Financial leverage Total assets ÷ Total equity 1.69

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.


FRA Understanding Balance Sheets Part 4