Balance Sheet Analysis 1

S5 Finance Gestion
Financial Diagnostic
2. Balance Sheet Analysis
EMLV
2011/2012
S5 Finance Gestion
Jill Tynan Wantz
Contents:
1.Introduction
1.Balance Sheet Analysis Liquidity & Ratios Operating cycle - Asset management Working capital - Financial structure
EMLV
2011/2012
S5 Finance Gestion
2. Balance Sheet Analysis We look briefly at the balance sheet:

The balance sheet is a summary of the assets, liabilities, and equity of a business at a particular point in timeusually the end of the firm's fiscal year. Assets are the resources of the business. They are used to generate future benefits. If a firm owns plant and equipment that will be used to produce goods 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
S5 Finance Gestion
2. Balance Sheet Analysis We look briefly at the balance sheet: Liabilities are obligations of the business. They represent commitments to creditors in the form of cash outflows. When a firm borrows, say, by issuing a long-term bond, it becomes obligated to pay interest and principal on this bond as promised.
EMLV 2011/2012
S5 Finance Gestion
2. Balance Sheet Analysis We look briefly at the balance sheet: Equity, also called shareholders' equity or stockholders' equity, reflects ownership.
The equity of a firm represents the part of its value that is not owed to creditors and therefore is left over for the owners. In the most basic accounting terms, equity of an organization is the difference between what the firm ownsits assetsand EMLV 2011/2012
S5 Finance Gestion
2. Balance Sheet Analysis Liquidity The firms ability to meet its short-term obligations using those assets that are most readily converted into cash. cash Can the firm pay its bills ?
EMLV 2011/2012
S5 Finance Gestion
Degree of demand
High d
Degree of liquidity
High d Current Assets Cash
Balance sheet Current Liabilities
Accounts receivable
Accounts payable Tax payable
Invertory Long-term Assets Low d

Property, Plant & E Intangible assets Investment
Long-term Liabilities Shareholders Equity Low d
Can the current assets pay for the current liabilities ?

EMLV 2011/2012
S5 Finance Gestion
How much liquidity the company needs depends on the Operating cycle The operating cycle is the duration from when cash is invested in goods to the time when the sale of goods Operating cycle produces cash.
Goods and services bought ..transformed....Sold .......cash received from customers
This cycle can also be called Cash Conversion Cycle

EMLV 2011/2012
S5 Finance Gestion
The operating cycle:

Four phases :
1. Purchase raw material, merchandise, produce goods 2. Sale of goods 3. Extend credit creating accounts receivable 4. Collect accounts receivable, generating cash
EMLV
2011/2012
S5 Finance Gestion
2. Balance Sheet Analysis - Liquidity Balance sheet

< 1 year Short-term Assets Short-term Liabilities
Operating cycle
(-1 year)
> 1 year
Long-term Liabilities Long-term Assets Shareholders Equity
Investing& Financing
+1 year
How much liquidity the company needs depends on its Operating cycle
EMLV 2008/2009
S5 Finance Gestion
The operating cycle concerns accounts of day-to-day activity such as :

cash, receivables, inventory, Liabilities payables, and Current Accounts payable accruals
Tax payable
Current Assets
Cash Accounts receivable Invertory
Liquidity Ratios indicate how liquid each of these EMLV 2008/2009 accounts are. Liquidity expressed in days.
S5 Finance Gestion
Liquidity Ratios indicate:

1. The turnover of inventory in nbr. of days 2. The number of days credit the firm allows its clients 3. Average purchases days 4. The net operating cycle in days 5. Current ratio, the proportion of current assets to current liabilities 6. Net working capital to sales ratio EMLV 2008/2009
S5 Finance Gestion
1. The turnover of inventory in
Liquidity Ratios :
nbr. of days
1. The turnover of inventory in nbr. of days. The number of days the company ties up funds in inventories, is calculated by using:
the total amount of money represented in inventory EMLV 2011/2012
S5 Finance Gestion
Liquidity Ratios nbr. of days
The average days cost of goods sold =
Cost of goods sold* / 365 days
*cost of goods sold is found in 2011/2012 the income statement EMLV
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Liquidity Ratios : nbr. of days

amount of inventory on hand average days cost of goods sold
Number of days of inventory =
The total amount of money represented in inventory How many days worth of goods is this ?
EMLV 2011/2012
S5 Finance Gestion
allows its clients:
Liquidity Ratios : 2. The number of days credit the firm
number of days credit = Accounts receivable Credit sales per day Credit sales per day* =
Credit sales* 365 days
Accounts receivable Credit sales per day
Number of days credit =
*We presume that all sales are on credit

EMLV 2011/2012
S5 Finance Gestion
Liquidity Ratios : 3. average days purchases on credit.
We also need to look at the liabilities on the balance sheet to see how long it takes the firm to pay its short-term debts.
First we need to determine how many average days purchases on credit.
Purchases Average days purchases* = 365 days
Accounts payable Number of days of purchases =days purchases average
*We assume that all purchases are on credit

EMLV 2011/2012
S5 Finance Gestion
Liquidity Ratios : 4. The net operating cycle in days

We now know how long it takes the firm to turn current assets into cash and to pay its short-term debts.
Number of Net Operating cycle = days of + Number of days of credit inventory
We can calculate the net operating cycle :

Number of days of purchases
By not paying for its purchases immediatly the firm reduces its liquidity needs.
The longer the net operating cycle the greater the liquidity required
EMLV 2011/2012
Application 1 :
Given the balance sheet and the income statement of the company , calculate , for 2007: 1- the Average days cost of goods sold 2- 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 cycle
EMLV 2008/2009
F TIOUSC IC orporation B ANC S E T , AL E HE

AS ETS S Cash Marketable securities Accounts receivable Inventories Total current as sets Gross plant and equipment Less: Accumulated depreciation Net plant and equipment Intangible assets T otal as sets L IABILITIESAND S HARE HOLDE ' E RS QUITY Accounts payable Other current liabilities L -termdebt ong Total liabilities Preferred stock (12.5% $100 par value) ; Comm stock: ($1 par value on Additional paid-in capital Retained earnings Total shareholders equity ' T otal liabilitiesands hareholders equity '
2007
2006
In thousands $
400 200 600 1,800 3 00 ,0 11,000 4,000 7,000 1,000 $ 11,000
200 -0800 1,000 $ 2 00 ,0 10,000 3,000 7,000 1,000 $ 10 ,000
500 500 4 00 ,0 5 00 ,0 800 1,500 1,500 2,200 6 00 ,0
$ 400 200 5 00 ,0 5 00 ,6 800 1,200 800 1,600 4 00 ,4 $10,000
$ 11,000
I nc o m e St a t e m e nt
2007
In thousands
2006
Sales Less: Cost of goods sold Gross profit Less: Lease expense Administrative expenses Earnings before interest and taxes (EBIT) Less: Interest Earnings before taxes Less: Taxes Net income Less: Preferred dividends Earnings available to common shareholders Less: Common dividends $ Retained earnings
$10,000 6,500 3,500 1,000 500 2,000 400 1,600 400 1,200 100 1,100 500 600
$9,000 6,000 3,000 500 500 2,000 500 1,500 500 1,000 100 900 400 $ 500
Application 1 :
$ 1. average days cost of goods sold6 500 000 = 365 = $ 17 808 per day
In other words the firm has $ 17 808 of cost of goods per day
EMLV 2008/2009
Application 1 :
2- Number of day of inventory =
$ 1 800 000 $ 17 808 per day
= 101 days In other words the firm has about 101 days of goods in stock at the end of the year. If sales continue at the same pace it would take the firm 101 days to run out of stock.
EMLV 2008/2009
Application 1 :
3- Credit sales per day =
$ 10 000 000 365 days
= $27 397 per day
EMLV 2008/2009
Application 1 :
$ 000 4- Number of days credit =600 per day $27 397
= 22 days This means that it takes the firm 22 days to collect the money owed by customers. In other words 22 days are needed for Sales to become cash.
EMLV 2008/2009
Application 1 :
The operating cycle in days:
It takes 101 + 22 days to turn inventories and credit sales into cash.
EMLV 2008/2009
Application 1 :
$ 6 500 000* 5- Average days purchases= 365 days
= $17 808 per day
*We assume that cost of good sold = purchases

EMLV 2008/2009
Application 1 :
7- Number of days of purchases =
$ 500 000 $17 808 per day
= 28 days This means it takes the firm 33 days to pay for its purchases.
EMLV 2008/2009
Application 1 :
8- Net Operating cycle = 101+22-28 = 95 days
EMLV 2008/2009
S5 Finance Gestion
5. Current ratios
Liquidity Ratios :
The Ratio that assesses the financial structure to make sure the current assets pay for the current liabilities is :
the Current ratio :
Current Assets Current Liabilities
The result must be > than 1, that means that the current assets can pay for the short-term EMLV 2011/2012 debts.
S5 Finance Gestion
5. Current ratios
$ 3 000 000 = $ 1 000 000
Liquidity Ratios : Current

Current Assets ratio Current Liabilities =
= 3.0
This indicates that the firm has 3 times as mush as it needs to cover obligations durnig the year. An alternative current ratio is the quick ratio: Current assets inventories $ 1 200 000 Quick ratio = = 1.2
Current liabilities
$ 1 000 000
EMLV 2011/2012
Ae st ss Cret as t u n se r s : Cs ad s ot -t r inet et ah n hr em vsm s n Acut r civb con ee ale s Inet r s vn ie o Ttl cret ast o u n se a r s Microsoft Nnur n ast: ocret se s Corporation Poet, p n adeu m t r pry lat n qip e , n Euy ad o e inet mt qit n t r vs h es n O e as t t r se h s Balance Ttl nnuet ast o ocr n se a r s
20 04 1, 3 7 6 2 24 , 5 2 72 5 2, 3 03 2 11 , 1 6 1, 7 4 2 3 90 4 1, 2 63 9 3, 5 76 1
20 05 $3 9 2, 8 7 35 ,20 15 ,52 2, 0 8 0 6 10 ,93 1, 2 7 6 7 21 ,23 2, 4 1 2 8 5, 4 0 2 4
Exercise:
Calculate the current ratio for both years and comment.
sheet
Ttl ast o se a s
In $ millions
L bii s adS chl e ' Euy i i t n t ko r qi al e o ds t Cret liailit s : ur n b ie Acut pyb con aale s Ino e t xs pyb cm ae aale Acud cm na n cr e o p s t e io Uer e r vne nand eeu Oe tr h Ttl cret laiii s o u n i bt a r le Nn c ret liailit s o ur n b ie ( as bns lon, od) Soko es euy t chldr ' qit : Cnet le pe re sok ovrib r f r d t c e P id-in cpa a ait l Rt ind er ins e e an g a Ttl sa hl e ' euy o hr o r qi a e ds t Ttl laiii s adsa hl e ' euy o i bt n hr o r qi a le e ds t
84 7 10 , 7 6 36 9 43 , 9 2 10 , 2 6 81 , 8 7 90 8 1, 4 3 4 8 1, 1 3 4 6 2, 3 88 4 3, 5 76 1
2004 : 2.3 1 8 2005: 2.9 , 3 0
In 2005 CA are 0 almost 3 times 2, 1 greater than CL 2 6 5

1, 7 8 3 1 4, 8 09 6 5, 4 02 4
53 8 57 5 4 1 Good result and , 6 8 2 1 improving from , 4 7 9 5 2004 to 2005. , 3 7 -
S5 Finance Gestion Financial
M ro ft C rp raio Sae et o Ino e ic so o o t n t t mn f c m

(m n e ce t e rn g p r sh re illio s x p a in s e a ) Nt r v ne e ee us C st o re e u s o f vne Gos poit rs rf O e tin e p n s: p ra g x e se G n ra a d a m israiv e e l n d in t t e R se rc a d d v lo mn e a h n ee p e t Sa s a d mrk tin le n a e g Oh r e p n e t e xes s T ta o e tin e p n s o l p ra g x e se O eain ino e pr t g c m O e in o e (e p n ) th r c m x e se In o e b fo in o e ta e c m e re c m x s Pro isio fo in o e ta e v n r c m xs N t ino e e cm Pre rre sto d id n s fe d ck iv e d N t in m a a b fo c m o e co e v ila le r o mn sh re o e a h ld rs
Earnings per share
Diagnostic
Fo th Ye r En e Ju e 3 r e a dd n 0 20 04 20 05 1 ,7 7 94 2 ,9 6 25 -2 1 ,8 4 -3 0 ,0 2 1 ,9 3 63 1 ,9 4 95 69 8 27 ,9 0 33 ,2 1 15 1 70 ,0 5 10 ,0 9 37 ,7 5 44 ,1 1 9 2 9 1 -9 1 ,0 7 ,0 7 1 ,9 7 03 33 ,3 8 1 ,2 5 47 -4 5 ,8 4 92 ,4 1 0 92 ,4 1
1.81
-7 0 ,0 5 92 ,9 8 16 ,9 3 1 ,8 1 19 -4 0 ,1 6 78 ,7 5 -2 8 75 ,7 7
1.54
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Liquidity Ratios : 6. Net working capital to sales ratio

Another way to measure the firms ability to satisfy short term obligations is the Net working capital to sales ratio
which compares net working capital (current assets current liabilities) to sales.
the Net working capital is the cash available for daily operations of the company.
EMLV 2011/2012
S5 Finance Gestion
Liquidity Ratios : 6. Net working capital to sales ratio

Net working capital Sales
Net working capital to sales
current assets current liabilities Sales = $ 3 000 000 - 1 000 000 $ 10 000 000
20%
= 0.2 or
The ratio tells us that for every dollar of sales the firm has 20 cents of working capital to support. Or Working capital represents 20% of sales.
EMLV 2011/2012
S5 Finance Gestion
Asset management - How well assets are used.

Activity ratios or Turnover ratios (slightly different from Liquidity ratios) To evaluate the benefits produced by the totality of the firms assets. A. Inventory management B. Accounts receivable management C. Overall Asset management
S5 Finance Gestion
A. Inventory management How well the firm uses stock to generate sales. Inventory turnover ratio =
Cost of goods sold Inventory
is a measure of the number of times inventory is sold or used in a time period such as a year
S5 Finance Gestion

Average Cost of goods A. Inventory management sold Average Inventory Inventory turnover ratio = $ 6 500 000 $ 1 800 000
times per year
= 3.61
This tells us that the firm turns over its stocks 3.6 times a year. Check with liquidity ratio number of days 101 = 3.6 times per year
S5 Finance Gestion

A. Inventory management A low turnover rate may point to overstocking, obselesence or deficiencies in the product line or marketing effort. However, in some instances a low rate may be appropriate, such as where higher inventory levels occur in anticipation of rapidly rising prices or shortages. A high turnover rate may indicate inadequate inventory levels, which may lead to a loss in business.
S5 Finance Gestion

B. Accounts receivable management How efficiently the firm is using credit extended to customers
Advantage : rise sales, sales would not happen without credit. Disadvantage : Customer might not pay when promised. Net credit sales Accounts receivable $ 10 000 000
Accounts receivable turnover ratio =600 000 $

=
= 16.67 times per year This means that there is almost 17 times a year , a
S5 Finance Gestion

B. Accounts receivable management A high ratio implies either thata company operates on a cash basis or that its extension of credit and collection of accounts receivable is efficient. A low ratio implies the company should re-assess its credit policies in order to ensure the timely collection of imparted credit that is not earning interest for the firm.
S5 Finance Gestion

C. Overall Asset management For a more general picture of the productivity of the firm we can compare Total assets to the Sales they produce. This tells us how many times a year the value of the Balance Sheet Income statement firms (total assets) is generated in sales. Sales
Total Assets X X
Net sales Total Assets
$ 10 000 000 $ 11 000 000
Total assets turnover ratio =
S5 Finance Gestion

C. Overall Asset management See also Fixed assets compared to the Sales they produce. This tells us how many times a year the value of the Balance Sheet Income statement firms total assets is genrated in sales. Sales
Fixed Assets Net sales Fixed Assets X $ 10 000 000 $ 7 000 000
Fixed assets turnover ratio = = 1.43
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From these Ratios we can see that: Inventory flows in and out almost 4 times a year or every 101 days All receivables are collected every 22 days or 17 times a year We cannot see: The number of sales not made because of the credit conditions are too stringent How much credit sales are not collected Which assets contribute most to sales
S5 Finance Gestion
To continue see file Balance Sheet 2

Balance Sheet Analysis 1

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S5 Finance Gestion

2. Balance Sheet Analysis

2. Balance Sheet Analysis We look briefly at the balance sheet:

Balance sheet Current Liabilities

Accounts payable Tax payable

Invertory Long-term Assets Low d

Long-term Liabilities Shareholders Equity Low d

Can the current assets pay for the current liabilities ?

This cycle can also be called Cash Conversion Cycle

The operating cycle:

2. Balance Sheet Analysis - Liquidity Balance sheet

Long-term Liabilities Long-term Assets Shareholders Equity

The operating cycle concerns accounts of day-to-day activity such as :

Liquidity Ratios indicate:

Liquidity Ratios nbr. of days

1. The turnover of inventory in

The average days cost of goods sold =

Cost of goods sold* / 365 days

*cost of goods sold is found in 2011/2012 the income statement EMLV

Liquidity Ratios : nbr. of days

1. The turnover of inventory in

Number of days of inventory =

Liquidity Ratios : 2. The number of days credit the firm

Number of days credit =

*We presume that all sales are on credit

Liquidity Ratios : 3. average days purchases on credit.

*We assume that all purchases are on credit

Liquidity Ratios : 4. The net operating cycle in days

We can calculate the net operating cycle :

F TIOUSC IC orporation B ANC S E T , AL E HE

400 200 600 1,800 3 00 ,0 11,000 4,000 7,000 1,000 $ 11,000

200 -0800 1,000 $ 2 00 ,0 10,000 3,000 7,000 1,000 $ 10 ,000

500 500 4 00 ,0 5 00 ,0 800 1,500 1,500 2,200 6 00 ,0

$ 400 200 5 00 ,0 5 00 ,6 800 1,200 800 1,600 4 00 ,4 $10,000

= $27 397 per day

= $17 808 per day

*We assume that cost of good sold = purchases

Liquidity Ratios : Current

20 05 $3 9 2, 8 7 35 ,20 15 ,52 2, 0 8 0 6 10 ,93 1, 2 7 6 7 21 ,23 2, 4 1 2 8 5, 4 0 2 4

2004 : 2.3 1 8 2005: 2.9 , 3 0

In 2005 CA are 0 almost 3 times 2, 1 greater than CL 2 6 5

53 8 57 5 4 1 Good result and , 6 8 2 1 improving from , 4 7 9 5 2004 to 2005. , 3 7 -

S5 Finance Gestion Financial

M ro ft C rp raio Sae et o Ino e ic so o o t n t t mn f c m

Liquidity Ratios : 6. Net working capital to sales ratio

Liquidity Ratios : 6. Net working capital to sales ratio

Net working capital to sales

Asset management - How well assets are used.

Asset management - How well assets are used.

times per year

Asset management - How well assets are used.

Asset management - How well assets are used.

Accounts receivable turnover ratio =600 000 $

Asset management - How well assets are used.

Asset management - How well assets are used.

Net sales Total Assets

$ 10 000 000 $ 11 000 000

Total assets turnover ratio =

Asset management - How well assets are used.

Fixed assets turnover ratio = = 1.43

Asset management - How well assets are used.

To continue see file Balance Sheet 2