How to perform a Balance Sheet analysis in 4 steps.
Balance sheet structure;
1. Identify the large numbers
Large numbers will be the main investments and sources of financing for the company. If the company is having financial troubles then the problems will be seen in those large numbers. First of all, you need to analyse the Short Balance Sheet* (NFO+FA) on the assets side and (Debt + Equity) on the finance side and, then analyse the entire Balance Sheet.
*ATTENTION! It may help to look at the “warning signs” which are typically; Decreasing cash* or Increasing payables, those are signs of financial distress*, but this are symptoms, not causes, of a company’s financial problems! *Decreasing cash; if the cash is plentiful, the company does not have financial problems (need of financing). It may have economic problems (lose money) or it may have room for financial improvement but rarely will have financial problems. *Financial distress; it’s a condition in which a company cannot meet, or has difficulties to pay off, its financial obligations to its creditors.
2. Sources and uses of funds (SUF) or (SAF)
It’s probably the most useful tool to understand the financial evolution of a company. We obtain SUF through the difference between this year’s Balance Sheet and Last Year’s Balance Sheet result.
If the company has financial problems we will compare the most recent Balance Sheet with the last one in which the company was in a good financial position.
Example;
First column of numbers represents the data of 2018 and the second column represents the data of 2019, in order to calculate if it’s a Use or a Source we need to calculate the difference, which will be the amount of 2019 minus the amount of 2018 as the third column indicates. In order to classify if the corresponding result is a USE or a SOURCE you need to follow the following rules;
Any increase in Assets (Positive numbers in the third column) represents a use of funds and may indicate why the company needs more money, which strategy are they using and where are they investing their money.
A decrease in Assets (Negative numbers in the third column) represents a source of funds or funds available for other usage (paying off debt, dividends, etc.)
An increase in Liabilities or equity (Negative numbers in the third column), represents an inflow or source of funds and indicates where the money is coming from.
A decrease in Liabilities or Equity (Positive numbers in the third column), is an application or use of funds (Example; a decrease in debt means that we are repaying the debt and therefore it’s a use of funds).
*IMPORTANT; take into account that the TOTAL amount of USES has to be EQUAL to the total amount of SOURCES.
Once you get the numbers, take a look to the large numbers, they may be the source of the financial problems, if any.
Try to find out the cause of the increase. Important points to take into account:
· Any substantial increase in receivables?
· A big increase in inventories?
· A big increase in payables?
To answer all these questions you will also have to calculate the Operational Ratios*.
*Operational Ratios’ explanation will be published in another post, to clarify any possible doubt!
3. NFO vs. WC
Need of funds for operations (NFO) are the funds required to finance operations.
NFO = [Minimum Cash + Receivables + Inventory – Payables – Spontaneous financing (other liabilities)]
If a company has a financial problem (if it needs more money), it is either due to an increase of NFO or a decrease of WC, or both combined. Therefore, we must look at the evolution of NFO and WC.
Working Capital (WC) is usually defined as; [WC = CA – CL] or [WC = Cash + Receivables + Inventories – Payables – Other short-term liabilities – Credit]. Therefore, WC is perceived as an ASSET, as a CA is typically = CA > CL = “Invest in WC” = Asset.
You can interpret it as you want but;
The classic definition doesn’t allow calculating the credit needed, the crucial variable in a financial forecast.
If a large WC is desirable and WC is seen as CA, there’s a temptation to increase receivables and suppliers (more financing required).
Finally, the distinction between NFO and WC is essential to diagnose possible company problems.
If WC is scarce, the company has a structural problem
If NFO is in excess, the company has operational problems
*More information about NFO vs. WC will be published in the following posts since it’s a very important topic to understand.
4. Risks of the Balance
To get an idea of the financial risk of a company, we have to take a look to the largest numbers in the asset side and their “quality”. It’s not the same to have a million € invested in unsold inventory as in receivables.
It’s important, as well, to compare the size of the liabilities with the Equity [Leverage ratio = Liabilities/Equity, which tells us “How much money both, the owners and stakeholders have invested in the company”].
You can also compare the bank debt with the net income; banks use the ratio; Debt/EBITDA. In good times, they ask for a maximum of 4 but, in bad times, or whenever the bank doesn’t want to lend, they may ask for 3 or less.
Finally, there should be equilibrium between the operational risk (variability of profits due to operations) and the financial risk (variability of income due to debt).
So, you need to check the following;
Operational risk: variability of profits due to operations
Look at largest numbers in the asset side and their quality
Look at operational ratios
Financial risk: variability of income due to debt
Compare the size of liabilities with equity
Leverage ratios
Liabilities/Equity
Assets/Equity (DuPont)
Equity/Liabilities (Solvency ratios)
Liabilities/Total assets (Debt ratio)
Equilibrium: Companies with big operational risk should have low financial risk (and vice versa).
If you have any question, or doubt, do not hesitate to let a comment or send me one.
*All information has been gathered from Tecnocampus University, "Finance for Managers from Eduardo Martinez Abascal" and own notes.
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