Balance Sheet Analysis – Beginners Guide

© 2016 South University

Page 2 of 4 Financial Management of Healthcare Organizations

©2016 South University

2 Balance Sheet Analysis – Beginners Guide

We are going to explain some easy ways to analyze the balance sheet. We are going to focus on three key areas liquidity, financial strength and how well the business is being managed.

The first area we are going to look at is liquidity. This is essentially how easily can the company pay from existing assets for its ongoing expenses including payroll, inventory and investments in capital equipment. As with the income statement the easiest way to analyze the balance sheet is to look at ratios. The first ratio we are going to look at is called the current ratio and sometimes is referred to as the working capital ratio. It is very easy to calculate, it is simply current assets divided by current liabilities. In this example that means $6,670,000 of current assets divided by $1,839,000 of current liabilities and gives us a number of 3.63.

The accounting textbooks will tell you that a current ratio of 2.0 or higher is an indicator of the company having sufficient liquidity. This is one of the key measures of liquidity.

The next ratio we are going to look at is the quick ratio, this excludes some of the current assets that can't easily be turned into cash, such is inventory. So it's more and like extremely liquid current assets and then this amount is divided by current liabilities. So in this example the assets that would qualify as liquid current assets include cash, marketable securities and accounts receivable. And then we divide that sum by the total of current liabilities and we get a ratio of 1.91. The accounting textbooks basically say a ratio of 1.0 or higher shows adequate liquidity for most companies.

After evaluating liquidity the next thing to look at is financial strength. The most common ratios to look at here are a couple different debt to equity ratios. The first one is long term debt divided by equity. And the other ratio is total debt divided by equity. When we talk about debt here, when we are talking about interest bearing debt that means loans and bank revolving lines of credit. We are not talking about non interest bearing liabilities which are also debts such as accounts payable. And equity as you recall is the amount of money that shareholders have invested in the company plus net income that has been earned and retained over the years. When evaluating company strength using debt to equity ratios, the smaller the ratio the better. As a company is financially stronger the less debt it has compared to equity. However in many industries it is normal for debt to be several times the amount of equity. Although is that ratio gets higher and higher it begins to be known as junk debt rather than at investment-grade. So you can see in the first example the $2,332,000 of long term debt is divided by shareholders equity of $4,203,000 and we get a ratio of 0.55 which is excellent. When we look at total debt we got the short term debt which is the current portion of long term debt and that is $1,021,000 and we add that to the 2.3 million of long term debt and divide that sum by the same total equity amount and this time the ratio is higher. It's 0.8. But it's still well below 1.0. So the financial strength of this company looks solid.

Another indicator of financial strength is a interest coverage. Also sometimes referred to as times interest earned. Essentially this is operating profit divided by interest expense. Neither of these items is on the balance sheet. They are actually from the income statement. But when you talk about debt equity ratios in a company’s debt, it's also important in evaluating financial health. To look at the company’s current operating profit, first the amount of interest it has to pay to its debt holders. Clearly, we want the ratio to be above one to indicate that operating profit is more than interest expense. And usually something at 5 to 7 times is considered very healthy. For this company they have very little interest expense and quite a bit of operating profit. So their interest coverage ratio is extremely healthy.

Page 3 of 4 Financial Management of Healthcare Organizations

©2016 South University

3 Balance Sheet Analysis – Beginners Guide

Next we are going to measure how efficiently management is running the company, the first ratio will look at is return on equity. This is a measure of the company’s earnings on the equity that the shareholders have invested. We simply take the net income and divided by shareholders equity. In this example $397,000 of net income divided by $4,203,000 of shareholders equity gives us a return on equity of 9.45 %. In today’s market with low inflation and high risk people are happy with a 9% return. As with other ratios it would be good to be compare this return on equity to other companies in the same line of business to get a better idea of how well this management team is generating a profit compared to its peers. Discuss how to get information on other companies in the same industry in the intermediate financial statement analysis series.

The next efficiency ratio is very similar, but it is return on total assets instead of just shareholders equity. This is a measure of profit on all capital invested in the business which was used to acquire assets. To calculate this, we simply take net income and divided by total assets. In this example the net income of $397,000 is divided by total assets of $8,374,000 and we get a return on assets of 4.74%. Return on equity ratio is impacted by the debt to equity ratio of the specific company. The return on assets ratio eliminates the impact of the source of financing, regardless if it is debt or equity to measure management efficiency. And that is why it is good to look at both ratios when comparing companies.

There are 3 other efficiency ratios that we can look at to get an idea of how well management is actually managing is few specific important company assets. The first is inventory turnover, it shows how well they are managing their inventory. One way to calculate this is to simply take cost of goods sold and divide that by ending inventory. In this example we divide cost of goods sold of $9,905,000 by ending inventory of $2,936,000 and we get the result of 3.73, which means that the company sells its inventory 3.73 times a year. Some people prefer to look at this as the number of days that is in inventory. So to see that we divide 365 days by the 3.73 inventory turns and the result is 108 days. This means it takes on average 108 days to sell all the inventory. There are several other ways to modify this calculation which is discussed in the intermediate financial statement analysis series. The best way to understand if the resulting number is good or bad is to compare with other companies in the industry.

Another efficiency ratio is the accounts receivable debts outstanding, also known as debt sales outstanding and frequently referred to as DSO. This measures how well management turns sales into cash and represents how long it takes to collect on sales. The longer it takes the more working capital is needed to finance the company and it could lead to debt collection problems. It may also be an indicator that management is not focusing on keeping accounts receivable inline or that they are having to give longer terms or sold a riskier slower pain customers in order to get sales. To calculate this we simply take the accounts receivable balance at the end of the period and divide it by sales for the past year and then multiply that by 365 days. So in this example we have $1,667,000 in accounts receivable on the balance sheet and divide that by total sales of $11,892,000 and multiply that number by 365. This gives us a result of 51.5 days. For this company it takes an average of 51 and a half days to collect on its sales.

The final efficiency ratio we are going to look at is the accounts payable debts outstanding. This is an indication of how fast the company pays its bills. For company’s thinking about doing business with this company, this is a very important ratio. As you want to know how fast you will get paid. To calculate it we simply take the accounts payable balance and divide it by the cost of goods sold and then multiply that by 365 days. The reason we use cost of goods sold instead of sales in this calculation is that payables are associated with cost not revenues. For companies where cost of goods sold is a small

Page 4 of 4 Financial Management of Healthcare Organizations

©2016 South University

4 Balance Sheet Analysis – Beginners Guide

portion of total operating expenses. It may be better to use cost of goods sold plus operating expenses as the denominator in the equation. To calculate the standard ratio for this company, they had $625,000 in accounts payable outstanding and we divide that by cost of goods sold of $9,905,000 and then multiply that by 365. And it shows that their debts payable outstanding was only 23 days. This means they are very fast pair. Companies who are thinking about providing credit to this business should be very comfortable with this number.

* The Kaplan Group. (2013). Balance sheet analysis – Beginners guide [Video]. Available from https://www.youtube.com/watch?v=NkNRcHdXB3Y