Investing: How to analyse a company’s balance sheet

Okay! So, we have covered the income statement, as well as the cash flow statement of a business. Now, we move on to the balance sheet of a company. What is a balance sheet? It is a statement that shows the financial condition of a company. There are 3 main sections of a balance sheet: assets, liabilities and equity. We will also be using the financial statements of Sheng Siong to illustrate some pointers.

Assets

Also known as what the company owns, assets are divided into two types: current asset and non-current assets.

Current assets are assets that are reasonably expected to be converted to cash within one year. Examples include cash and cash equivalents, inventory, account receivables and prepaid expenses. In Sheng Siong’s example, current assets would include inventories and trade and other receivables.

Non-current assets, on the other hand, are long term assets whose value would not be realized within a financial year. Examples include property, plant and equipment and goodwill. For instance, in Sheng Siong’s balance sheet, non-current assets include property, plant and equipment and investment in subsidiaries.

Liabilities

Known as what the company owes, liabilities are similarly divided into two types: current liabilities and non-current liabilities.

Current liabilities are money that needs to be paid to creditors by 1 year’s time. Examples include short term debt and accounts payable. For instance, current liabilities in Sheng Siong’s balance sheet include trade and other payables and current tax payable.

Non-current liabilities are long term financial obligations that a company owes for more than a year. Examples include long term borrowing and bonds payable. In Sheng Siong’s case, non-current liabilities would include deferred tax liabilities.

Equity

Equity is known as the difference between the total value of liabilities subtracted from the total value of assets in a company. It represents the shareholders’ ownership interest in a business. In the example of Sheng Siong’s balance sheet, the equity portion is represented by equity attributable to owners of the company.

So, how do we analyse the balance sheet after knowing all these terms? We use financial ratios to analyse them.

Solvency Ratios

These ratios determine if a business can continue running its operations without running into financial trouble.

Current Ratio = Current Assets / Current Liabilties

The current ratio measures if a company can pay its short term obligations when it’s due. If the current ratio is less than 1, you need to take note. It doesn’t mean the business will exit the industry, but you need to further investigate the reason behind the low current ratio. Sheng Siong’s current ratio is about 1.09, which is a borderline case.

Quick Ratio =  (Current Assets – Inventories) / Current Liabilities

The quick ratio measures a company’s ability to pay its short term debts with its most liquid assets. The higher the quick ratio , the better the financial state of the company. Looking at Sheng Siong’s balance sheet, its quick ratio is 0.64. Doesn’t seem to be too good to me…

Debt/Equity Ratio

A high ratio indicates the growth of a business is due to borrowings. It is calculated by:

Total Debt/Equity Ratio = Total Liabilities / Shareholders Equity

In Sheng Siong’s case, it has a debt/equity ratio of 0.47. This means that about half of its growth is due to debt.

Activity Ratios

These ratios measure how well a business is able to turn its assets into cash or revenue.

Days Sales Outstanding (DSO) = (Receivables / Revenue) x 365

A low DSO means that a company is taking few days to cash in its account receivable. A high DSO indicates a company is selling its products on credit. Sheng Siong has a DSO of ($10,216/$629,554) x 365 = 5.92 days.

Days Inventory Outstanding (DIO) = (Inventory / COGS) x 365

This ratio is used to measure the average number of days a company holds inventory before selling it. This ratio is industry specific and should be used to compare competitors. Sheng Siong has a DIO of ($51,999/$467,259) x 365 = 40.62 days.

Days Payable Outstanding (DPO) = (Accounts Payable / COGS) x 365

This ratio shows the time in days a business has to pay back its short term obligations. The longer a company can delay payments, the better. Sheng Siong has a DPO of ($102,584/$467,259) x 365 = 80.13 days.

Cash Conversion Cycle (CCC) = DIO + DSO – DPO

The cash conversion cycle is a measure of a business’s operating effectiveness. The lower, the better. It is also a good way to compare the ratio with other similar competitors. Sheng Siong’s CCC is 40.62 + 5.92 – 80.13 = -33.59 days.

Turnover Ratios

Receivables Turnover = Revenue / Average Accounts Receivables

The receivables turnover ratio measures the company’s effectiveness in collecting its credit sales. For Sheng Siong, its ratio is $629,554/ [ ($10,216 + $10,364)/2 ] = 61.18.

Inventory Turnover = Revenue / Average Inventory

The inventory turnover ratio for Sheng Siong’s case is $629,554/ [ ($51,999 + $61,886)/2 ] = 11.06.

Inventory to Sales = Inventory / Revenue

This ratio measures how inventory is being managed as it will signal potential problems with cash flow.

A rise in the ratio can mean your investment in inventory is growing faster than sales or sales are dropping. Conversely, if the ratio decreases, it can indicate that your investment in inventory is lesser than sales or sales are increasing.

Sheng Siong’s ratio in 2016 is $61,886/ $599,685 = 0.1032 while in 2017, it was $51,999/ $629,554 = 0.08260. This means that Sheng Siong’s sales has risen over the 1 year period, which is good.

I know it is a lot of financial ratios to digest, but take your time (: There are more, but these are the important few that I highlight in my blog post for today. Obviously, I didn’t get this information by myself; here are the website references you may want to look up to if you are keen:

  1. Balance Sheet Basics
  2. Financial Ratios explained

 

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