How to evaluate a company’s balance sheet

For investors, the balance sheet is an important financial statement, which should be explained when considering investing in a company. The balance sheet reflects the company’s assets and liabilities owed at a certain point in time. The strength of a company’s balance sheet can be evaluated by three types of investment quality metrics: working capital or short-term liquidity, asset performance, and capitalization structure. The capitalization structure is the amount of debt and equity on the company’s balance sheet.

Key points

  • The strength of a company’s balance sheet can be evaluated by three investment quality measures.
  • The cash conversion cycle shows how efficiently the company manages its accounts receivable and inventory.
  • The fixed asset turnover rate measures how much income is generated from the use of the company’s total assets.
  • Return on assets shows how a company uses its assets to create profit or net income.

Cash conversion cycle (CCC)

The cash flow cycle is a key indicator to measure the adequacy of the company’s working capital. Working capital is the difference between a company’s current assets (such as cash) and current liabilities (such as payments due to suppliers of raw materials). Current assets and liabilities are short-term in nature, which means that their book value is usually less than one year.

The cash conversion cycle is a measure of the company’s ability to effectively manage the two most important assets (accounts receivable and inventory). Accounts receivable is the total amount that customers owe the company for booking sales.

Components of the cash conversion cycle (CCC)

The number of unfinished sales days is the average number of days it takes for a company to collect payment from customers after completing a sale. The cash conversion cycle uses days of outstanding sales to help determine whether the company is effectively collecting payments from customers.

The cash conversion cycle calculation also calculates the time it takes for the company to pay the bills. The outstanding days of accounts payable represents the average number of days it takes for a company to pay its suppliers and suppliers.

The third component of CCC includes how long the inventory is idle. Inventory open days is the average number of inventory days before the inventory is sold.

CCC is calculated in units of days and reflects the time required to collect sales and the time required to turn inventory. Cash conversion cycle calculations help determine the company’s collection and payment of short-term cash transactions. For example, if the company is slow to collect its accounts receivable, it may result in a cash shortage and the company may have difficulty paying bills and accounts payable.

The shorter the period, the better. Cash is king, and smart managers know that fast-moving working capital is more profitable than unproductive working capital bundled with assets.

Formula and calculation of cash conversion cycle

CCC = DIO + DSO − DPO where: DIO = open inventory days DSO = open sales days DPO = open days payable begin{aligned} &text{CCC} = text{DIO} + text{DSO} -text {DPO}\ &textbf{where:}\ &text{DIO} = text{open inventory days} \ &text{DSO} = text{open sales days} &text{ DPO} = text{days outstanding} \ end{aligned}

CCC=Dior+DSODPOWhere:Dior=Inventory daysDSO=Sales daysDPO=Days of accounts payable

  1. Obtain the company’s outstanding inventory days and add that number to the outstanding sales.
  2. Take the result and subtract the company’s accounts payable days to get the cash conversion cycle

There is no single best indicator for CCC, which is also called the company’s operating cycle. Generally, a company’s CCC will be severely affected by the type of products or services it provides and the characteristics of the industry.

Investors looking for investment quality in this area of ​​the company’s balance sheet must track CCC over a long period of time (for example, 5 to 10 years) and compare its performance with that of competitors. The consistency and decline of the operating cycle are positive signs. Conversely, unstable collection times and an increase in existing inventory are usually negative indicators of investment quality.

5 tips for reading balance sheets

Turnover rate of fixed assets

The fixed asset turnover rate measures how much income is generated from the use of the company’s total assets. Since assets can cost a lot of money, investors want to know how much income is derived from these assets and whether they are being used effectively.

Fixed assets, such as real estate, plant and equipment (PP&E), are physical assets owned by a company and are usually the largest component of total assets.Although the word Fixed assets are Usually regarded as the company’s PP&E, assets are also called non-current assets, which means they are long-term assets.

The number of fixed assets a company owns depends to a large extent on its business scope. Some companies are more capital intensive than others. Large capital equipment manufacturers, such as agricultural equipment manufacturers, require a large amount of fixed asset investment. Service companies and computer software manufacturers need relatively few fixed assets. Mainstream manufacturers usually use 25% to 40% of their assets for PP&E. Therefore, the turnover rate of fixed assets in different industries will be different.

The formula and calculation of the turnover rate of fixed assets

Fixed Asset Turnover = Net Sales Average Fixed Assets begin{aligned} &text{Fixed Asset Turnover} = frac{ text{Net Sales} }{ text{Average Fixed Assets} }\ end{aligned }

Turnover rate of fixed assets=Average fixed assetsNet sales

Calculation of fixed asset turnover steps.

  1. Get net sales from the company’s income statement.
  2. If necessary, net sales can be calculated by subtracting returns and exchanges from revenue or total sales. Some industries use net sales because they have returned goods, such as clothing retail stores.

The fixed asset turnover rate can tell investors how the company’s management effectively uses its assets. This ratio is a measure of the productivity of a company’s fixed assets relative to its income generation. The more turnover of PP&E, the more revenue or net sales generated by the company using these assets.

It is important for investors to compare the turnover rate of fixed assets over several periods, as the company may upgrade and add new equipment over time. Ideally, investors should seek to increase turnover over multiple periods. In addition, it is best to compare the turnover rate with similar companies in the same industry.

Return on assets

The return on assets (ROA) is considered the profitability rate, which means that it shows the net income or profit earned from its total assets. However, ROA can also be used as an indicator to determine the performance of a company’s assets.

As mentioned earlier, fixed assets require a large amount of capital to purchase and maintain. Therefore, ROA can help investors determine the company’s use of the capital investment to generate income. If a company’s management team has poorly invested in asset purchases, it will appear in the ROA indicator.

In addition, if a company does not update its assets, such as equipment upgrades, it will result in a lower ROA compared to similar companies upgrading its equipment or fixed assets. Therefore, it is very important to compare the ROA of companies in the same industry or similar products (such as car manufacturers). Comparing the ROA of capital-intensive companies such as automakers with the ROA of marketing companies with few fixed assets cannot tell which company is a better investment.

Formula and calculation of return on assets

ROA = Net Income Average Total Assetsbegin{aligned} &text{ROA} = frac{ text{Net Income} }{ text{Average Total Assets} }\ end{aligned}

Return on assets=Average total assetsnet income

  1. Find the net income in the company’s income statement.
  2. In many ROA formulas, total assets or ending total assets figures are used as the denominator.
  3. However, if you want to use the average total assets, add the total assets at the beginning of the period to the total assets at the end of the period and divide by two to calculate the average total assets.
  4. Divide net income by total assets or average total assets to get ROA.
  5. Please note that the above formula will produce a decimal number, such as 0.10. Multiply the result by 100 to move the decimal and convert it to a percentage, for example, .10 * 100 = 10% ROA.

The reason the ROA ratio is expressed as a percentage return is to allow comparisons as a percentage of how much profit is generated from the total assets. If a company’s ROA is 10%, then it will generate 10 cents for every dollar of profit or net income it makes.

A high percentage rate of return means that assets are well managed. Once again, the ROA ratio is best used as a comparative analysis of the company’s own historical performance.

The impact of intangible assets

Many non-physical assets are considered intangible assets and can be roughly divided into three different types:

Unfortunately, there is little uniformity in terms used in the balance sheet presentation or account titles of intangible assets. Usually, intangible assets are hidden in other assets and are only disclosed in the notes to the financial statements.

The funds involved in intellectual property rights and deferred fees are usually not important, and in most cases, there is no need for excessive analysis and review. However, we encourage investors to look carefully at the amount of goodwill purchased on the company’s balance sheet-an intangible asset generated when acquiring an existing business. Some investment professionals are disturbed by the goodwill of large purchases. Only when the acquisition can be converted into positive income in the future can the return to the acquired company be realized.

Conservative analysts deduct the amount of goodwill purchased from shareholders’ equity to arrive at the company’s tangible net worth. In the absence of any precise analysis and measurement criteria to judge the impact of such deductions, investors use common sense. If the deduction of purchased goodwill has a significant negative impact on the company’s equity, it should cause concern. For example, if debt liabilities significantly exceed its tangible equity, a moderately leveraged balance sheet may not be attractive.

Companies acquire other companies, so buying goodwill is a reality in financial accounting. However, investors need to look closely at the relatively large purchases of goodwill on the balance sheet. The impact of this account on the investment quality of the balance sheet needs to be judged based on the scale of its comparison with shareholders’ equity and the company’s acquisition success rate. This is indeed a judgment, but it requires careful consideration.

Bottom line

Assets represent valuable items that the company owns, owns, or expires. Among the various items owned by the company, accounts receivable, inventory, PP&E and intangible assets are usually the four largest accounts in terms of balance sheet assets. Therefore, a strong balance sheet is built on the effective management of these major asset types, while a strong investment portfolio is built on an understanding of how to read and analyze financial statements.

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