PART 2 – How to read a Balance Sheet like a novel and take control of your journey

Analysing the Balance Sheet 

The balance sheet basically illustrates the financial position of a business at a specific point in time and shows where the money came from and where it is being used. 

Determining the businesses financial performance

The best way to determine how well the business is performing financially is through  analysing the ratios between 2 or more parameters.  

The results need to be compared to previous performance and/or benchmarked against industry standards and acceptable norms. 

In order to analyse business performance, the income statement and balance sheet need to be available for the same date. 

Below are the consolidated Income Statements for the same company. As you will notice, the end dates of the Income Statement is the same dates as the Balance Sheet. However, the Income Statement is obviously the trading results over a period of time (12 months) and the Balance Sheet is the position on a specific date (28 February)  

Income Statement

The Income Statement (also known as Profit & Loss Statement) provides the Revenue (Sales), the Gross Profit, the Expenses (Overheads) and the Net Profit as the main contributors to the ratio analyses. 

The Balance Sheet contributes the Assets (Fixed and Current), the Liabilities (Long Term and Current) and the Owner’s Equity numbers for the ratio analysis. 

Categories of Ratio

There are 4 main categories of ratio that need to be analysed, namely, Liquidity, Debt, Profitability and Activity or management

Liquidity ratios are used to determine the ability of the business to pay off its short term debts.  

Debt ratios establish to what extent the business uses debt to fund its operations. It is also showing the level of equity left at a point in time. 

Profitability ratios show the business ability to generate profits relative to its revenue. These ratios use the Income Statement information. 

Activity ratios are also known as efficiency ratios. These ratios use both the Balance Sheet and the Income Statement and measure the efficiency of the business. They are used to monitor how well the management in generating revenue and cash from its resources.  

The main ratios are explained below and later we will take a look at how their interpretation is applied to our case study. 

Liquidity Ratio

Current = Current Assets / Current Liabilities – the current ratio shows how many times the current assets exceed current liabilities. Any number above 1.0 is positive since the business is able to cover its liabilties. 

Working Capital = Current Assets – Current Liabilities – this defines the value by which the current assets exceed current liabilities. 

Quick/Acid Ratio = (Current Assets – Inventory) / Current Liabilities – this ratio is the similar to the current ratio, however, it excludes the value of Inventory, since Inventory (Stock) is an illiquid asset and not cash that is available quickly. 

Solvency = Total Assets / Total Liabilities – This ratio illustrates ability of the business to meet its long term financial commitments, unlike the current ratio. 

Stock to Working Capital = Inventory / Working Capital – shows the extent by which Inventory value is part of the total working capital.  

Altmann Z Score – this is a bankruptcy predictor developed by Edward Altmann in 1968 and still used today by the Fortune 500. Scores below 1.8 means companies are headed for bankruptcy, while score above 3 mean no risk of bankruptcy. 

Debt Ratio

Debt = Long Term Liabilities / Capital Employed – this illustrates the amount of debt as a percentage of total equity 

Equity = Shareholder Equity / Capital Employed – this illustrates the amount of total equity as a percentage of total capital employed in the business (Long term Liabilities + Owners Equity) 

Debt/Equity = Long Term Liabilities / Shareholders Equity – this indicates the percentage of the businesses assets that are provided via debt. It is the ratio of total debt to total assets. 

Profitability Ratio

Gross Profit = (Sales – Cost of Sales) / Sales – relationship of gross profit to net revenue.  

Operating Margin = Net Profit + Interest + Tax – determines the percentage profit from operations before subtracting for interest and tax 

Net Profit Margin = (Gross Profit + Other Income – Total Expenses) / Sales – percentage of Net Profit from trading (Revenue) over a period of time  

ROI (Return on Investment) = Net Profit / Total Assets – measures the profitability achieved from the resources used (Assets). The higher the ROI the more efficiently the assets were used. 

ROE (Return On Equity) = Net Profit / Shareholders Equity – shows the ability of the business to generate profits from its shareholders investments.  

Activity Ratio

Stock Turnover = Cost of Sales / Average Accounts Receivable – measure efficiency in managing inventory. The higher the result, the more stock is “turned” or sold over a period. 

Average Collection Period = Net Sales / Average Accounts Receivable –  illustrates the number of days it takes the business to collect payment from its customers. 

Average Payment Period = Net Trade Purchases / Average Accounts Payable – shows the average number of days the business takes to pay its trade suppliers.  

Fixed Asset Turnover= Net Sales / Fixed Assets – it shows how efficiently the business is using its machinery, equipment etc. in generating revenue.  

Turnover of Working Capital = Net Sales / Working Capital – this shows how efficiently a business is using its working capital to generate sales. A high value illustrates good efficient use of working capital.  

Days Sales in Stock = Inventory / Cost Of Sales – this indicates how many days it would take to sell out the inventory on hand at a point in time, based on previous sales history. 

Break Even Hourly Rate =  Total Expenses / Number of Working Hours for the period – the value that a business needs to charge per hour to break even based on its overheads and average gross profit.  

Break Even Sales =  Total Expenses / Gross Profit Margin – the amount of Revenue required for a period in order for the business to break even. 

Operating Cycle = Days Inventory Outstanding + Days Sales Outstanding – the amount of time it takes a business from the day it receives the inventory to the day it gets paid for the sale. It measure the time  taken to convert inventory to cash. 

Cash cycle = Days Sales Outstanding + Days Inventory Outstanding – Days Payables Outstanding –measure the number of days that cash is tied up in inventories and accounts receivable. It is a measure of working capital management.  

Economic Value Add = Net Operating Profit After Tax – (Weighted Average Cost of Capital x Owners Equity & Long Term Liabilities)  – it measures residual wealth after deducting cost of capital. It is known as economic profit. A positive figure show a business is generating value from funds invested in it. 

Working Capital Required –  Inventory + Accounts Receivable – Accounts Payable – amount required in order to pay its debt and expense obligations 

Below is the ratio analysis of the Balance Sheet 

In the next chapter, the meaning and interpretation of these ratios will provide a clear understanding of how to analyse the performance of this business. 

Although there are many other important measurements that should be used to monitor performance, they can only be done with a detailed Income Statement which we will cover at a different time.