Knowing how to read a balance sheet is a very important skill for bankers. This is because the balance sheet can reveal a lot of information about how risky a company is.
While the income statement records how much we earn and spend within a period of time, the balance sheet shows us what we own and owe at a given date.
This is a 3-part series on the “Beginners Guide to Investing”. It’s a continuation of the previous post on “How to read an income statement“.
It is important to know how to read not just the income statement, but also the balance sheet and cash flow statement. Looking at all 3 financial statements would give a more complete picture of a company’s financial health.
Before we begin, there is one very important formula to remember in accounting.
What we own is called assets.
What we owe is called liabilities.
Assets minus liabilities = shareholders’ equity.
If we pay off everything we owe with what we have, then the remaining balance belongs to us. This balance is called shareholders’ equity.
The equation must always match. That’s why it is called a balance sheet.
1. What is a Balance Sheet?
A balance sheet records 3 things.
- All the assets we own
- All the liabilities we owe
- Shareholders’ Equity (Assets – Liabilities)
This is an example of how a simple balance sheet would look like.
Within the “Assets” category, it is split into current assets and non-current assets.
Current assets are short-term assets that can be converted to cash within 12 months. Non-current assets are long-term assets that can’t be converted to cash within 12 months.
Similarly, the “Liabilities” category is split between current liabilities and non-current liabilities.
Current liabilities are short-term liabilities that are expected to be paid off within 12 months. Non-current liabilities are long-term debts that take more than 12 months to be paid off.
Cash & Cash Equivalents
The first line item you would often see is cash & cash equivalents. Sometimes you would also see marketable securities. These are those very low-risk investments. Examples are short-term government bonds or fixed deposits.
The order of the line items in the balance sheet is ranked based on liquidity. Liquidity is meant by how easy it is to sell something for cash.
For example, selling shares on the market is liquid. You can get the money within a couple of days. However, selling land or big machines is not liquid. You have to take time to find buyers, arrange paperwork, legal documents, negotiation and etc. It would take months before you sell it and receive cash.
That is the reason why cash is the first item on assets and Plant, Property & Equipment is the last item. Because it flows down from liquid (current) to non-liquid assets (non-current). From easy to sell to hard to sell.
Account receivables are sales that you have made but have not collected cash yet. Usually, in B2B, people don’t pay cash immediately when you sell something. There are payment terms in the invoice.
For example, company XYZ may sell a batch of 50,000 wallets to another distributor for $10,000. Under the payment terms, the distributor is allowed up to 45 days to pay XYZ.
Recording a Transaction in the Journal Entry
In this case, a journal entry would be passed to debit account receivables and credit sales revenue. (Refer to option 2) This is known as recording a transaction in the journal entry.
It is good to know a little about the basics of how every transaction is done. How are the numbers in the income statement or balance sheet derived?
It is through a summation of all the transactions that are recorded in the journal entry.
In the above example, a transaction is made. So we have to record a journal entry. Since it is credit sales, we will look pass on the journal entry of 2. If it is cash, then look at journal entry 1.
Company XYZ made a revenue of $10,000 and their accounts receivables will increase by $10,000. This is how the figures would flow.
The “revenue” which is found in income statement would increase by $10,000. On the other hand, the “Accounts receivables” which is found in the balance sheet would also increase by $10,000.
However, no cash is received yet. This is because we have given the distributor 45 days to repay us back the $10,000.
What happens when the distributor pays us back after 15 days? Then we would pass on a journal entry (Refer to 3). Account receivables would DEDUCT $10k and cash would INCREASE by $10k. While revenue stays unchanged in the income statement, the $10k has moved from account receivables to cash in the balance sheet.
Now you start to see a little of how the income statement and balance sheet is connected.
Importance of Cash Flow
Then you might ask, what difference does it make, whether the sale is made in cash or receivables?
Imagine you owe a supplier $5,000. You also owe the bank a short-term loan of $10,000. Your payments are due and they want money immediately.
However, most of your sales are made on credit. Even though your revenue might be $20,000 and your account receivables is $20,000. BUT you have no cash! Then the supplier charges you penalty fees and the bank downgrades your credit.
Next month comes and they chase you again for payment, but your customers delay payment and your account receivables stay at $20,000. Now you see the problem?
That’s why cash flow is very important. This would be discussed in the third series of this guide. Even though your revenue might look good as you earned $20,000, but if you can’t meet short-term obligations then trouble will come knocking on your front door.
Inventories are simply raw materials that are purchased but have not been sold to the customers yet.
A company must maintain the optimal amount of inventory to be stored. It can’t be too little or else it fails to meet the order demands from customers. On the other hand, it can’t be too much also as there are storage costs, spoilage costs, and obsolescence costs.
Additionally, cashflow might be affected as you spent cash to purchase inventories that end up doing nothing. There is an opportunity cost as it could have been used for other short-term investments or spending needs.
The “inventories” on the balance sheet is connected to the “cost of goods sold” in the income statement.
For example, if $20k worth of goods is being sold to the customers, then inventories would deduct $20k and COGs would increase $20k.
Knowing how much COGs and inventories also allow us to calculate inventory turnover. This will be discussed in the later section.
If you see a company’s inventory piling up over the years, it is usually not a good sign, unless there is a reason like stocking up for an upcoming festive season.
Increasing inventory in the balance sheet generally means your goods are stuck in the warehouse and no sales are being made.
Property, Plant & Equipment (PPE)
PPE is found at the non-current assets of the balance sheet. These are the lands, factories, plants, and machinery. They are assets that last for 10 or 20 years.
So how is PPE connected to the income statement? This is another important concept to learn and that is accrual accounting.
Accrual accounting means you only record revenue and expenses as and when it is incurred.
In this case, if you purchase a piece of machinery for $100,000, it doesn’t get expensed fully. This means that in the income statement, there is no expense line item that says $100,000 for buying the machine.
Instead, the cost of the machine is spread over the expected useful life. If we estimate that the machine can last for 10 years, then a depreciation expense of $10,000 ($100k divided by 10 years) would be recorded in the income statement every year for the next 10 years.
That’s the reason why you see another line item in the balance sheet called “Accumulated Depreciation”. Accumulated depreciation is simply the cumulative depreciation that has been recorded. For example, if it is year 3 then the accumulated depreciation would be $30,000 ($10k x 3 years).
PPE minus accumulated depreciation equal to net PPE. This is the fair value of the PPE at the balance sheet date.
Short-term debts are debts that are due in <12 months. A company usually borrows short-term loans to finance working capital needs. These include all the daily operational activities like buying inventories, paying up suppliers or refinancing previous short-term loans. In short, short-term debt is used to finance short-term needs.
Accounts payable is the opposite of accounts receivables. When we purchase a batch of materials, we are usually allowed 30 days or 45 days to make the payment to the supplier.
The key to maximizing cash flow is to collect payments early from customers and delay payments to suppliers.
There is a saying: “Pay your bills but never before they are due”.
If accounts payable are increasing in the balance sheet, it means the company is purchasing inventories. However, if you see inventories remain unchanged but account payable is increasing, then what does that tell you? It probably means the company is short of cash and they are delaying payments. Not a good sign.
Long-term debt is loans that are due > 12 months. These are loans that are taken up from banks that could be 5 years, 10 years or longer.
A company usually borrows long-term debt to finance long-term assets. Examples of long-term assets are Plants, Property & Equipment (PPEs).
Hence, you realized that current liabilities match current assets and non-current liabilities match non-current assets? Short-term loans are used for short-term assets. Long-term loans are used for long-term assets.
When a company does an IPO and raise money from the public, they issue out shares. For example, if they want to raise $10 million, it can do so by selling 10,000,000 shares at $1 each.
This $10 million capital that they collected from investors fall under “Share Capital” in the shareholders’ equity section of the balance sheet.
This share capital figure can increase if the company raises money through equity financing. Or the company can reward employees with new shares.
Generally speaking, it is not a good sign if a company issue out more shares. The reason is because of share dilution. Think of the same amount of earnings are now being split among more people.
However, it can be good news if the money raised from issuing out new shares can increase the profits even higher. But how do we check this? Just look at the Earnings Per Share.
The last section is retained earnings. From the “net income” in the income statement, the management has two options.
Either, they give out a part of the net profits as dividends to shareholders OR they retain it for continual business expansion.
Retained earnings is exactly as the term implies. It means whatever net profits that are retained after paying off dividends to shareholders.
Hence, the “retained earnings” that you see on the balance sheet is the cumulative net profits that the company has retained throughout the years.
The retained earnings of a company should be increasing over the years. Decreasing retained earnings is a dangerous sign as that means the company’s net profits are falling or it is paying out too many dividends.
Here is a look at what happens to the share price when retained earnings start falling.
This is Singtel’s retained earnings and share price over the past 10 years. The blue line represents Singtel’s share price while the bar chart represents Singtel’s retained earnings. See the correlation?
Lastly, if we add total shareholders’ equity and total liabilities. It should be exactly equal to the total assets.
2. How to Read a Balance Sheet?
Now that we know the structure and components of the balance sheet, the next question is how to read and analyze a balance sheet?
You know the definitions and all. But if you look at company XYZ’s balance sheet, what can you tell from it? Does it look good or bad? Probably not much if it is your first time you are looking at it. But trust me, it really isn’t that complicated.
Balance Sheet Analysis Guide
When you read the balance sheet, think of risk. Imagine yourself as a banker and ask yourself if you were to lend this company money, what would you look out for? The answer is liquidity and cash flow.
I have come up with 8 liquidity ratios that you can use to evaluate a company. The list is not exhaustive, but these are the most common balance sheet metrics you would often see and hear.
The purpose of analyzing a company’s liquidity is simply to ask one question: Does the company have enough assets that can be readily converted to cash to pay off short-term spending needs?
(1) Current Ratio
The formula for the current ratio is simply current assets divided by current liabilities. It is asking how much assets do I have for every dollar of liabilities. Ideally, it has to be at least 1 or higher. Current ratio <1 means current liabilities are higher than current assets.
Hence, the higher the current ratio the better. It simply means I have more short-term assets to pay off those short-term liabilities. But remember again, compare within the industry and previous years. There are times within the industry that the current ratio of <1.0 is common.
(2) Quick Ratio
The current ratio can be modified to the Quick Ratio. Sometimes its called the “acid-test”. So what is the difference between the current ratio and quick ratio?
The quick ratio is saying that the current ratio does not really tell us about the liquidity of the company. Why? Because inventories take time to be sold. It is not exactly a liquid asset. Even though it is still less than 12 months, the inventories can be stuck in the warehouse for like 7 months. If you have to settle the current liabilities quickly, 7 months is considered a long time.
To better measure the company’s liquidity, we should exclude inventories. That is the only difference between the quick ratio and the current ratio. It is sort of like a test to see what happens if we don’t factor in inventories in the current assets.
(3) Cash Ratio
However, what if suppliers and banks demand immediate cash payment now? Like the next day. There are items in the current assets that we can’t pay. How can we pay them with accounts receivables or inventories?
Inventories take time to be sold to the customers. That is the quick ratio variation.
But even when inventories are sold, it is not immediate cash also. It turns into accounts receivables. Account receivables also take time for customers to pay us back in cash. So it is not really liquid also. Customers can take 30 days to pay cash, but what if creditors want payment latest by next week?
There are cases when the current ratio appears healthy but in reality, it isn’t. To illustrate, look at this example here.
Both A & B gives the same current ratio of 1.4. On first glance, you might think this company looks fairly decent. Current assets are $10k more than current liabilities.
But if you dig deeper, A has cash of only 2.5k while most of it is stuck in inventories. B has a much healthier picture of 20k cash. Now comparing the cash ratio, A is significantly lower than B.
For every dollar of short-term liability, A only has $0.10 of cash while B has $0.80. The situation in A is much riskier than B even though the current ratio is the same.
The cash ratio is the most conservative metric as compared to the quick ratio and current ratio. It is like testing the worst-case scenario. Cash ratio is evaluating whether the company would survive if it was to settle all the short-term liabilities the next day.
Liquidity of Cash Flow in the Balance Sheet
Next, when we look at cash flow, there are 3 things we want to know from the balance sheet.
- Speed of selling inventories
- Speed of collecting cash from receivables
- The time that is taken to pay suppliers
(4) Days Inventory Outstanding (DIO)
For inventories, we can calculate how fast it takes for the company to sell inventories and convert them into sales revenue.
The formula is Days Inventory Outstanding (DIO). DIO is calculated by taking inventory divided by COGs x 365 days. It tells us the average number of days it takes for a company to sell inventory.
Generally, the lower the better as that means the inventory stocks are moving fast and they are making sales. A high DSI means inventories are stuck in the warehouse and they are not selling.
(5) Days Sales Outstanding (DSO)
For accounts receivables, we can evaluate how fast it takes for the company to collect cash from receivables.
The formula is Days Sales Outstanding (DSO). DSO is calculated by taking account receivables divided by revenue x 365 days. It tells us the number of days it takes for a company to collect cash from customers.
Hence, the lower the number the better as that means we are collecting cash faster. I have personally seen before companies with customer receivables that are more than 1 year. It means that the customers have not paid them anything. This makes you question the effectiveness of the company’s credit policy.
(6) Days Payable Outstanding (DPO)
Lastly, under accounts payable in the balance sheet, we can calculate how long it takes for a company on average to pay its suppliers.
The formula for DPO is calculated by taking accounts payable divided by COGs x 365 days.
Generally, the higher the DPO the better as you can delay cash outflow.
The rule of thumb in managing efficient working capital is to collect cash fast and pay others slowly.
(7) Cash Conversion Cycle
Why do we need to calculate DSO, DIO, and DPO? And how does knowing all these days help? To answer this question, we must first understand what is the cash conversion cycle.
To start off, a company first purchases some inventories to produce goods. It owes the suppliers and has up to 45 days to make the payment.
At this juncture, 2 questions popped up. Firstly, how long does it take to pay suppliers? Secondly, how long does it take to sell the inventories?
When the inventories are sold, customers will have up to 45 days to pay us. Then the third question to ask is how long does it take to collect cash from customers?
Before we collect cash from customers, we would have already made the payment to the suppliers. This is because it takes additional time to sell inventories.
Therefore, the cash conversion cycle means how many days it takes for a company to convert inventories into cash. It is calculated by taking DIO + DSO – DPO.
The smaller the number the better as that means the company is collecting cash faster. They always have enough cash for payments. What you don’t want to see is those companies that take many days to collect cash. In such cases, it is the other way round. The company is paying faster than it is collecting cash. It probably has very little cash on hand for daily operations and spending needs.
Why is the cash conversion cycle important? Because the availability of cash flow determines the limit of what you can or can’t do in the daily operations of your business. If you have cash flow, you have options. If your cash flow is tied up, you can’t do anything.
(8) Debt-to-Equity Ratio
The last metric is the debt-to-equity ratio or otherwise known as financial leverage. This tells us how much debt the company is using. The more debt a company has, the higher leveraged it is. Remember from the first series that the company raises money through 2 ways? Either debt or equity.
The debt-to-equity ratio is calculated by taking total debt divided by total shareholders’ equity. Total debt is equal to short-term debt + long-term debt. It is asking how much debt do we have for every dollar of equity.
If it is 0.5, it means every shareholder’s dollar owes $0.50 of debt. If it is 2, it means every shareholder’s dollar owes $2 of debt. As a shareholder, would you prefer a lower or higher debt-to-equity ratio?
Generally speaking, the higher the debt %, the riskier the company is. Why? Because debt is an obligation. You have to pay interest expenses regardless your sales are up, down or worse, declining month after month.
However, there are times when debt is good. That’s why it is known as “financial leverage”. Because it can multiply the return on equity (ROE).
The Effects of Financial Leverage
To illustrate, look at these 2 examples.
Imagine that a company wants to buy a machinery asset that costs $1,000,000, it has to think of how to raise this sum of money. The company will decide the proportion of debt and equity to finance the asset.
In the above illustration, it can be seen that the company on the left uses more debt and has a higher ROE of 25%. That is because it is only using $200,000 of its own money to earn $100,000.
The financial leverage is the debt-to-equity ratio which is 4. ($800k debt divided by $200k equity) For every dollar of shareholders’ equity, it owes $4 of debt. Just now we thought this was bad, it is highly risky. But it amplifies the ROE.
On the other hand, the company on the right uses less debt and has an ROE of only 9%. Because it is using $800,000 of its own money to earn $100,000. The debt-to-equity ratio is 0.25 or $200k divided by $800k.
You can see how if the financial leverage is higher, the ROE is higher. Furthermore, interest expenses are also tax-deductible. This means the company can generate additional tax savings by borrowing more.
The risk comes when earnings start falling. Imagine next year operating profits fall to $40k. But interest expenses is $40k for the company that borrows 80%. They are going to be screwed. The company that borrows 20% still can tide through the crisis as their interest expense is only $10k.
This is how debt serves as financial leverage to magnify returns. But it also comes with a downside risk if a company borrows excessively. A company should know the optimal debt-to-equity ratio to maximize the firm’s value.
3. Summary of How to Read a Balance Sheet
In summary, Assets = Liabilities + Shareholders’ Equity. The equation must always match.
Assets are made up of current and non-current assets. Liabilities are made up of current and non-current liabilities.
One is <12 months while the other is >12 months. Current liabilities fund current assets and non-current liabilities fund non-current assets.
Shareholders’ equity is the balance of what we have after all the liabilities are being paid with all the assets. Assets – Liabilities = Shareholders’ equity.
There are 8 balance sheet ratios that we can use to evaluate the liquidity cash flow of a company.
The balance sheet can tell us how much debt or financial leverage a company is using. How many days it takes to collect cash from inventories to sales. And lastly, the liquidity risks of settling short-term liabilities.
All of these ratios should be compared against previous years or the industry average to be meaningful. If not you would have no idea how high is high or how low is low.
Hope you have gained a better understanding of how to read a balance sheet. Stay tuned for the last series on “How to Read a Cash Flow Statement?”