Lecture2_Balance Sheet Analysis

7/25/2019 Lecture2_Balance Sheet Analysis

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Balance Sheet Analysis


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The balance sheet is a snapshot of the firms

assets and liabilities at a given point in time

Assets are listed in order of liquidity

Ease of conversion to cash

Without significant loss of value

Balance Sheet Identity

Assets = Liabilities + Stockholders Equity


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To remember. . .

Basic equationsAssets = Debt + Equity

Assets minus debts = equity

Assets - equity = debt


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The Balance-Sheet Modelof the Firm

Current Assets

Fixed Assets

1 Tangible

2 IntangibleShareholders

Equity

Current

Liabilities

Long-Term

Debt

Investmentdecision

The Capital Budgeting Decision

Financing

decision

Workingcapital

management


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There is a

financialequilibriumbetweenresources andtheir uses?

Net

WorkingCapital

Shareholders

Equity

Current

LiabilitiesCurrent Assets

Fixed Assets

1 Tangible

2 Intangible

Long-Term

Debt

Balance Sheet Structure


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Current Liabilities

short-term notes, accrued expenses,

accounts payable

Long-Term Debt and Equity bonds, preferred stock, common stock

Which are more expensive for the firm? Which help avoid risk of illiquidity?



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Current Liabilities short-term notes, accrued expenses,

accounts payable

Long-Term Debt and Equity

bonds, preferred stock, common stock

Risk-Return Trade-off:Current liabilities are less expensive, butincrease the risk of illiquidity.



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Balance Sheet

Current Assets Current Liabilities

Fixed Assets Long-Term Debt

Preferred Stock

Common Stock

To illustrate, lets finance all current assetswith current liabilities, and finance all

fixed assets with long-termfinancing.


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Balance Sheet

Current Assets CurrentLiabilities

Fixed Assets Long-Term Debt

Preferred Stock

Common Stock

Suppose we use long-term financing to

finance some of our current assets.

This strategy would be less risky, but more

expensive!


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Balance Sheet

Current Assets Current Liabilities

Fixed Assets

Long-Term Debt

Preferred Stock

Common Stock

Suppose we use current liabilities to financesome of our fixed assets.

This strategy would be less expensive, butmore risky!


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Permanent Assets (those held > 1 year)

should be financed with permanent and

spontaneous sources of financing

Temporary Assets (those held < 1 year)

should be financed with temporary sources

of financing

The hedging principle


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Two Basic Questions:

1. What is the appropriate level for

current assets, both in total and byspecific accounts?

2. How should current assets befinanced?



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The Requirement for Current

Assets Financing depends on: Seasonal Variations

Business Cycles

Expansion of the companysactivity


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Permanent cu rrent assets

TIME

DOLLA

R

AMOUNT

Tempo rary current assets

Current Assets


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Current Assets

Permanent Current AssetsCurrent asset balances that do not change

due to seasonal or economic conditions--even at the trough of a firms business cycle

Permanent Current Assets


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Temporary Current AssetsCurrent assets that fluctuate with seasonalor economic variations in a firms business

Current Assets

Temporary Current Assets


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Alternative Current AssetFinancing Policies

ModerateMatch the maturity of theassets with the maturity of the financing.

AggressiveUse short-term financing tofinance permanent assets.

ConservativeUse permanent capital for

permanent assets and temporary assets.


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Maturity Matching, or

Self-Liquidating ApproachA financing policy that matches assetand liability maturities

This would be considered a moderate

current asset financing policy

Alternative Current Asset

Financing Policies


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Hedging (or Maturity

Matching) Approach

A method of financing where each asset would be offset with a financinginstrument of the same approximate maturity.

TIME

DOLLA

R

AMOUNT

Long-term financing

Fixed assets

Current assets*

Short-term financing**


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Conservative ApproachA policy where all of the fixed assets,all of the permanent current assets, andsome of the temporary current assets ofa firm are financed with long-term

capital


Financing Policies


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Risks vs. Costs Trade-Off

(Conservative Approach)

Firm can reduce risks associated with short-term borrowing by using alarger proportion of long-term financing.

TIME

DOLLA

R

AMOUNT

Long-term financing

Fixed assets

Current assets

Short- term financin g


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Aggressive ApproachA policy where all of the fixed assets ofa firm are financed with long-term capital,but some of the firms permanent current

assets are financed with short-term non-

spontaneous sources of funds


Financing Policies


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Firm increases risks associated with short-term borrowing by using alarger proportion of short-term financing.

TIME

DOLLA

R

AMOUNT

Long-term financing

Fixed assets

Current assets

Short-term financing

Risks vs . Cos ts Trade-Off

(Aggressive Approach )


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Summary of Short- vs.

Long-Term Financing

Financing

Maturity

AssetMaturity

SHORT-TERM LONG-TERM

Low

Risk-Profitability

Moderate

Risk-Profitability

Moderate

Risk-Profitability

High

Risk-Profitability

SHORT-TERM

(Temporary)

LONG-TERM

(Permanent)


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Analysis of balance sheets Liquidity

A companys ability to meet its short-term financialcommitments.

Assessment focus: The companys ability to convert assets tocash and to pay for operating needs.

SolvencyA companys ability to meet its financial obligations over the

longer term.

Assessment focus: The companys financial structure and itsability to pay long-term financing obligations.

Analytical ToolsCommon-size analysis.

Balance sheet ratios.

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common-size balance sheets

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($ thousands) A B CASSETS

Cash, cash equivalents, marketable securities 1,900 200 3,300

Accounts receivable 500 1,050 1,500Inventory 100 950 300

Total current assets 2,500 2,200 5,100

Property, plant, and equipment, net 750 750 4,650Goodwill 0 300 0Total assets 3,250 3,250 9,750LIABILITIES AND EQUITY

Accounts payable 0 2,500 600Total current liabilities 0 2,500 600

Long-term bonds payable 10 10 9,000Total liabilities 10 2,510 9,600Total shareholders equity 3,240 740 150Total liabilities and shareholders equity 3,250 3,250 9,750


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common-size balance sheets

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(percent of total assets) A B CASSETS

Cash, cash equivalents, marketable securities 58% 6% 34%

Accounts receivable 15% 32% 15%

Inventory 3% 29% 3%

Total current assets 77% 68% 52%

Property, plant, and equipment, net 23% 23% 48%

Goodwill 0% 9% 0%

Total assets 100% 100% 100%

LIABILITIES AND SHAREHOLDERS EQUITY

Accounts payable 0% 77% 6%

Total current liabilities 0% 77% 6%Long-term bonds payable 0% 0% 92%

Total liabilities 0% 77% 98%

Total shareholders equity 100% 23% 2%

Total liabilities and shareholders equity 100% 100% 100%


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Balance sheet Ratios: liquidityratios

Ratio

Calculation

Current Current assets/Current liabilitiesQuick (acid test) (Cash + Marketable securities + Receivables)/

Current liabilities

Cash(Cash + Marketable securities)/Current liabilities

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Liquidity ratios indicate a companys ability to meet

current liabilities.


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Balance sheet Ratios: SolvencyRatios

Ratio

Calculation

Long-term debt to equity Total long-term debt Total equity

Debt to equity Total debt Total equity

Total debt (also known asdebt to assets)

Total debt Total assets

Debt to capital Total debt (Total debt + Total equity)

Financial leverage Total assets Total equity

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Solvency ratios indicate financial risk and financial leverage anda companys ability to meet its financial obligations over time.


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summary

Balance Sheet: what an entity owns (or controls), what itowes, and what the owners claims are at a specific point

in time.

Balance sheets usually present current and noncurrent

assets and liabilities.

Accounting issues relate primarily to measurement(historical cost versus fair value).

Tools for balance sheet analysis include common-size

analysis and balance sheet ratios.

Balance sheet ratios indicate liquidity and solvency.

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Quick Quiz What is the balance-sheet equation?

What is the difference between Romanian Form and Anglo-Saxon Form of thebalance sheet?

Which things should be kept in mind when looking at a balance sheet?

Which is the most important piece of information we have to look for in abalance sheet, as stockholders (creditors, or other stakeholders)?

How should current assets be financed? Which are the implications of financing short term assets by long term

resources?

Which are the implications of financing long term assets by short termresources?

Conservative or Aggressive Financing Policy? Which one are you inclined touse? Why?

How do you see the situation of an retail company, which has a negative networking capital?

QuickGrow is in an expanding market, and its sales are increasing by 25percent per year. Would you expect its net working capital to be increasing ordecreasing?

Why do you think one would need market values in the financial analysis of theb l h t?

Lecture2_Balance Sheet Analysis

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