Balance Sheet Analysis

Introduction
In this section, we will look at some of the tools you can use in making an investment decision from balance sheet information. If you are not familiar with balance sheets, you are advised to first read the section entitled, "Understanding the Balance Sheet". It provides a good overview of the functions of a balance sheet and its components. We will cover the following topics here: Why You Should Analyze a Balance Sheet Liquidity Ratios Leverage Bankruptcy Tying It All Together

A thorough analysis of a company's balance sheet is extremely important for both stock and bond investors.

Why You Should Analyze a Balance Sheet

The analysis of a balance sheet can identify potential liquidity problems. These may signify the company's inability to meet financial obligations. An investor could also spot the degree to which a company is leveraged, or indebted. An overly leveraged company may have difficulties raising future capital. Even more severe, they may be headed towards bankruptcy. These are just a few of the danger signs that can be detected with careful analysis of a balance sheet. Beyond liquidity and leverage, the following section will discuss other analysis such as working capital and bankruptcy. As an investor, you will want to know if a company you are considering is in danger of not being able to make its payments. After all, some of the company's obligations will be to you if you choose to invest in it. We will start with Liquidity Ratios, an important topic for all investors.

Liquidity Ratios
The following liquidity ratios are all designed to measure a company's ability to cover its short-term obligations. Companies will generally pay their interest payments and other short-term debts with current assets. Therefore, it is essential that a firm have an adequate surplus of current assets in order to meet their current liabilities. If a company has only illiquid assets, it may not be able to make payments on their debts. To measure a firm's ability to meet such short-term obligations, various ratios have been developed. You will study the following balance sheet ratios: Current Ratio Acid Test (or Quick Ratio) Working Capital Leverage

These tools will be invaluable in making wise investment decisions. Current Ratio The Current Ratio measures a firm's ability to pay their current obligations. The greater extent to which current assets exceed current liabilities, the easier a company can meet its short-term obligations.

Current Assets Current Ratio = ---------------------------

Current Liabilities After calculating the Current Ratio for a company, you should compare it with other companies in the same industry. A ratio lower than that of the industry average suggests that the company may have liquidity problems. However, a significantly higher ratio may suggest that the company is not efficiently using its funds. A satisfactory Current Ratio for a company will be within close range of the industry average. Acid Test or Quick Ratio The Acid Test Ratio or Quick Ratio is very similar to the Current Ratio except for the fact that it excludes inventory. For this reason, it's also a more conservative ratio.

Current Assets - Inventory Acid test = --------------------------Current Liabilities Inventory is excluded in this ratio because, in many industries, inventory cannot be quickly converted to cash. If this is the case, inventory should not be included as an asset that can be used to pay off short-term obligations. Like the Current Ratio, to have an Acid Test Ratio within close range to the industry average is desirable. Working Capital Working Capital is simply the amount that current assets exceed current liabilities. Here it is in the form of the equation: Working Capital = Current Assets - Current Liabilities This formula is very similar to the current ratio. The only difference is that it gives you a dollar amount rather than a ratio. It too is calculated to determine a firm's ability to pay its short-term obligations. Working Capital can be viewed as somewhat of a security blanket. The greater the amount of Working Capital, the more security an investor can have that they will be able to meet their financial obligations. You have just learned about liquidity and the ratios used to measure this. Many times a company does not have enough liquidity. This is often the cause of being over leveraged.

Leverage
Leverage is a ratio that measures a company's capital structure. In other words, it measures how a company finances their assets. Do they rely strictly on equity? Or, do they use a combination of equity and debt? The answers to these questions are of great importance to investors.

Long-term Debt Leverage = ---------------------Total Equity A firm that finances its assets with a high percentage of debt is risking bankruptcy should it be unable to make its debt payments. This may happen if the economy of the business does not perform as well as expected. A firm with a lower percentage of debt has a bigger safety cushion should times turn bad. A related side effect of being highly leveraged is the unwillingness of lenders to provide more debt financing. In this case, a firm that finds itself in a jam may have to issue stock on unfavorable terms. All in all, being highly

leveraged is generally viewed as being disadvantageous due to the increased risk of bankruptcy, higher borrowing costs, and decreased financial flexibility. On the other hand, using debt financing has advantages. Stockholder's potential return on their investment is greater when a firm borrows more. Borrowing also has some tax advantages. The optimal capital structure for a company you invest in depends on which type of investor you are. A bondholder would prefer a company with very little debt financing because of the lower risk inherent in this type of capital structure. A stockholder would probably opt for a higher percentage of debt than the bondholder in a firm's capital structure. Yet, a company that is highly leveraged is also very risky for a stockholder. When a firm becomes over leveraged, bankruptcy can result. Read on to learn more about this dreaded occurrence.

Bankruptcy
Bankruptcy is a legal mechanism that allows creditors to assume control of a firm when it can no longer meet its financial obligations. Bankruptcy is a result feared by both stock and bond investors. Generally, the firm's assets are liquidated (sold) in order to pay off creditors to the extent that is possible. When bankruptcy occurs, stockholders of a corporation can only lose the amount they have invested in the bankrupt company. This is called Limited Liability. The stockholders' liability to creditors is limited to the amount invested. Therefore, if a firm's liabilities exceed the liquidation value of their assets, creditors also stand to lose money on their investments. When bankruptcy occurs, a federal court official steps in and handles the payments of assets to creditors. The remaining funds are always distributed to creditors in a certain pecking order: 1. 2. 3. 4. 5. 6. 7. Unpaid taxes to the IRS and bankruptcy court fees Unpaid wages Secured bondholders General creditors and unsecured bonds Subordinated debentures Preferred Stockholders Common Stockholders

Obviously, to hold secured bonds rather than unsecured bonds is more advantageous in the event of a bankruptcy. This is where you must examine your risk/reward requirements. As you move down this hierarchy, your risk of losing your investment increases. However, you are "rewarded" for taking more risk with potentially higher investment returns. How do you predict bankruptcy? Well, no one can do it perfectly. However, one popular method called a Zscore (developed by Edward Altman) has a good track record. To learn more about "Z-scores" go to your local library. We will recap a few of the most important points about learning to analyze a company's balance sheet.

Tying It All Together

Analyzing a balance sheet is fundamental knowledge for anyone who wishes to carefully select solid and profitable investments. The balance sheet is the basic report of a firm's possessions, debts and capital. The composition of these three items will vary dramatically from firm to firm. As an investor, you need to know how to examine and compare balance sheets of different companies in order to select the investment that meets your needs. After reading this section, you should have an understanding of liquidity, leverage and bankruptcy and know how to apply basic ratios to measure each. These ratios should be compared to other firms in the same industry in order for them to have relevance. Be careful, however, that the firms are not fundamentally different even if they are in the same industry.