Financial reporting and analysis:

05/10/2024
Chapter 3:

Balance Sheet:
The balance sheet shows the financial condition of an accounting entity as of a particular
date. It is the most basic financial statement, and it is read by various users as part of their
decision-making process.
1. Understand the Balance Sheet Structure
• Assets: Resources owned by the company (e.g., cash, inventory, property).
o Current Assets: Expected to be converted to cash within a year (e.g., cash,
accounts receivable, inventory).
o Non-Current Assets: Long-term investments (e.g., property, plant, equipment,
intangible assets).
• Liabilities: Obligations the company owes (e.g., loans, accounts payable).
o Current Liabilities: Due within a year (e.g., short-term debt, accounts payable).
o Non-Current Liabilities: Long-term obligations (e.g., long-term debt, deferred tax
liabilities).
• Shareholders’ Equity: The residual interest in the assets after deducting liabilities (e.g.,
common stock, retained earnings).
2. Assess Liquidity
• Current Ratio: Current Assets / Current Liabilities
o Measures the company’s ability to pay short-term obligations.
o Ideal Ratio: Typically between 1.5 and 2, but varies by industry.
• Quick Ratio: (Current Assets - Inventory) / Current Liabilities
o Evaluates the ability to meet short-term obligations without relying on inventory.
o Ideal Ratio: Generally above 1.

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3. Evaluate Solvency
• Debt-to-Equity Ratio: Total Liabilities / Shareholders’ Equity
o Indicates the proportion of company financing that comes from creditors and
investors.
o Ideal Ratio: Varies by industry; lower ratios suggest less risk.
• Interest Coverage Ratio: EBIT1 / Interest Expenses
o Assesses the ability to pay interest on outstanding debt.
o Ideal Ratio: Higher values indicate better coverage.
4. Analyze Asset Management Efficiency
• Inventory Turnover: Cost of Goods Sold / Average Inventory
o Shows how efficiently inventory is managed.
o Higher Turnover: Indicates strong sales or efficient inventory management.
• Accounts Receivable Turnover2: Net Credit Sales3 / Average Accounts Receivable
o Measures how effectively the company collects receivables.
o Higher Turnover: Better collection efficiency.
• Total Asset Turnover: Net Sales / Average Total Assets
o Evaluates how efficiently assets generate sales.
5. Examine Profitability Indicators
• Return on Assets (ROA): Net Income / Average Total Assets
o Indicates how effectively assets generate profit.
• Return on Equity (ROE): Net Income / Average Shareholders’ Equity
o Measures the return generated on shareholders’ investments.

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EBIT means earnings before interest and taxes
.‫ معدل دوران احلساابت املدينة‬2
‫ متوسط حساابت املديني‬/)‫ متوسط املبيعات اآلجلة (االئتمانية‬3
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6. Benchmark Against Industry Standards ‫املقارنة مبعايري الصناعة‬
• Compare Ratios and Metrics: Assess how the company stands relative to its peers.
• Identify Strengths and Weaknesses: Highlight areas where the company outperforms
or underperforms the industry.
7. Review Notes and Disclosures
• Understand Accounting Policies: Gain insights into how financial figures are
calculated.
• Identify Contingent Liabilities: Recognize potential risks not evident in the primary
balance sheet.
8. Evaluate Capital Structure
• Assess Mix of Debt and Equity: Determine the balance between financing through debt
versus equity.
• Consider Cost of Capital: Understand how the chosen structure affects the company’s
cost of capital and financial flexibility.
9. Look for Red Flags
• Negative Equity: Indicates that liabilities exceed assets.
• Declining Cash Reserves: May signal liquidity issues.
• High Debt Levels: Could lead to solvency problems if not managed properly.
10. Integrate with Other Financial Statements
• Link with Income Statement: Correlate profitability with balance sheet items.
• Connect with Cash Flow Statement: Understand how cash is generated and used.
Practical Tips:
• Consider the Industry Context: Different industries have varying norms for financial
metrics.
• Stay Updated on Accounting Standards: Changes in accounting policies can impact
how items are reported.
Example Workflow:
1. Start with Liquidity: Ensure the company can meet its short-term obligations.
2. Move to Solvency: Assess long-term financial stability and debt levels.
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 3. Evaluate Efficiency: Look at how well the company manages its assets and operations.
4. Analyze Profitability: Determine how effectively the company generates profit from its
resources.
5. Compare and Benchmark: Place the company’s performance in the context of
historical data and industry standards.
6. Review Comprehensive Notes: Gain a complete understanding by considering all
disclosures and notes.
By systematically applying these steps, you can perform a thorough and effective analysis of a
balance sheet, gaining valuable insights into a company's financial health and operational
efficiency.

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Example:
ABC Manufacturing Co.
Step 1: Present the Balance Sheet
Here’s the simplified balance sheet for ABC Manufacturing Co. as of December 31, 2023:
ABC Manufacturing Co. Balance Sheet

Assets $ Liabilities & Equity $

Current Assets Current Liabilities

Cash 50,000 Accounts Payable 40,000

Accounts Receivable 30,000 Short-Term Debt 20,000

Inventory 20,000 Total Current Liabilities 60,000

Total Current Assets 100,000

Non-Current Assets Non-Current Liabilities

Property, Plant & Equipment 150,000 Long-Term Debt 80,000

Intangible Assets 30,000 Total Non-Current Liabilities 80,000

Total Non-Current Assets 180,000

Total Assets 280,000 Total Liabilities 140,000

Shareholders’ Equity

Common Stock 50,000

Retained Earnings 90,000

Total Shareholders’ Equity 140,000

Total Liabilities & Equity 280,000

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Step 2: Calculate Key Financial Ratios
We’ll calculate several important ratios to assess liquidity, solvency, efficiency, and
profitability.
a. Liquidity Ratios
1. Current Ratio

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c. Efficiency Ratios

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 1. Return on Equity (ROE)

o Interpretation: An ROE of 28.57% signifies that the company is generating a

strong return on shareholders’ investments, which is attractive to investors.
Step 3: Perform Trend Analysis
Assume we have the previous year's (2022) balance sheet with the following key figures:
• Total Current Assets: $90,000
• Total Current Liabilities: $55,000
• Total Assets: $260,000
• Total Liabilities: $130,000
• Shareholders’ Equity: $130,000
• Net Income: $35,000
Trend Analysis Observations:
1. Current Ratio Improvement: Increased from 1.64 (90,000 / 55,000) in 2022 to 1.67 in
2023.
2. Debt-to-Equity Ratio Stable: Remained at 1.0 (130,000 / 130,000) both years.
3. ROE Increased: Rose from 26.92% (35,000 / 130,000) to 28.57%.
4. Total Assets Growth: Increased by $20,000 (from 260,000 to 280,000).
5. Net Income Growth: Increased by $5,000 (from 35,000 to 40,000).
Interpretation:
• Liquidity: Slight improvement in the current ratio suggests enhanced short-term
financial stability.
• Leverage: Consistent debt-to-equity ratio indicates stable financing structure.
• Profitability: Increase in ROE and net income reflects improved profitability and
efficient use of equity.
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 • Asset Growth: Growth in total assets alongside increased net income suggests that asset
expansion is contributing positively to profitability.
Conclusion
Through this practical analysis of ABC Manufacturing Co.’s balance sheet, we’ve determined
that the company is in a strong financial position with good liquidity, manageable leverage,
and robust profitability. Trend analysis shows improvement over the previous year, and
benchmarking against industry standards highlights ABC’s competitive advantage. However,
attention should be given to contingent liabilities and future capital expenditures to maintain
financial stability.
By following this structured approach, you can effectively analyze any company’s balance
sheet to assess its financial health and make informed decisions.