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How To Evaluate A Company's Balance Sheet

2011-07-29 09:10:16

For stock investors, the balance sheet is an important consideration for

investing in a company because it is a reflection of what the company owns and

owes. The strength of a company's balance sheet can be evaluated by three broad

categories of investment-quality measurements: working capital adequacy, asset

performance and capitalization structure.

Tutorial: Financial Statement AnalysisIn this article, we'll look at four

evaluative perspectives on a company's asset performance: (1) the cash

conversion cycle, (2) the fixed asset turnover ratio, (3) the return on assets

ratio and (4) the impact of intangible assets.

The Cash Conversion Cycle (CCC)

The cash conversion cycle is a key indicator of the adequacy of a company's

working capital position. In addition, the CCC is equally important as the

measurement of a company's ability to efficiently manage two of its most

important assets - accounts receivable and inventory.

Calculated in days, the CCC reflects the time required to collect on sales and

the time it takes to turn over inventory. The shorter this cycle is, the

better. Cash is king, and smart managers know that fast-moving working capital

is more profitable than tying up unproductive working capital in assets.

CCC = DIO + DSO DPO

DIO - Days Inventory Outstanding

DSO - Days Sales Outstanding

DPO - Days Payable Outstanding

There is no single optimal metric for the CCC, which is also referred to as a

company's operating cycle. As a rule, a company's cash conversion cycle will be

influenced heavily by the type of product or service it provides and industry

characteristics.

Investors looking for investment quality in this area of a company's balance

sheet need to track the CCC over an extended period of time (for example, five

to 10 years), and compare its performance to that of competitors. Consistency

and/or decreases in the operating cycle are positive signals. Conversely,

erratic collection times and/or an increase in inventory on hand are generally

not positive investment-quality indicators. (To read more on CCC, see

Understanding the Cash Conversion Cycle and Using The Cash Conversion Cycle.)

The Fixed Asset Turnover Ratio

Property, plant and equipment (PP&E), or fixed assets, is another of the "big"

numbers in a company's balance sheet. In fact, it often represents the single

largest component of a company's total assets. Readers should note that the

term fixed assets is the financial professional's shorthand for PP&E, although

investment literature sometimes refers to a company's total non-current assets

as its fixed assets.

A company's investment in fixed assets is dependent, to a large degree, on its

line of business. Some businesses are more capital intensive than others.

Natural resource and large capital equipment producers require a large amount

of fixed-asset investment. Service companies and computer software producers

need a relatively small amount of fixed assets. Mainstream manufacturers

generally have around 30-40% of their assets in PP&E. Accordingly, fixed asset

turnover ratios will vary among different industries.

The fixed asset turnover ratio is calculated as:

Fixed Asset Turnover Ratio = Net Sales / Average Fixed Assets

Average fixed assets can be calculated by dividing the year-end PP&E of two

fiscal periods (ex. 2004 and 2005 PP&E divided by two).

This fixed asset turnover ratio indicator, looked at over time and compared to

that of competitors, gives the investor an idea of how effectively a company's

management is using this large and important asset. It is a rough measure of

the productivity of a company's fixed assets with respect to generating sales.

The higher the number of times PP&E turns over, the better. Obviously,

investors should look for consistency or increasing fixed asset turnover rates

as positive balance sheet investment qualities.

The Return on Assets Ratio

Return on assets (ROA) is considered to be a profitability ratio - it shows how

much a company is earning on its total assets. Nevertheless, it is worthwhile

to view the ROA ratio as an indicator of asset performance.

The ROA ratio (percentage) is calculated as:

ROA = Net Income / Average Total Assets

Average total assets can be calculated by dividing the year-end total assets of

two fiscal periods (ex 2004 and 2005 PP&E divided by 2).

The ROA ratio is expressed as a percentage return by comparing net income, the

bottom line of the statement of income, to average total assets. A high

percentage return implies well-managed assets. Here again, the ROA ratio is

best employed as a comparative analysis of a company's own historical

performance and with companies in a similar line of business.

The Impact of Intangible Assets

Numerous non-physical assets are considered intangible assets, which can

essentially be categorized into three different types: intellectual property

(patents, copyrights, trademarks, brand names, etc.), deferred charges

(capitalized expenses) and purchased goodwill (the cost of an investment in

excess of book value).

Unfortunately, there is little uniformity in balance sheet presentations for

intangible assets or the terminology used in the account captions. Often,

intangibles are buried in other assets and only disclosed in a note to the

financials.

The dollars involved in intellectual property and deferred charges are

generally not material and, in most cases, don't warrant much analytical

scrutiny. However, investors are encouraged to take a careful look at the

amount of purchased goodwill in a company's balance sheet because some

investment professionals are uncomfortable with a large amount of purchased

goodwill. Today's acquired "beauty" sometimes turns into tomorrow's "beast".

Only time will tell if the acquisition price paid by the acquiring company was

really fair value. The return to the acquiring company will be realized only

if, in the future, it is able to turn the acquisition into positive earnings.

Conservative analysts will deduct the amount of purchased goodwill from

shareholders equity to arrive at a company's tangible net worth. In the absence

of any precise analytical measurement to make a judgment on the impact of this

deduction, try using plain common sense. If the deduction of purchased goodwill

has a material negative impact on a company's equity position, it should be a

matter of concern to investors. For example, a moderately leveraged balance

sheet might look really ugly if its debt liabilities are seriously in excess of

its tangible equity position.

Companies acquire other companies, so purchased goodwill is a fact of life in

financial accounting. Investors, however, need to look carefully at a

relatively large amount of purchased goodwill in a balance sheet. The impact of

this account on the investment quality of a balance sheet needs to be judged in

terms of its comparative size to shareholders' equity and the company's success

rate with acquisitions. This truly is a judgment call, but one that needs to be

considered thoughtfully.

Conclusion

Assets represent items of value that a company owns, has in its possession or

is due. Of the various types of items a company owns; receivables, inventory,

PP&E and intangibles are generally the four largest accounts in the asset side

of a balance sheet. As a consequence, a strong balance sheet is built on the

efficient management of these major asset types and a strong portfolio is built

on knowing how to read and analyze financials statements.

To learn more about reading balance sheets, see Breaking Down The Balance

Sheet, Reading The Balance Sheet and What You Need To Know About Financial

Statements.

by Richard Loth

Richard Loth has more than three decades of international experience in banking

(Citibank, Industrial National Bank, and Bank of Montreal), corporate financial

consulting, and non-profit development assistance programs. During the past 12

years, he has been a registered investment adviser and a published author of

books and publications on investing. Currently, he devotes his professional

activities to educational endeavors, writing and lecturing, aimed at helping

individual investors improve their investing know-how (see http://