For investors, the balance sheet is an important financial statement that should be interpreted when considering an investment in a company. The balance sheet is a reflection of the assets owned and the liabilities owed by a company at a certain point in time. The strength of a company's balance sheet can be evaluated by three broad categories of investment-quality measurements: working capital, or short-term liquidity, asset performance, and capitalization structure. Capitalization structure is the amount of debt versus equity that a company has on its balance sheet.
- The strength of a company's balance sheet can be evaluated by three investment-quality measurements.
- The cash conversion cycle shows how efficiently a company manages its accounts receivable and inventory.
- The fixed asset turnover ratio measures how much revenue is generated from the use of a company's total assets.
- The return on assets ratio shows how well a company is using its assets to generate profit or net income.
The Cash Conversion Cycle (CCC)
The cash conversion cycle is a key indicator of the adequacy of a company's working capital position. Working capital is the difference between a company's current assets, such as cash and current liabilities, such as payables owed to suppliers for raw materials. Current assets and liabilities are short-term in nature, meaning they're usually on the books for less than one year.
The cash conversion cycle is an indicator of a company's ability to efficiently manage two of its most important assets–accounts receivable and inventory. Accounts receivable is the total money owed to a company by its customers for booked sales.
Components of the The Cash Conversion Cycle (CCC)
Days sales outstanding is the average number of days it takes a company to collect payment from their customers after a sale is made. The cash conversion cycle uses days sales outstanding to help determine whether the company is efficient at collecting from its clients.
The cash conversion cycle calculation also calculates how long it takes a company to pay its bills. Days payables outstanding represents the average number of days it takes a company to pay its suppliers and vendors.
The third component of the CCC includes how long inventory sits idle. Days inventory outstanding is the average number of days that inventory has been in stock before selling it.
Calculated in days, the CCC reflects the time required to collect on sales and the time it takes to turn over inventory. The cash conversion cycle calculation helps to determine how well a company is collecting and paying its short-term cash transactions. If a company is slow to collect on its receivables, for example, a cash shortfall could result and the company could have difficulty paying its bills and payables.
The shorter the cycle, the better. Cash is king, and smart managers know that fast-moving working capital is more profitable than unproductive working capital that is tied up in assets.
Formula and Calculation of the Cash Conversion Cycle
CCC=DIO+DSO−DPOwhere:DIO=Days inventory outstandingDSO=Days sales outstandingDPO=Days payables outstanding
- Obtain a company's days inventory outstanding and add the figure to the days sales outstanding.
- Take the result and subtract the company's days payables outstanding to arrive at the cash conversion cycle
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 CCC 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 must track the CCC over an extended period of time (for example, 5 to 10 years) and compare its performance to that of competitors. Consistency and decreases in the operating cycle are positive signals. Conversely, erratic collection times and an increase in on-hand inventory are typically negative investment-quality indicators.
5 Tips For Reading A Balance Sheet
The Fixed Asset Turnover Ratio
The fixed asset turnover ratio measures how much revenue is generated from the use of a company's total assets. Since assets can cost a significant amount of money, investors want to know how much revenue is being earned from those assets and whether they're being used efficiently.
Fixed assets, such as property, plant, and equipment (PP&E) are the physical assets that a company owns and are typically the largest component of total assets. Although the term fixed assets is typically considered a company's PP&E, the assets are also referred to as non-current assets, meaning they're long-term assets.
The amount of fixed assets a company owns is dependent, to a large degree, on its line of business. Some businesses are more capital intensive than others. Large capital equipment producers, such as farm equipment manufacturers, require a large amount of fixed-asset investment. Service companies and computer software producers need a relatively small amount of fixed assets. Mainstream manufacturers typically have 25% to 40% of their assets in PP&E. Accordingly, fixed asset turnover ratios will vary among different industries.
Formula and Calculation of the Fixed Asset Turnover Ratio
Fixed Asset Turnover=Average Fixed AssetsNet Sales
- Obtain net sales from the company's income statement.
- If necessary, net sales can be calculated by taking revenue–or gross sales–and subtracting returns and exchanges. Some industries use net sales since they have returned merchandise, such as clothing retail stores.
The fixed asset turnover ratio can tell investors how effectively a company's management is using its assets. The ratio is a measure of the productivity of a company's fixed assets with respect to generating revenue. The higher the number of times PP&E turns over, the more revenue or net sales a company's generating with those assets.
It's important for investors to compare the fixed asset turnover rates over several periods since companies will likely upgrade and add new equipment over time. Ideally, investors should look for improving turnover rates over multiple periods. Also, it's best to compare the turnover ratios with similar companies within the same industry.
The Return on Assets Ratio
Return on assets (ROA) is considered a profitability ratio, meaning it shows how much net income or profit is being earned from its total assets. However, ROA can also serve as a metric for determining the asset performance of a company.
As noted earlier, fixed assets require a significant amount of capital to buy and maintain. As a result, the ROA helps investors determine how well the company is using that capital investment to generate earnings. If a company's management team has invested poorly with its asset purchases, it'll show up in the ROA metric.
Also, if a company has not updated its assets, such as equipment upgrades, it'll result in a lower ROA when compared to similar companies that have upgraded their equipment or fixed assets. As a result, it's important to compare the ROA of companies in the same industry or with similar product offerings, such as automakers. Comparing the ROAs of a capital intensive company such as an auto manufacturer to a marketing firm that has few fixed assets would provide little insight as to which company would be a better investment.
Formula and Calculation of the Return on Assets Ratio
ROA=Average Total AssetsNet Income
- Locate net income on the company's income statement.
- In many ROA formulas, total assets or the ending period total assets figure is used in the denominator.
- However, if you want to use average total assets, add total assets from the beginning of the period to the ending period value of total assets and divide the result by two to calculate the average total assets.
- Divide net income by the total assets or average total assets to obtain the ROA.
- Please note that the above formula will yield a decimal, such as .10 for example. Multiply the result by 100 to move the decimal and convert it to a percentage, such as .10 * 100 = 10% ROA.
The reason that the ROA ratio is expressed as a percentage return is to allow a comparison in percentage terms of how much profit is generated from total assets. If a company has a 10% ROA, it generates 10 cents for every one dollar of profit or net income that's earned.
A high percentage return implies well-managed assets and here again, the ROA ratio is best employed as a comparative analysis of a company's own historical performance.
The Impact of Intangible Assets
Numerous non-physical assets are considered intangible assets, which are broadly categorized into three different types:
- Intellectual property (patents, copyrights, trademarks, brand names, etc.)
- Deferred charges (capitalized expenses)
- 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 in the financials.
The dollars involved in intellectual property and deferred charges are typically not material and, in most cases, do not warrant much analytical scrutiny. However, investors are encouraged to take a careful look at the amount of purchased goodwill on a company's balance sheet—an intangible asset that arises when an existing business is acquired. Some investment professionals are uncomfortable with a large amount of purchased goodwill. 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, investors use 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. For example, a moderately-leveraged balance sheet might be unappealing 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. However, investors need to look carefully at a relatively large amount of purchased goodwill on 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.
The Bottom Line
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 typically the four largest accounts on the asset side of a balance sheet. Therefore, 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 financial statements.