Analysis of Balance Sheets | CFA Level I FSA

We’re diving into some techniques for analysing a balance sheet. Analyzing a company’s balance sheet can provide insight into the company’s liquidity and solvency, as well as the economic resources the company controls. We’ll examine the balance sheets for 2 hypothetical companies, Giant and Pixie, to help us with our analysis.

Liquidity and Solvency Ratios

One commonly used tool is to convert balance sheet figures into ratios. There are two main classes of balance sheet ratios:

• Liquidity Ratios: These measure the firm’s ability to satisfy its short-term obligations.
• Solvency Ratios: These measure the firm’s ability to satisfy its long-term obligations.

Liquidity Ratios

Liquidity ratios evaluate if the amount of liquid assets are sufficient to satisfy the short-term debt due within a year. Common liquidity ratios include:

• Current Ratio: Ratio of current assets to current liabilities.
• Quick Ratio: Ratio of cash plus marketable securities plus receivables, to current liabilities. Excludes inventory from the calculation.
• Cash Ratio: Cash plus marketable securities divided by current liabilities. Excludes both inventory and receivables from the calculation.

Solvency Ratios

Solvency ratios should be considered collectively to form a more accurate picture of a company’s solvency situation. Common solvency ratios include:

• Long-term Debt-to-Equity Ratio: Ratio of long-term debt to equity.
• Total Debt-to-Equity Ratio: Ratio of total debt to total equity.
• Debt Ratio: Ratio of total debt to total assets.
• Financial Leverage: Ratio of total assets to total equity.

Common-size Analysis

Common-size analysis can be prepared by expressing each item of the balance sheet as a percentage of total assets. This eliminates the size effect and allows for more effective comparison between companies.

Common-size analysis can also be used to examine a firm’s strategies. For example, a significant amount of goodwill might indicate growth through acquisitions, and a high percentage of liabilities could suggest that the firm is financing these acquisitions with debt.

There are two types of common-size analysis:

• Cross-sectional: Compares ratios across companies.
• Time-series: Compares ratios for the same company across different time periods, helping analysts identify trends over time.

That wraps up this topic on understanding balance sheets. We’ll move to understanding cash flow statements in the next lesson.