As a manager you can gain a significant amount of knowledge about an organization from understanding the financial information shown in a balance sheet, which can tell you:

● How much it owns—its assets.
● How much it owes—its liabilities
● How much equity owners have—its shareholder equity account

If you were investigating Fred’s Factory you would be able to see that their total assets are $370,000 and their total liabilities are $309,000, with $61,000 shareholder equity. In addition to these figures, you will usually want to gain an appreciation of an organization’s liquidity and solvency, as well as how its tangible assets compare to its intangible ones.

From the balance sheet you would also be able to perform a common-size analysis, which expresses the figures as percentages to reveal how efficiently the organization is being
managed. There are also a variety of financial ratios you can calculate that enable you to assess how well an organization is managing its inventory and receivables.

Liquidity and Solvency

A key part of your investigation into any organization is to gain understanding of:

● Liquidity—the organization’s ability to meet its short-term obligations. This includes such items as how much working capital it requires and its debt obligations.

● Solvency—the ability of an organization to sustain its activities into the future.

If you wish to assess an organization’s liquidity you would use the ‘Current Ratio,’ which assesses the relationship of its current assets to its current liabilities as defined in the previous sections.

Financial institutions usual require a small organization to have a 2:1 current ratio, but it does depend on the industry sector in question. For instance, a traditional industrial manufacturer will have a lower liquidity ratio than a small retailer.

This 2:1 ratio means that there are twice as many current assets as liabilities. If we look at Fred’s Factory his current ratio would be 3:1 and although this represents a good liquidity ratio at first sight you would need to compare to their industry sector before you draw any firm conclusions.

There is one aspect of the current ratio some analysts are not happy to include in assessing an organization’s liquidity and that is ‘inventory.’ This is because it is difficult to turn inventory into cash. For this reason analysts prefer to use what is known as the ‘quick ratio’ to measure liquidity.

If you choose to use the quick ratio you would calculate the current assets that are judged to be the easiest to turn into cash (for example, cash on hand, marketable securities, and receivables), which you then divide by current liabilities.

As before, being mindful of the industry your organization operates in is essential, as many sectors can more easily than others turn stock into cash. For example, a sector
such as retail can collect its receivables more easily than other industries.

The quick ratio for Fred’s Factory shows a reduced liquidity ratio because nearly a third of their current assets are accounted for by stock ($44,000).

When you want to assess an organization’s solvency you want to see an element of balance between its total debt and the equity used to capitalize it. This shows how well the
organization is able to sustain its activities for an extended period in the future.

The element of ‘balance’ will vary between different industries as some (for example banks) use debt to finance their activities, whereas a service company is more likely to
finance its growth through equity

Tangible Versus Intangible Assets

The next aspect of the balance sheet you need to assess is the ability an organization has to liquidate an asset. This is achieved by looking at whether or not assets are tangible or intangible.

The definitions of these different types of assets are:

● Tangible assets are items that are physical in nature and include cash, inventory, buildings, equipment, and accounts receivable.

● Intangible assets are items like patents and trademarks.

In the case of intangible assets you need to take great care as to how you assign a value to them. When one of an organization’s key activities is acquiring other organizations
there is likely to be considerable ‘goodwill’ listed on the balance sheet as an asset. This is classified as an intangible asset because if the organization needs access to funds quickly they cannot cash in this goodwill. During the negotiations, if the expected outcome is not attained the buying organization will have to write down the goodwill.
In the case of Fred’s Factory, the majority of their assets are tangible beca use there is no listing of any patents or trademarks. This means that if Fred’s needed to they could easily liquidate assets.

There is another key aspect you must look at within the balance sheet when assessing an organization and that is what is referred to as ‘other comprehensive income.’ This item is recorded in shareholders’ equity and results from any income or losses that occur as part of foreign currency conversions.

Due to the nature of such items they are not included in an organization’s income statement. Such income occurs where organizations earn revenue in one currency, such as
the yen, but never actually convert it to dollars. In terms of assets, whilst the item may show significant sums of money it cannot be relied upon in the event of liquidation, as it may never be realized.

Key Points

* An organization’s balance sheet allows you to determine its liquidity and solvency as well as the ratios of its tangible and intangible assets.
* You can also use it to determine key ratios like the current ratio and the quick ratio.
* Assessing the ability of an organization to liquidate its tangible assets will give you an idea of how well it could deal with a liquidity problem.

Performing a Common-Size Analysis

In the same way that breaking an income statement down into percentages (by dividing each item by revenues) is informative, it is equally revealing for a balance sheet. Performing a common-size analysis on a balance sheet can be done in one of two ways:

● Vertical common-size analysis

● Horizontal common-size analysis

When using a vertical common-size analysis, you express inventory, liabilities, and equity as a percentage of total assets. In the case of Fred’s Factory its inventory of $44,000 is nearly 12% of its total assets of $370,000.

To fully appreciate the ability of an organization’s management, such figures need to be compared to those of the two or three previous years to gain some insight from changes
that occur over this period.
For example,

If you know that Fred’s inventory this last year was 12% of total assets but that this figure was only 10% in previous years, then you would be able to say that their inventory is growing faster than their total assets.

You could then look into this particular area to discover why this is the case. You may prefer to perform a horizontal common-size analysis as this compares the change year on year for each item of both the income statement and the balance sheet. This enables you to look at how an item has changed relative to the change in total assets
and revenue.

The table below gives you some additional figures so that you can see how Fred’s inventory has changed when using this method.

From this, you can see that revenue has grown by 33%, while assets have only grown by 6%, although inventory increased by 22%. You would need to carry out further investigations to be able to discern the reasons why both revenue and inventory have grown so much whilst assets are relatively stable.

You would also want to determine what the long-term impact of this pattern could be if it continued. It may indicate that Fred’s need to watch their earnings quality or that
they may be in danger of overstating inventory or building it up too much. Whatever the reason, the balance sheet has highlighted this as a potential area of inefficiency that will need to be addressed.

Another key area to watch closely is receivables. If your calculations show that they are increasing faster than revenue, this may indicate that Fred’s Factory has a problem with collections. You would want to understand the management’s attitude to increasing its allowance for doubtful accounts, because if receivables are increasing faster than revenue Fred’s may need to change to a faster pace in this area.

Other Key Ratios

Earnings quality is only one of many ratios you can use to assess the ability of an organization’s management. You can also judge how well an organization is managing its
inventory and receivables.

A few important ratios you may wish to use as part of your assessment of an organization are:

● Inventory turnover = cost of goods sold ÷ average inventories
● Receivables turnover = sales ÷ average accounts receivable
● Total asset turnover = sales ÷ average total assets

Key Points

* Performing a common-size analysis on a balance sheet can be done either horizontally or vertically.

* A vertical common-size analysis expresses inventory, liabilities, and equity as a percentage of total assets.

* A horizontal common-size analysis compares the change year on year for each item of the balance sheet enabling you to look at how an item has changed relative to total assets.