Analysis of a balance sheet provides information about a company’s liquidity (short-term financial position), and solvency (long-term capital structure). Tools used for balance sheet analysis include common-size balance sheet and balance sheet ratios.
Common-size analysis of the balance sheet
A vertical common-size balance sheet expresses each item on the balance sheet as a percentage of the total assets. It helps analysis of a company across time (time series analysis) and with its peer companies (cross-sectional analysis). Common-size balance sheet is a standardized balance sheet in that it takes out the effect of size on a company’s balance sheet. It can help with a preliminary analysis of a company’s capital structure and may provide insight into a company’s strategy. For example, a company with large PPE may have a strategy to produce in-house. Similarly, presence (or absence) of goodwill may show that the company has been aiming at growth through acquisitions (or organic growth).
Cross-sectional analysis of a balance sheet
In conducting a cross-sectional analysis, it is important to compare a company’s balance sheet with its peer companies because different industries have different asset concentration behavior. For example, utilities and telecommunication companies have the largest share of PPE in total assets and lowest inventories and receivables, financial companies have very high leverage (ratio of total liabilities to assets), inventories are highest in consumer discretionary sector, followed by materials and consumer staples, IT companies have the least amount of leverage, etc.
Balance sheet ratios
Balance sheet ratios are ratios involving only balance sheet items. Liquidity ratios focus on short-term financial position while solvency ratios are useful in long-term analysis.
Liquidity ratios include:
- Current ratio: calculated by dividing current assets by current liabilities.
- Quick (acid test) ratio: (cash + marketable securities + receivables) divided by current liabilities.
- Cash ratio: (cash + marketable securities) divided by current liabilities.
Solvency ratios include:
- Long-term debt to equity: total long-term debt divided by total equity.
- Debt to equity: total debt divided by total equity.
- Total debt: total debt divided by total assets.
- Financial leverage: total assets divided by total equity.
Limitations of ratio analysis
However, there are important limitations of cross-sectional ratio analysis. For example, different companies use different accounting policies and methods which reduces comparability. Similarly, many companies do not fit neatly into a single industry (in which case segment-wise ratio analysis is better).
Ratio analysis requires a significant amount of judgment, particularly in understanding the limitations of ratios. For example, the current ratio provides information about current assets relative to current liabilities, but it does not provide any additional details about the relative liquidity of the current assets themselves. Further, ratio analysis is more sensitive to end of period operating results and decision. Determining an appropriate benchmark for comparison of a company’s ratio also requires extensive research.
Which of the following ratios can be obtained directly from a common-size balance sheet?
- Total debt ratio
- Financial leverage ratio
- Debt to equity ratio
A is correct. A common-size balance sheet expresses each line item on a balance sheet as a proportion of total assets. Since total debt has total assets in the denominator, it can be obtained directly from a common-size balance sheet.