Introduction –

Balance sheet analysis is a powerful process to sustain the financial strength and soundness of a business. By appropriately and effectively reviewing the balance sheet of a business, stakeholders can gain an overall understanding of the firm‘s liquidity and operating efficiency. The procedure is to analyze the solvency, liquidity, asset management, and profitability of the firm. This process of balance sheet evaluation is the sole task of an expert financial analyst. In this article, we will look into the definition of a balance sheet, key components, steps for analysis, limitations, and some tips for effective evaluation.

 

Definition and Key Points –

• The balance sheet analysis is a process to analyze the firm‘s financial position effectively through an effective examination of its balance sheet. Among the most basic financial statements is the company’s balance sheet. Two other types of financial statements used in business evaluation are the income statement and cash flow statement. All essential information regarding shareholder equity, assets, and liabilities of the company is found in a balance sheet.
• As the name suggests, a balance sheet should balance out where all the liabilities and equity of the shareholder or owner should be equal to the total assets. The value of liabilities and assets are split into short-term and long-term, while equity is the value remaining when the liabilities are removed from the assets.
• The potential investors, business managers, creditors, and shareholders of a firm will look into balance sheets to analyze the company‘s financial position at a specific point in time and make informed decisions accordingly. It is important to know how to read a balance sheet, understand its structure, and how to analyze it.
• The balance sheet evaluation is done using key financial metrics like debt-to-equity ratio, current ratio, and return on equity. They are used for assessing an organization’s ability to achieve short-term goals or financial obligations, generate profits from its assets, and manage the levels of debts incurred in the company. By analyzing these components, the stakeholders can make informed decisions about the company’s strategic direction.
• Some of the long-term liabilities recorded by a business firm include payable bonds and bank loans. Liabilities such as payable bonds are usually presented and recognized at an amount to pay off in a balance sheet. The owner‘s or shareholder‘s equity section in a balance sheet includes preferred shares, comprehensive income, capital, treasury shares, non-controlling interest, and retained earnings. The balance sheet ratios are solvency and liquidity ratios.
• It is analyzed by many stakeholders related to the company, which includes its creditors, financial analysts, the company‘s management, and the investors. These analyze to inform them of any decision regarding investing in the firm or not and for the purpose of lending money. Financial analysts make analyses to guide their client firms with strategic planning, insights, and recommendations on matters affecting it. The company management team analyzes the balance sheet to track and monitor the company‘s position in terms of finance within the industry. Proper decisions will guide them with suitable strategies and enables strategic financial planning for further growth and stability.
• The company has plenty of advantages which it would derive by evaluating its balance sheets.
  This analysis of balance sheets will provide the information required in determining financial risks. Businesses will then be able to assess the amount of money they are in debt or liability, the number of assets that they own, and whether they have adequate assets or funds to meet the financial requirements for running the business.
  Another significant benefit is that the business can secure capital or private equity funds. The money lenders or investors will look at the balance sheets and analyze them to know the financial health of the company if they are eligible to repay these debts, and measure their reliability and creditworthiness.
• An efficient balance sheet analysis will enable financial managers to devise strategies to improve the financial health of a company. Also, it will retain and attract talented employees to the company. Employees can know whether their company is in a good financial position or not.

Components Included in a Balance Sheet –

• One of the significant elements included in the balance sheet is assets. It is defined as the resources that are owned by an organization. These assets are expected to enable future benefits for the company. There are two types of assets – non-current assets and current assets. Non-current assets are long-term investments, long-term assets, property, immaterial assets, industrial plants, and equipment. The current assets are the cash and other material assets that can be converted into cash in a period of one year. It includes inventory, short-term investments, and accounts receivable.
• The next component in a balance sheet is the owner’s or shareholder’s equity. It is the remaining interest of the assets of a business after reducing the liabilities incurred by the company. The common stock denotes the equity stake of the typical shareholders in the company. While the retained earnings are the collective earnings of a company which have been kept aside for the reinvestment or paying off the debts incurred by the company.
• Lastly, liabilities are another component of a balance sheet. It is referred to as the financial obligations that the company owes to another entity or outside parties. These parties can be money lenders, creditors, banks, and other stakeholders. The non-current liabilities are long-term obligations and financial debts that are mostly due for more than a year. Bond payable and other long-term leases are typical examples under this category. Current liabilities are mostly listed as the obligations or debts that are due within a year. Major current liabilities are the short-term loans, accrued expenses, and accounts payable.

How to Perform Balance Sheet Evaluation – 

With an appropriate balance sheet analysis, you will be able to understand the financial position of a business firm and make efficient and informed decisions for its development and sustainable growth. The section below elaborates on the steps involved in the analysis of a company’s balance sheet.

• The first step in the evaluation process is getting a proper understanding of the structure of the balance sheet. A balance sheet has equity, assets, and liabilities as its main components. The balance sheet records both current assets (cash, inventory, and accounts receivable that can be converted into cash in one year) and non-current assets (equipment, property, and long-term investments). Shareholder’s equity includes both common stock and retained earnings (which is meant to pay off debts or for reinvestment purposes). Lastly, liabilities have both current liabilities (accounts payable and short-term loans that are due in one year) and non-current liabilities (long-term debts that are due beyond a year).

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• The second step is the assessment of the company’s liquidity. Liquidity calculates the ability of a company to achieve its short-term financial obligations. It is measured using 2 major key metrics – current ratio (calculation of current assets divided by current liabilities) and quick ratio (measurement of ‘current assets minus inventory’ divided by current liabilities. A current ratio above 1 value represents good liquidity.
• Next is the evaluation of the company’s solvency. It measures the company’s capability to meet long-term financial obligations. It includes both debt-to-equity ratios and interest coverage ratios. The debt-to-equity ratio is the total liabilities divided by the shareholder’s equity. A lower value in this ratio shows a less risky structure of finance. The interest coverage ratio is the measurement of EBIT (earnings before interest and taxes) divided by the interest expense. This ratio’s value shows the capacity of a company to cover its interest payments.

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• Analyzing the asset management is the next process. It evaluates how efficiently a company can utilize its assets. It calculates two major ratios – receivables turnover ratio and inventory turnover ratio. The receivables turnover ratio is the value of net credit sales divided by the average account receivable. It shows the effectiveness of a company’s receivables assets. The inventory turnover ratios are the value of the cost of sold goods divided by the inventory average value. A higher ratio indicates that the company has efficient inventory management.
• This step examines the profitability of a company. It is the measurement of the company’s ability to make profit returns from its valuable assets. The major components are return on assets (ROA equals net income divided by the total asset’s average value) and return on equity (ROE – value of net income divided by average value of shareholder’s equity). ROA indicates the profitability relative to the total assets owned by the company, while ROE shows the returns generated by the equity of shareholders.
• The next procedure in balance sheet analysis is the comparison over a period of time. Evaluating balance sheets over multiple time periods enables companies to identify the patterns, trends, and areas where they can bring improvements or corrections/revisions.
• It is a significant step in the balance sheet evaluation to compare the company’s measured ratios with the industrial benchmarks. This benchmarking process against the industry averages will provide highlights and clear contexts regarding the company’s weaknesses and strengths. 
• Lastly, make sure to consider all the qualitative factors for the analysis. The qualitative factors can be the business model of the company, its competitive position, and relative economic conditions. These factors will have an impact on the company’s financial health and therefore, they must be considered along with the analysis of quantitative factors.

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Limitations or Challenges in Evaluation of a Balance Sheet  – 

It is clear that balance sheet evaluation is a vital tool to understand the financial health of the company. However, just like any other analysis, this evaluation of a company’s balance sheet also comes with several challenges. With proper awareness and critical thinking, expert analysts will be able to mitigate these risks and challenges to the best of their ability. 

• The quality and transparency of the financial reporting will differ in various companies. Poor quality financial reporting can lead to incorrect evaluations. Another challenge is the short-term focus of the balance sheet. It only provides the analysis for a specific point in time, which might not show you data about the long-term company financials. 
• There will be several factors like economic downturns, changes in interest rates, and market volatility that will have unpredictable impacts on the balance sheet. In order to avoid any potentially misleading results, it is better to include these factors in your balance sheet evaluation process. Along with these external factors, several international there may be currency fluctuations that affect the value of liabilities and assets.
• There may be problems with the valuation of assets in the historical cost versus fair value and intangible assets. The estimations and assumptions taken for depreciation, allowances, and amortization may lead to bias and affect the accuracy of the analysis. Another major challenge is the changing accounting standards that may affect the reporting of certain items. It is difficult to benchmark the performance with other companies since different companies follow different accounting practices, financial reporting standards, and industry norms. 

Effective Tips for Evaluation of a Balance Sheet –

• The basic and best practice is to ensure that your balance sheet matches and adds up. Ensure you do not miss any financial data in your balance sheet and recalculate all the numbers to ensure the accuracy of the information.
• One of the practical tips for an effective balance sheet analysis is the comparison over time. It is a best practice to analyze the balance sheets over multiple periods of time. This can reveal several recurring trends and patterns in the financials of a company. It will identify the areas in the business where you can implement financial improvements and adjustments to enhance the performance of the business.
• Consider alternative ways to acquire major assets and resources. A big purchase of inventory may impact the balance sheet numbers as it will lead to a decrease in the working capital amount. 
• It is a best practice to do the calculations on separate schedules rather than doing it in the balance sheet itself. You will need separate schedules for debt, equity, working capital, and depreciation. It is also advisable to use the built-in error checks.
• To measure future financial assets, the key aspect used is the working capital. Assessment of working capital shows you how many short-term resources will be left over after meeting short-term liabilities. You can also use it as a priority for increasing the value of assets and decreasing the company’s liabilities. 
• It is always better to look up to the major accounts receivables. Of course, there may be delays in getting the accounts receivable money back to your business, but make sure not to drag too much. At the least, you can make frequent reminder communications with those who owe you money and revise the payment plans that best suit you.

Conclusion –

A balance sheet which is also known as the statement of a company’s financial position shows what an organization owns and owes at a particular point in time i.e. their assets and liabilities for a specific time period. A proper understanding of a balance sheet structure and aspects will allow an analyst to evaluate a company’s financial position, solvency, asset management, profitability, and liquidity. An expert financial analyst will be able to perform an accurate and efficient analysis of balance sheets. In short, the process of balance sheet analysis has a vital role in maintaining the financial position and making informed decisions for a company.

FAQs-

1. Why is the analysis of balance sheet so important?

Balance sheet analysis is very crucial in the assessment of a company’s financial position in the industry. It evaluates the solvency, operational efficiency, and liquidity of the company. It also assists the management personnel, investors, and creditors in making well-informed decisions regarding the company’s financial stability and future aspects.

2. What are the financial ratios or financial metrics used in the balance sheet evaluation?

The evaluation process of a balance sheet involves analyzing and calculating several key financial ratios and metrics. Major ones are current ratios, debt-to-equity ratios, quick ratios, interest coverage ratios, return on equity (ROE), and return on assets (ROA).

3. What do you mean by solvency and how is it calculated?

• Solvency is a company’s ability to achieve its long-term financial obligations and maintain business operations over a longer period of time. It shows if a company has enough resources and assets to cover all its liabilities, even the long-term debts. The measurement of this key aspect – solvency is very crucial in estimating the prevailing financial stability of a company. It reflects the firm’s capacity to uphold financial stress and continue its business functions without any financial hindrances.
• The solvency of a company is evaluated using financial ratios like the debt-to-equity ratio and the interest coverage ratio. Lower levels of debt and higher levels of interest coverage show that the company has better solvency.

4. How can you identify financial trends with a balance sheet analysis?

Financial trends can be identified by approximating the balance sheets over multiple periods. You can take the balance sheet from previous years to compare them and find any potential patterns or trends. It will reveal trends in liability management, changes in shareholder’s equity, and growth in assets. These revealed patterns or trends will enable you to identify the areas in business where you can implement improvements and restructuring. It will also show the areas of concerts that represent any potential issues or risks in the business financials.

5. How will the external factors influence the balance sheet analysis?

Certain external factors have a significant impact on the results of your business’s balance sheet evaluation. The external factors can be market conditions, interest rates, and economic conditions. Financial analysts would consider these factors external factors in providing a more accurate and transparent financial assessment of the company’s financial position.