The analysis of a balance sheet provides indicators of the financial strength of a company. In combination with numbers from the P & L and the cashflow statement it is also needed to provide a number of other measures of financial strength, profitability and performance.
Financial strength and stability
The most important metrics to be derived from the balance sheet are basic measures of financial strength and stability. These tell you what resources a company has to pay its debts. For most companies you should start with gearing (leverage in the US) and either the current assets ratio or the quick assets ratio. Which of the latter you consider more important depends on how saleable you consider a company's stocks (inventory). If there is doubt about the ability to shift stock and generate money from it in the short term, then you should use the quick assets ratio, which excludes that doubtful element of the current assets.
It is worth considering whether there are any adjustments you need to make to the balance sheet numbers. For example, you may wish to deduct goodwill from the assets, or add back off balance sheet liabilities. Being able to do the latter is one reason why you need to have read the note by the time you start serious analysis.
Also cautious about applying rule of thumb levels of what a ratio should be. They give you a rough idea of what constitutes a high or low leve, but you need to take into account the stability of the business: a business with very safe and predictable sales may be able to sustain a very low current assets ratio without being particularly risky as a result.
It is also possible for economically similar situations to lead to very different balance sheets. For example, a sale and leaseback of assets may make a balance sheet look very different from buying the same assets with borrowed money (depending on what IFRSs say this week), but the underlying reality of being able to use an asset to generate cash, and paying interest on the money used to buy it is the same.
The ratios discussed so far are purely balance sheet numbers, and investors primary interest in them lies in what the latest numbers are, rather than in looking at trends. There are also some ratios that combine balance sheet numbers with those from other accounting statements. An increase in, or a high level, of creditor days may be an indication that a company is finding it difficult to pay its suppliers (it may also reflect better credit terms, so look at the details). Similarly, an increase in Debtor days may be an indication that customers are finding harder to pay on time, or that the company is being forced to offer more credit to make sales. In both cases look at both levels compared to industry norms and for any worsening trend.
Equally important are the measures of financial strength based on cashflow and P & L measures. These are sometimes combined with balance sheet based measures to calculate more complex measures such as Piotroski's F-score and Altman's Z-score
Performance measures
Most measures of how well a company is performing are either based on profits and cashflow, or only use balance sheet numbers are a denominator to normalise what are primarily measures of profits of cash flow. Working capital is useful by itself when looking at trends (i.e asking whether working capital is being managed more or less efficiently than in the past) but is most useful relative to sales as that also allows inter-company comparisons, and comparisons over periods in which sales have changed significantly.
The remaining performance measures with a balance sheet element can be grouped into turnover measures (asset turnover, fixed asset turnover and stock turnover), that measure sales generated by assets, and profit measures (RoE, RoI, ROIC, CROIC, and various variants of these) that measure a profit or cashflow number relative to the assets used to generate it.
Valuation
Balance sheet based valuation usually of much less importance than valuation based on profit and cash flow measures. This is for a very good reason: the value of a security comes from the cash flows it can generate for investors (e.g. dividends). Profits and cash flows are much better indicators of what payments shareholders can expect than balance sheet numbers. The most important exceptions to this are businesses in which the value of a company lies wholly or in its assets (investment trusts, property and mining, for example) and for some value investors, especially extreme value strategies.
A purely balance sheet based valuation would use net assets per share based on either simple book value or adjustments. A simple adjusted variant is tanglible book value per share, but for anything more than simple screening it is unlikely that a purely balance sheet based approach would be adequate.
If you do decide to make net assets per share an important part of your approach to valuation, it becomes all the more important to correct for the many distortions in book value. At the very least you need to:
- deduct goodwill,
- add back off balance sheet numbers,
- look for undervalued or over valued assets and adjust them to market value
- examine accounting polices and the notes for anything that may distort values.