Balance Sheet Analysis

Balance Sheet Analysis

The balance sheet is a snapshot of the firms
assets and liabilities at a given point in time

Assets are listed in order of liquidity
Ease of conversion to cash
Without significant loss of value

Balance Sheet Identity
Assets = Liabilities + Stockholders Equity
Balance Sheet Analysis
To remember. . .

Basic equations
Assets = Debt + Equity
Assets minus debts = equity
Assets - equity = debt
The Balance-Sheet Model
of the Firm

Current Assets

Fixed Assets
1 Tangible
2 Intangible


Shareholders
Equity

Current
Liabilities

Long-Term
Debt

Investment
decision
The Capital Budgeting Decision
Financing
decision
Working
capital
management
There is a
financial
equilibrium
between
resources and
their uses?

Net
Working
Capital

Shareholders
Equity

Current
Liabilities
Current Assets

Fixed Assets
1 Tangible
2 Intangible


Long-Term
Debt

Balance Sheet Structure
Current Assets
cash, marketable securities, inventory,
accounts receivable

Long-Term Assets
equipment, buildings, land

Which earn higher rates of return?
Which help avoid risk of illiquidity?
Balance Sheet Structure
Current Assets
cash, marketable securities, inventory,
accounts receivable

Long-Term Assets
equipment, buildings, land

Risk-Return Trade-off:
Current assets earn low returns, but help reduce
the risk of illiquidity.
Balance Sheet Structure
Current Liabilities
short-term notes, accrued expenses,
accounts payable
Long-Term Debt and Equity
bonds, preferred stock, common stock

Which are more expensive for the firm?
Which help avoid risk of illiquidity?
Balance Sheet Structure
Current Liabilities
short-term notes, accrued expenses,
accounts payable

Long-Term Debt and Equity
bonds, preferred stock, common stock

Risk-Return Trade-off:
Current liabilities are less expensive, but
increase the risk of illiquidity.
Balance Sheet Structure
Balance Sheet

Current Assets Current Liabilities

Fixed Assets Long-Term Debt
Preferred Stock
Common Stock


To illustrate, lets finance all current assets
with current liabilities, and finance all
fixed assets with long-term financing.
Balance Sheet

Current Assets CurrentLiabilities

Fixed Assets Long-Term Debt
Preferred Stock
Common Stock

Suppose we use long-term financing to
finance some of our current assets.

This strategy would be less risky, but more
expensive!
Balance Sheet

Current Assets Current Liabilities

Fixed Assets
Long-Term Debt
Preferred Stock
Common Stock


Suppose we use current liabilities to finance
some of our fixed assets.
This strategy would be less expensive, but
more risky!
Permanent Assets (those held > 1 year)
should be financed with permanent and
spontaneous sources of financing

Temporary Assets (those held < 1 year)
should be financed with temporary sources
of financing


The hedging principle
Two Basic Questions:
1. What is the appropriate level for
current assets, both in total and by
specific accounts?

2. How should current assets be
financed?
Balance Sheet Structure
The Requirement for Current
Assets Financing depends on:
Seasonal Variations

Business Cycles

Expansion of the companys
activity
Permanent current assets
TIME
D
O
L
L
A
R

A
M
O
U
N
T

Temporary current assets
Current Assets

Current Assets
Permanent Current Assets
Current asset balances that do not change
due to seasonal or economic conditions--
even at the trough of a firms business cycle
Permanent Current Assets
Temporary Current Assets
Current assets that fluctuate with seasonal
or economic variations in a firms business
Current Assets
Temporary Current Assets
Alternative Current Asset
Financing Policies
Moderate Match the maturity of the
assets with the maturity of the financing.
Aggressive Use short-term financing to
finance permanent assets.
Conservative Use permanent capital for
permanent assets and temporary assets.
Maturity Matching, or
Self-Liquidating Approach
A financing policy that matches asset
and liability maturities
This would be considered a moderate
current asset financing policy
Alternative Current Asset
Financing Policies
Hedging (or Maturity
Matching) Approach
A method of financing where each asset would be offset with a financing
instrument of the same approximate maturity.
TIME
D
O
L
L
A
R

A
M
O
U
N
T

Long-term financing
Fixed assets
Current assets*
Short-term financing**
Conservative Approach
A policy where all of the fixed assets,
all of the permanent current assets, and
some of the temporary current assets of
a firm are financed with long-term
capital
Alternative Current Asset
Financing Policies
Risks vs. Costs Trade-Off
(Conservative Approach)
Firm can reduce risks associated with short-term borrowing by using a
larger proportion of long-term financing.
TIME
D
O
L
L
A
R

A
M
O
U
N
T

Long-term financing
Fixed assets
Current assets
Short-term financing
Aggressive Approach
A policy where all of the fixed assets of
a firm are financed with long-term capital,
but some of the firms permanent current
assets are financed with short-term non-
spontaneous sources of funds
Alternative Current Asset
Financing Policies
Firm increases risks associated with short-term borrowing by using a
larger proportion of short-term financing.
TIME
D
O
L
L
A
R

A
M
O
U
N
T

Long-term financing
Fixed assets
Current assets
Short-term financing
Risks vs. Costs Trade-Off
(Aggressive Approach)
Summary of Short- vs.
Long-Term Financing
Financing
Maturity
Asset
Maturity
SHORT-TERM LONG-TERM
Low
Risk-Profitability
Moderate
Risk-Profitability
Moderate
Risk-Profitability
High
Risk-Profitability
SHORT-TERM
(Temporary)
LONG-TERM
(Permanent)
Quick Quiz
What is the balance-sheet equation?
What is the difference between Romanian Form and Anglo-Saxon Form of the
balance sheet?
Which things should be kept in mind when looking at a balance sheet?
Which is the most important piece of information we have to look for in a
balance sheet, as stockholders (creditors, or other stakeholders)?
How should current assets be financed?
Which are the implications of financing short term assets by long term
resources?
Which are the implications of financing long term assets by short term
resources?
Conservative or Aggressive Financing Policy? Which one are you inclined to
use? Why?
How do you see the situation of an en-detail trading company, which has a
negative net working capital?
QuickGrow is in an expanding market, and its sales are increasing by 25
percent per year. Would you expect its net working capital to be increasing or
decreasing?
Why do you think one would need market values in the financial analysis of the
balance sheet?