Financial Analysis of the Balance Sheet: Part III

Since I covered a decent portion of the assets on the balance sheet in the previous two articles, we’re going to go to liabilities.  Liabilities, just like assets, are broken into two sections: noncurrent (long-term) and current (short-term).  Today, we’re covering a little bit of each, which include short-term debt, accounts payable and long-term debt.

Short-Term Debt:

 In accounting terms, short-term is classified as one operating period for a company, or one fiscal year.  Therefore, anything that equals a year or less is considered a short-term item, or current item.  Anything beyond that is long-term or a non-current item.  Subsequently, short-term debt is debt a company incurs that is one year or less.  Short-term debt can have a lot of different line items lumped into it such as accounts payable, taxes payable, and wages payable.  If you do not see those line items on the balance sheet then that means they were probably put together with short-term debt, which would be a little worrying because of the lack of transparency.  That is normally not the case though and short-term debt typically has two main portions that it is packed together with.  The first and most common type of short-term debt is short-term bank loans that the company receives to help with operation needs.  These type of loans are called “bank plugs” because these loans fill the financing gaps between long-term loans.  The second portion that fills up short-term debt is when a company’s long-term debt turns into short-term debt because it’s within a year of maturing.  This can be worrying if a company didn’t plan the right way and they have a small amount of cash on hand with a lot of long-term debt maturing at the same time.  However, this normally doesn’t happen without some finance guys getting fired.

Ideally, we want to see this line item smaller than the Cash and Cash equivalents (or short-term investments) line item because if it’s smaller then that means the company has enough liquid capital on hand to pay down their short-term debts.

Accounts Payable:

 Imagine you own a company that just purchased 40 books from another company.  The company you bought them from delivers the books to you and gives you an invoice saying you have 30 days to pay.  This is recorded on your balance sheet under accounts payable and it is recorded on the other companies balance sheet as accounts receivable.  Simple right?  Well, the key is figuring out how to analyze this line item.

Some goods or services that a company purchases will include an incentive for them to pay early, maybe a 2% discount for paying before the 30-day period.  It is helpful to see if a company is taking these discount opportunities. 2% might not seem like much but over time it definitely adds up.  On the contrary, we can also check to see if the company is accruing late fees for not paying on time.  If a company isn’t paying their bills it’s an obvious red flag but it’s important to figure out why they’re not paying them.  Is it because they’re low on cash, or are they simply bad at managing their expenses?  That’s for you to figure out on a case-by-case basis.

Another tool you can use is to look at the payable turnover rate which is:

Average payable turnover = {Total annual purchases}{average total payable balance}

When the turnover rate is increasing it means the company is paying off their suppliers quicker, and the opposite is true when the average payable is decreasing.  We can also figure out the average amount of days a company is taking to pay their bills, do the following:

(Payable turnover rate/365 days)= Amount of days a company takes to pay their bills

Long-term debt

We always hear how bad it is to go into debt.  It can ruin individual’s lives and it can ruin companies if they’re not careful.  Therefore, the question becomes why even go into debt in the first place?  Well, companies finance themselves with debt because it’s the fastest way to receive capital.  Also, equity requires a higher rate of return for the investors which can make the capital structure for the company that’s unfavorable.  If a company has a steady stream of income and favorable cash flow, then financing with long-term debt at low interest rates can actually be a very beneficial thing to do.  In a low-interest rate environment, a company can attempt more projects because the required return from those projects is relatively low to break even.

The problems with debt arise when it is too much relative to the amount of equity.  If this debt-to-equity ratio is too high that means the company is mostly financing with debt which can lead to problems if the company runs into income or cash flow problems.  With equity, the company can decide to pay investors a dividend and if they do decide to, they can also decide how much.  There is no guarantee.  If a company cannot pay their debt then they go into bankruptcy, there isn’t an option to pay your debt.  When analyzing a company, it’s essential to look at the industry peers and see how this company finances themselves.  If the whole industry has a debt-to-equity ratio of 2.0 (which means for every dollar of equity there are 2 dollars of debt), but your company has a debt-to-equity ratio of 5.0, then it would definitely be something to look into further. Overall, the industry considers lower debt-to-equity ratios as being favorable to higher ones, especially in a rising interest rate environment.

There are plenty of different items to analyze on the balance sheet and an unlimited amount of ways to interpret them when all the line items are combined into one analysis of the whole balance sheet.  Just like with any other skill, it takes practice to identify what’s good and what’s bad, even though both identifications will be your subjective analysis.  Your subjective analysis is your artwork and art can be improved with practice.

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