Editor’s Note: This is the second in a series about the balance sheet. Follow the series in the related content section.
The information in a balance sheet is vitally important to investors, management, employees, and regulators – but it’s challenging to gauge the overall financial health of a business if one doesn’t understand the figures it contains. Understanding the components of a balance sheet will help you figure out if a company is thriving, surviving, or on the brink of failure.
Accounting standards
There are different accounting standards employed around the world. Most companies rely on IFRS (International Financial Reporting Standards) and U.S. GAAP (Generally Accepted Accounting Principles), but there’s also Canadian Accounting Standards for Private Enterprises (ASPE), which are used by private Canadian companies (although they too can choose to use IFRS).
All three qualify as GAAP, which is a set of accounting rules and guidelines that govern the preparation of financial statements, including the balance sheet. IFRS is mandatory for the majority of public companies and used in more than 140 countries, while U.S. GAAP is only used in the United States.
This leads to variations in how some items are measured, valued, and presented. Some that are reported differently include inventory, investment property, income taxes, intangible assets, leases, contingent liabilities, and R&D.
Differing values
Balance sheet equity book value amounts are not equivalent to either market values or intrinsic values (also referred to as fair values). The market value refers to the price at which a company’s stock is actually trading while intrinsic value is the price at which investors believe the security should be trading.
This is because different measurement bases (e.g. historical versus fair value accounting) can have a significant effect on the reported amounts and since items shown at current value reflect the value only on the reporting date.
Market value could exceed book value if market participants think a higher equity value is warranted, possibly due to the company’s earnings power. Meanwhile, when market value is lower than book value, it could signal investors have lost confidence in the company and its future potential.
Other accounting items
There are some accounting terms that the average person likely won’t be familiar with; the more consequential ones are described below.
Depreciation
Depreciation refers to the process of systematically allocating the cost of a long-life asset over its useful life (or to recognize this as an expense). It’s a fixed cost under all but one depreciation method, as the amount is set each year, regardless of the business’ activity level. Note that land is never depreciated.
Goodwill
Goodwill is an intangible asset that denotes any excess value over a company’s assets minus its liabilities. Things like brand recognition, client base, strong employee relations, proprietary technology, and intellectual property can all contribute to goodwill. It doesn’t get amortized or depreciated, but must be reviewed annually, and written down, if need be.
An introduction to accounting ratios
One of the primary means of analyzing a balance sheet is to calculate and assess accounting ratios, which are a subset of financial ratios. This type of balance sheet analysis evaluates whether a business can readily cover unexpected expenses or has more debt than it can comfortably carry.
Interpreting the balance sheet using accounting ratios can tell you how a company is performing; both its strengths and weaknesses. Comparing balance sheets can also provide insight into how a business’ finances have changed over time.
The current ratio, debt-to-equity ratio, and quick ratio are widely regarded as the three most important accounting ratios.
Current ratio
Current Ratio = Current Assets / Current Liabilities
Target: 1.5 to 2
Businesses must have enough current assets to cover current liabilities, which is what this liquidity ratio is meant to tell us. A current ratio below 1 means the company will have difficulty meeting its short-term obligations. The inability to pay off all debts in the next twelve months is usually viewed as a warning sign.
Current assets mainly include cash, accounts receivable, temporary investments, and inventory, while current liabilities are mostly comprised of accounts payable, accrued expenses, and any deferred revenues.
Conversely, if the ratio is too high, the company may not be effectively deploying its resources, which could limit long-term returns.
Debt-to equity ratio (D/E)
Debt to Equity Ratio = Total Liabilities / Owners’ or Shareholders’ Equity
2:1 is considered acceptable
This is a good indicator of a company’s long-term ability to generate enough income to service and repay debts.
It helps investors and bankers to decide if they will lend to the company, since it tells you if it will generate sufficient cash flow or profits to cover all expenses. A high D/E ratio suggests the company relies heavily on loans and financing.
Higher values could be disastrous for investors, who would end up with very little or nothing, if all earnings and cash flows were suddenly needed to pay off debts. A high D/E ratio means the company is at risk of financial distress or bankruptcy.
Quick ratio
Quick Ratio = (Cash and Equivalents + ST Investments + Accounts Receivable) / Current Liabilities
Target: 1 is ideal
The quick ratio is also referred to as the acid test ratio. It’s a stricter test of liquidity than the current ratio as it doesn’t include all current assets. It measures whether the most liquid assets – cash, accounts receivables, and marketable securities – are sufficient to cover all current liabilities.
A value of less than 1 means the company cannot fully pay off its liabilities with their most liquid assets, which could be problematic.
Management’s Discussion and Analysis (MD&A)
MD&A is a component of the full suite of financial statements – not dedicated to the balance sheet alone – that complements the financial statements. It provides information relevant to understanding and interpreting the reports, as well as any economic or industry trends that could reasonably be expected to impact the business.
The notes matter
Companies put all manner of things in the notes, so they shouldn’t be ignored. You can never assume there’s nothing important in the notes.
The financial statement footnotes provide additional information relative to certain sections of the balance sheet, which helps improve comprehension for the reader and ensures all essential background information is included and properly explained.