How to Evaluate a Company's Balance Sheet

For stock investors, the balance sheet is an important financial statement that should be interpreted when considering an investment in a company. The balance sheet is a reflection of the assets and the liabilities owned by the company at a certain point in time. The strength of a company's balance sheet can be evaluated by three broad categories of investment-quality measurements: working capital adequacy, asset performance, and capitalization structure.

The cash conversion cycle is a key indicator of the adequacy of a company's working capital position. In addition, the CCC is an indicator of a company's ability to efficiently manage two of its most important assets – accounts receivable and inventory.

Calculated in days, the CCC reflects the time required to collect on sales and the time it takes to turn over inventory. The shorter the cycle, the better. Cash is king, and smart managers know that fast-moving working capital is more profitable than unproductive working capital that is tied up in assets.

$\begin{aligned} &\text{CCC} = \text{DIO} + \text{DSO} - \text{DPO}\\ &\textbf{where:}\\ &\text{DIO} = \text{Days inventory outstanding} \\ &\text{DSO} = \text{Days sales outstanding} \\ &\text{DPO} = \text{Days payables outstanding} \\ \end{aligned}$​CCC=DIO+DSO−DPOwhere:DIO=Days inventory outstandingDSO=Days sales outstandingDPO=Days payables outstanding​

There is no single optimal metric for the CCC, which is also referred to as a company's operating cycle. As a rule, a company's CCC will be influenced heavily by the type of product or service it provides and industry characteristics.

Investors looking for investment quality in this area of a company's balance sheet must track the CCC over an extended period of time (for example, five to 10 years) and compare its performance to that of competitors. Consistency and/or decreases in the operating cycle are positive signals. Conversely, erratic collection times and/or an increase in on-hand inventory are typically negative investment-quality indicators.

Property, plant, and equipment (PP&E), or fixed assets, is another important indicator on a company's balance sheet. This value often represents the single largest component of a company's total assets. Readers should note that the term fixed assets is the financial professional's shorthand for PP&E although investment literature sometimes refers to a company's total non-current assets as its fixed assets.

A company's investment in fixed assets is dependent, to a large degree, on its line of business. Some businesses are more capital intensive than others. Large capital equipment producers, such as farm equipment manufacturers, require a large amount of fixed-asset investment. Service companies and computer software producers need a relatively small amount of fixed assets. Mainstream manufacturers typically have 30% to 40% of their assets in PP&E. Accordingly, fixed asset turnover ratios will vary among different industries.

The fixed asset turnover ratio is calculated as:

$\begin{aligned} &\text{Fixed Asset Turnover} = \frac{ \text{Net Sales} }{ \text{Average Fixed Assets} }\\ \end{aligned}$​Fixed Asset Turnover=Average Fixed AssetsNet Sales​​

This fixed asset turnover ratio indicator, looked at over time and compared to that of competitors, gives the investor an idea of how effectively a company's management is using this large and important asset. It is a rough measure of the productivity of a company's fixed assets with respect to generating sales. The higher the number of times PP&E turns over, the better. Obviously, investors should look for consistency or increasing fixed asset turnover rates as positive balance sheet investment qualities.

Return on assets (ROA) is considered a profitability ratio – it shows how much a company is earning on its total assets. Nevertheless, it is worthwhile to view the ROA ratio as an indicator of asset performance.

The ROA ratio (percentage) is calculated as:

$\begin{aligned} &\text{ROA} = \frac{ \text{Net Income} }{ \text{Average Total Assets} }\\ \end{aligned}$​ROA=Average Total AssetsNet Income​​

The ROA ratio is expressed as a percentage return by comparing net income, the bottom line of the income statement, to average total assets. A high percentage return implies well-managed assets. Here again, the ROA ratio is best employed as a comparative analysis of a company's own historical performance and with companies in a similar line of business.

Numerous non-physical assets are considered intangible assets, which are broadly categorized into three different types: intellectual property (patents, copyrights, trademarks, brand names, etc.), deferred charges (capitalized expenses), and purchased goodwill (the cost of an investment in excess of book value).

Unfortunately, there is little uniformity in balance sheet presentations for intangible assets or the terminology used in the account captions. Often, intangibles are buried in other assets and only disclosed in a note in the financials.

The dollars involved in intellectual property and deferred charges are typically not material and, in most cases, do not warrant much analytical scrutiny. However, investors are encouraged to take a careful look at the amount of purchased goodwill on a company's balance sheet—an intangible asset that arises when an existing business is acquired. Some investment professionals are uncomfortable with a large amount of purchased goodwill. The return to the acquiring company will be realized only if, in the future, it is able to turn the acquisition into positive earnings.

Conservative analysts will deduct the amount of purchased goodwill from shareholders' equity to arrive at a company's tangible net worth. In the absence of any precise analytical measurement to make a judgment on the impact of this deduction, investors use common sense. If the deduction of purchased goodwill has a material negative impact on a company's equity position, it should be a matter of concern. For example, a moderately-leveraged balance sheet might be unappealing if its debt liabilities are seriously in excess of its tangible equity position.

Companies acquire other companies, so purchased goodwill is a fact of life in financial accounting. Investors, however, need to look carefully at a relatively large amount of purchased goodwill on a balance sheet. The impact of this account on the investment quality of a balance sheet needs to be judged in terms of its comparative size to shareholders' equity and the company's success rate with acquisitions. This truly is a judgment call, but one that needs to be considered thoughtfully.

Assets represent items of value that a company owns, has in its possession or is due. Of the various types of items a company owns, receivables, inventory, PP&E, and intangibles are typically the four largest accounts on the asset side of a balance sheet. Therefore, a strong balance sheet is built on the efficient management of these major asset types, and a strong portfolio is built on knowing how to read and analyze financial statements.