Formulas and Calculations for Analyzing a Balance Sheet
Investing Lesson 3 - Analyzing a Balance Sheet
You've learned how to analyze a balance sheet! In Segment 2 of this lesson, we are going to work through old balance sheets of a few major American companies. Before we get into that, though, let's take a moment to review some of the balance sheet formulas and ratios you've learned along the way. Use this page as a handy reference guide in the future. You should memorize these as soon as possible; they are priceless tools for your investment toolbox, to be used for the rest of your life whenever convenient and appropriate.
Formulas & Calculations for the Balance Sheet
Let's break up each balance sheet formula, ratio, or calculation into one of two groups. The first covers those that demonstrate a company's financial strength and liquidity, while the second gives us a glimpse into a company's efficiency in using its asset base to generate earnings. Recall that many of these ratios require the use of the income statement in conjunction with the balance sheet.
Balance Sheet Calculation and Ratio Group I:
Tests of a Company's Financial Strength and Liquidity:
Working Capital: Current Assets - Current Liabilities
Working Capital per Dollar of Sales: Working Capital ÷ Total Sales1
Current Ratio: Current Assets ÷ Current Liabilities
Quick / Acid Test / Current Ratio: Current Assets minus inventory (called "Quick Assets) ÷ Current Liabilities
Debt to Equity Ratio: Total Liabilities ÷ Shareholders' Equity
Balance Sheet Calculation and Ratio Group II:
Tests of a Company's Efficiency:
Receivable Turnover: Net Credit Sales1 ÷ Average Net Receivables for the Period
Average Age of Receivables: Numbers of days in period ÷ Receivable Turnover
Inventory Turnover: Cost of Goods Sold1 ÷ Average Inventory for the Period
Number of Days for Inventory to Turn: Number of days in Period ÷ Inventory Turnover
1.) These can be found on the income statement, not the balance sheet.
Another of my favorite balance sheet formulas, which I barely touched upon in this lesson, involves taking the net income from the income statement and comparing it to the net tangible assets, especially over multiple-year spans that include at least one or more recessions, so you can get an idea of the economic characteristics of the business. This won't work in some specialty cases, such as investing in shares of the oil majors, because the earnings are tied to an underlying commodity or commodities, such as natural gas and crude oil, which tend to enter multi-decade bull and bear markets related to the underlying supply/demand/extraction/refining relationships in effect at the time. Nevertheless, it can often be an effective way to look through to the underlying economic reality of an enterprise and spot the caliber of the engine churning out profits for owners. Once you understand how drastically different the outcome can be between a good business and a great business, I imagine it will become one of your favorite metrics, too. You'll likely find yourself demanding ownership in only those businesses that produce copious amounts of free cash flow; capable of drowning you in ever-growing dividends or expanding book value rather than requiring on-going, low-or-mediocre returning capital expenditures that never quite seem to pay off the way you expected or hoped.
The last step before we dive into sample balance sheets is to look at the things a balance sheet can't tell you; the limitations and shortcomings you should be careful not to try and overcome by focusing too much on metrics that aren't meaningful or could be harmful, to the operating company itself.