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7/25/2019 Lecture2_Balance Sheet Analysis
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Balance Sheet Analysis
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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
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Balance Sheet Analysis
To remember. . .
Basic equationsAssets = Debt + Equity
Assets minus debts = equity
Assets - equity = debt
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The Balance-Sheet Modelof the Firm
Current Assets
Fixed Assets
1 Tangible
2 IntangibleShareholders
Equity
Current
Liabilities
Long-Term
Debt
Investmentdecision
The Capital Budgeting Decision
Financing
decision
Workingcapital
management
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There is a
financialequilibriumbetweenresources andtheir uses?
Net
WorkingCapital
Shareholders
Equity
Current
LiabilitiesCurrent Assets
Fixed Assets
1 Tangible
2 Intangible
Long-Term
Debt
Balance Sheet Structure
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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
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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, butincrease the risk of illiquidity.
Balance Sheet Structure
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Balance Sheet
Current Assets Current Liabilities
Fixed Assets Long-Term Debt
Preferred Stock
Common Stock
To illustrate, lets finance all current assetswith current liabilities, and finance all
fixed assets with long-termfinancing.
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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!
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Balance Sheet
Current Assets Current Liabilities
Fixed Assets
Long-Term Debt
Preferred Stock
Common Stock
Suppose we use current liabilities to financesome of our fixed assets.
This strategy would be less expensive, butmore risky!
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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
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Two Basic Questions:
1. What is the appropriate level for
current assets, both in total and byspecific accounts?
2. How should current assets befinanced?
Balance Sheet Structure
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The Requirement for Current
Assets Financing depends on: Seasonal Variations
Business Cycles
Expansion of the companysactivity
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Permanent cu rrent assets
TIME
DOLLA
R
AMOUNT
Tempo rary current assets
Current Assets
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Current Assets
Permanent Current AssetsCurrent asset balances that do not change
due to seasonal or economic conditions--even at the trough of a firms business cycle
Permanent Current Assets
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Temporary Current AssetsCurrent assets that fluctuate with seasonalor economic variations in a firms business
Current Assets
Temporary Current Assets
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Alternative Current AssetFinancing Policies
ModerateMatch the maturity of theassets with the maturity of the financing.
AggressiveUse short-term financing tofinance permanent assets.
ConservativeUse permanent capital for
permanent assets and temporary assets.
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Maturity Matching, or
Self-Liquidating ApproachA financing policy that matches assetand liability maturities
This would be considered a moderate
current asset financing policy
Alternative Current Asset
Financing Policies
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Hedging (or Maturity
Matching) Approach
A method of financing where each asset would be offset with a financinginstrument of the same approximate maturity.
TIME
DOLLA
R
AMOUNT
Long-term financing
Fixed assets
Current assets*
Short-term financing**
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Conservative ApproachA policy where all of the fixed assets,all of the permanent current assets, andsome of the temporary current assets ofa firm are financed with long-term
capital
Alternative Current Asset
Financing Policies
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Risks vs. Costs Trade-Off
(Conservative Approach)
Firm can reduce risks associated with short-term borrowing by using alarger proportion of long-term financing.
TIME
DOLLA
R
AMOUNT
Long-term financing
Fixed assets
Current assets
Short- term financin g
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Aggressive ApproachA policy where all of the fixed assets ofa 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
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Firm increases risks associated with short-term borrowing by using alarger proportion of short-term financing.
TIME
DOLLA
R
AMOUNT
Long-term financing
Fixed assets
Current assets
Short-term financing
Risks vs . Cos ts Trade-Off
(Aggressive Approach )
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Summary of Short- vs.
Long-Term Financing
Financing
Maturity
AssetMaturity
SHORT-TERM LONG-TERM
Low
Risk-Profitability
Moderate
Risk-Profitability
Moderate
Risk-Profitability
High
Risk-Profitability
SHORT-TERM
(Temporary)
LONG-TERM
(Permanent)
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Analysis of balance sheets Liquidity
A companys ability to meet its short-term financialcommitments.
Assessment focus: The companys ability to convert assets tocash and to pay for operating needs.
SolvencyA companys ability to meet its financial obligations over the
longer term.
Assessment focus: The companys financial structure and itsability to pay long-term financing obligations.
Analytical ToolsCommon-size analysis.
Balance sheet ratios.
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common-size balance sheets
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($ thousands) A B CASSETS
Cash, cash equivalents, marketable securities 1,900 200 3,300
Accounts receivable 500 1,050 1,500Inventory 100 950 300
Total current assets 2,500 2,200 5,100
Property, plant, and equipment, net 750 750 4,650Goodwill 0 300 0Total assets 3,250 3,250 9,750LIABILITIES AND EQUITY
Accounts payable 0 2,500 600Total current liabilities 0 2,500 600
Long-term bonds payable 10 10 9,000Total liabilities 10 2,510 9,600Total shareholders equity 3,240 740 150Total liabilities and shareholders equity 3,250 3,250 9,750
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common-size balance sheets
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(percent of total assets) A B CASSETS
Cash, cash equivalents, marketable securities 58% 6% 34%
Accounts receivable 15% 32% 15%
Inventory 3% 29% 3%
Total current assets 77% 68% 52%
Property, plant, and equipment, net 23% 23% 48%
Goodwill 0% 9% 0%
Total assets 100% 100% 100%
LIABILITIES AND SHAREHOLDERS EQUITY
Accounts payable 0% 77% 6%
Total current liabilities 0% 77% 6%Long-term bonds payable 0% 0% 92%
Total liabilities 0% 77% 98%
Total shareholders equity 100% 23% 2%
Total liabilities and shareholders equity 100% 100% 100%
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Balance sheet Ratios: liquidityratios
Ratio
Calculation
Current Current assets/Current liabilitiesQuick (acid test) (Cash + Marketable securities + Receivables)/
Current liabilities
Cash(Cash + Marketable securities)/Current liabilities
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Liquidity ratios indicate a companys ability to meet
current liabilities.
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Balance sheet Ratios: SolvencyRatios
Ratio
Calculation
Long-term debt to equity Total long-term debt Total equity
Debt to equity Total debt Total equity
Total debt (also known asdebt to assets)
Total debt Total assets
Debt to capital Total debt (Total debt + Total equity)
Financial leverage Total assets Total equity
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Solvency ratios indicate financial risk and financial leverage anda companys ability to meet its financial obligations over time.
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summary
Balance Sheet: what an entity owns (or controls), what itowes, and what the owners claims are at a specific point
in time.
Balance sheets usually present current and noncurrent
assets and liabilities.
Accounting issues relate primarily to measurement(historical cost versus fair value).
Tools for balance sheet analysis include common-size
analysis and balance sheet ratios.
Balance sheet ratios indicate liquidity and solvency.
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Quick Quiz What is the balance-sheet equation?
What is the difference between Romanian Form and Anglo-Saxon Form of thebalance 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 abalance 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 termresources?
Conservative or Aggressive Financing Policy? Which one are you inclined touse? Why?
How do you see the situation of an retail company, which has a negative networking capital?
QuickGrow is in an expanding market, and its sales are increasing by 25percent per year. Would you expect its net working capital to be increasing ordecreasing?
Why do you think one would need market values in the financial analysis of theb l h t?