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Balance Sheet Analysis

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

Balance Sheet Analysis


To remember. . .
Basic equations

Assets = Debt + Equity


Assets minus debts = equity
Assets - equity = debt

The Balance-Sheet Model


of the Firm
The Capital Budgeting Decision
Current Assets

Working
capital
management

Current
Liabilities

Long-Term
Debt

Fixed Assets
1 Tangible
2 Intangible

Financing
decision
Investment
decision

Shareholders
Equity

Balance Sheet Structure

Current Assets

Fixed Assets
1 Tangible
2 Intangible

Current
Liabilities
Net
Working
Capital

There is a
financial
equilibrium
between
resources and
their uses?

Long-Term
Debt

Shareholders
Equity

Balance Sheet Structure


Current Assets
cash, marketable securities, inventory,
accounts receivable
Long-Term Assets
equipment, buildings, land
Which earn higher rates of return?
Which help avoid risk of illiquidity?

Balance Sheet Structure


Current Assets
cash, marketable securities, inventory,
accounts receivable
Long-Term Assets
equipment, buildings, land
Risk-Return Trade-off:
Current assets earn low returns, but help reduce
the risk of illiquidity.

Balance Sheet Structure


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


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, but
increase the risk of illiquidity.

Balance Sheet
Current Assets

Current Liabilities

Fixed Assets

Long-Term Debt
Preferred Stock
Common Stock

To illustrate, lets finance all current assets


with current liabilities, and finance all
fixed assets with long-term financing.

Balance Sheet
Current Assets
Fixed Assets

CurrentLiabilities
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!

Balance Sheet
Current Assets

Current Liabilities

Fixed Assets
Long-Term Debt
Preferred Stock
Common Stock

Suppose we use current liabilities to finance


some of our fixed assets.
This strategy would be less expensive, but
more risky!

The hedging principle


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

Balance Sheet Structure


Two Basic Questions:
1. What is the appropriate level for
current assets, both in total and by
specific accounts?
2. How should current assets be
financed?

The Requirement for Current


Assets Financing depends on:
Seasonal Variations

Business Cycles
Expansion of the companys
activity

DOLLAR AMOUNT

Current Assets

Temporary current assets

Permanent current assets

TIME

Current Assets
Permanent Current Assets
Current asset balances that do not change
due to seasonal or economic conditions-even at the trough of a firms business cycle

Permanent Current Assets

Current Assets
Temporary Current Assets
Current assets that fluctuate with seasonal
or economic variations in a firms business

Temporary Current Assets

Alternative Current Asset


Financing Policies
Moderate Match the maturity of the
assets with the maturity of the financing.
Aggressive Use short-term financing to
finance permanent assets.
Conservative Use permanent capital for
permanent assets and temporary assets.

Alternative Current Asset


Financing Policies
Maturity Matching, or
Self-Liquidating Approach
A financing policy that matches asset
and liability maturities
This would be considered a moderate
current asset financing policy

Hedging (or Maturity


Matching) Approach
A method of financing where each asset would be offset with a financing
instrument of the same approximate maturity.

DOLLAR AMOUNT

Short-term financing**

Current assets*
Long-term financing
Fixed assets

TIME

Alternative Current Asset


Financing Policies
Conservative Approach
A policy where all of the fixed assets,
all of the permanent current assets, and
some of the temporary current assets of
a firm are financed with long-term
capital

Risks vs. Costs Trade-Off


(Conservative Approach)
Firm can reduce risks associated with short-term borrowing by using a
larger proportion of long-term financing.

DOLLAR AMOUNT

Short-term financing

Current assets
Long-term financing
Fixed assets

TIME

Alternative Current Asset


Financing Policies
Aggressive Approach
A policy where all of the fixed assets of
a firm are financed with long-term capital,
but some of the firms permanent current
assets are financed with short-term nonspontaneous sources of funds

Risks vs. Costs Trade-Off


(Aggressive Approach)
Firm increases risks associated with short-term borrowing by using a
larger proportion of short-term financing.

DOLLAR AMOUNT

Short-term financing

Current assets

Long-term financing
Fixed assets

TIME

Summary of Short- vs.


Long-Term Financing
Financing
Maturity
Asset
Maturity

SHORT-TERM

LONG-TERM

SHORT-TERM
(Temporary)

Moderate
Risk-Profitability

Low
Risk-Profitability

LONG-TERM
(Permanent)

High
Risk-Profitability

Moderate
Risk-Profitability

Quick Quiz

What is the balance-sheet equation?

What is the difference between Romanian Form and Anglo-Saxon Form of the
balance 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 a


balance 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 term
resources?
Conservative or Aggressive Financing Policy? Which one are you inclined to
use? Why?
How do you see the situation of an en-detail trading company, which has a
negative net working capital?
QuickGrow is in an expanding market, and its sales are increasing by 25
percent per year. Would you expect its net working capital to be increasing or
decreasing?
Why do you think one would need market values in the financial analysis of the
balance sheet?