It is important to understand how to use balance sheet ratios in managing your own business area. Let’s start by looking at a couple of ways in which balance sheet figures indicate how efficiently a company is operating.
Working capital. Subtracting current liabilities from current assets gives you the company’s net working capital, or the amount of money tied up in current operations. Financial managers give substantial attention to the level of working capital, which typically expands and contracts with the level of sales. Too little working capital can put a company in a bad position…it may be unable to pay its bills or take advantage of profitable opportunities. But, too much working capital reduces profitability since that capital must be financed in some way, usually through interest-bearing loans.
Inventory is a component of working capital that directly affects many non-financial managers. As with working capital in general, there’s a trade-offs between having too much and too little. On the one hand, plenty of inventory solves business problems such as filling customer orders without delay, and the inventory provides a buffer against potential production stoppages or interruptions in the flow of raw materials or parts. On the other hand, every piece of inventory must be financed, and the market value of the inventory itself may decline while it sits on the shelf.
Financial leverage. The use of borrowed money to acquire an asset is called financial leverage. People say that a company is highly leveraged when the percentage of debt on its balance sheet is high relative to the capital invested by the owners. Operating leverage, in contrast, refers to the extent to which a company’s operating costs are fixed rather than variable. Financial leverage can increase returns on an investment, but it also increases risk. In the United States and most other countries, tax policy makes financial leverage even more attractive by allowing businesses to treat the interest paid on loans as a deductible business expense. But leverage can cut both ways. If the value of an asset drops, or if it fails to produce the anticipated level of revenue, then leverage works against the asset’s owner. The negative potential of financial leverage is what keeps CEOs, their financial executives, and board members from maximizing their companies’ debt financing. Instead, they seek a financial structure that creates a realistic balance between debt and equity on the balance sheet. Although leverage enhances a company’s potential profitability as long as things go right, managers know that every dollar of debt increases risk, both because of the danger just cited and because high debt entails high interest costs, which must be paid in good times and bad. Many companies have failed when business reversals or recessions reduced their ability to make timely payments on their loans. When creditors and investors examine corporate balance sheets, therefore, they look carefully at the debt-to-equity ratio. They factor the balance sheet riskiness into the interest they charge on loans and the return they demand from a company’s bonds. A highly leveraged company, for example, may have to pay two or three times the interest rate paid by a less leveraged competitor. Investors also demand a higher rate of return for their stock investments in highly leveraged companies. They will not accept high risks without expecting commensurately large returns.
Other Balance Sheet Comments.
Balance sheet figures may not correspond to actual market values, except for items such as cash, accounts receivable, and accounts payable. This is because accountants must record most items at their historical cost. If, for example, a company’s balance sheet indicated land worth $700,000, that figure would be what the company paid for the land way back when. If it was purchased in downtown San Francisco in 1960, you can bet that it is now worth immensely more than the value stated on the balance sheet. So why do accountants use historical instead of market values? The short answer is that it’s the lesser of two evils. If market values were required, then every public company would be required to get a professional appraisal of every one of its properties, warehouse inventories, and so forth, and would have to do so every year…a logistical nightmare.
Where are the Human assets? As people look to financial statements to gain insights about companies, many notice the traditional balance sheet’s inability to reflect the value and profit potential of human capital and other intangibles. (Remember that the intangibles included in goodwill appear only when one company acquires another, and that the figure represents only the intangibles at the time of purchase.) The absence of intangibles from the balance sheet is particularly significant for knowledge-intensive companies, whose skills, intellectual property, brand equity, and customer relationships may be their most productive assets. A study several years ago by Baruch Lev of New York University found that 40% of the market valuation of the average company was missing from its balance sheet. For high-tech firms, the figure was over 50%. So managers and investors must look beyond the bricks and mortar, the equipment, and the cash that constitute balance sheet assets to determine the real value of a company.
For more thoughts on the Balance Sheet, view the free video entitled The Financials – Managing Your Business Session 1 Understanding Key Concepts and read a free sample of the new book “Small Business Thoughts Real-Time Strategic Planning“.
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