The following is a guest post from Henry Le, who blogs about investing at PaperCroc.I was delighted when Henry offered to write a series of posts, explaining the basics of how to analyze balance sheets and financial statements. In Part -1, Henry analyzed the Income Statement. This week, he continues with the Balance Sheet. Thank you Henry!
The Balance Sheet
In my previous post, I described the basic components that comprise the income statement. From there, I analyzed some common, but useful ratios to determine if the overall business is profitable and worth investing in.
Now we continue onwards to the infamous balance sheet. The balance sheet tells us how much a company owns (assets) and how much it owes (liabilities). The difference between assets and liabilities is known as equity.
Equity = Assets – Liabilities
Equity represents shareholders’ ownership within the company. The key thing to understand about the balance sheet is that it must be balance at all times, hence the name.
Whenever possible, I’ll be referring to the financial statements of Procter & Gamble (PG-N), which can be found on Google Finance.
|Year||Return on Equity||Return on Earnings||Total Assets||Total Liabilities||Retained Earnings|
|Year||Total Equity||Total Cash||Total Debt||Debt to Equity||Liabilities to Assets|
These are pending bills for which the company expects to receive payment soon. If accounts receivable is rising much faster than revenue, then this might raise some caution signs. It means that the company is increasing revenue by booking sales for which it hasn’t yet received payment.
Inventories consist of raw materials and goods that are ready or will be ready for sale. Having a large amount of inventory in storage is not a good sign since inventory soaks up capital and can’t be used for anything else. Increasing inventory can be especially troubling in the retail sector. For example, a retailer that needed to sell last season’s fashion line would likely have to significantly mark down their goods. Meanwhile, a construction company could probably get a decent price if it needed to sell some construction equipment. It’s always good to keep a watchful eye for increasing inventory.
The faster a company can sell its inventory, the greater the impact on profitability. A high inventory turnover frees up cash and makes it useful elsewhere. The equation for inventory turnover is:
Inventory Turnover = Cost of Revenue / Inventories
For example, in 2011 PG’s cost of revenue and inventories were $40.77 and $7.38 billion, respectively. Thus the inventory turnover rate is 5.52. This means PG went through its entire inventory 5.52 times over the course of the year.
Property, Plant, and Equipment (PP&E)
These are long-term assets that form the infrastructure of the company. They include: land, buildings, factories, furniture, equipment, etc. At the end of fiscal year 2011, PG had records $41.51 billion in PP&E on the balance sheet.
Total cash includes: cash and equivalents, short-term investments, and long-term investments
Total Cash = Cash & Equivalents + Short-Term Investments + Long-Term Investments
Cash and equivalents and short-term investments are money the company allocates in low-risk and fairly liquid investments. Long-term investments are money invested in either longer term bonds or in the stock of other companies.
In 2011, PG had $2.77 billion in cash and short-term investments and zero in long-term investments. Most companies don’t have enough cash on the balance sheet to matter, except for the technology sector, so total cash really isn’t a significant factor.
These are bills the company owes and are due within a year. Large companies that have higher leverage over their supplies can extend their payment deadline. Extending the payment deadline can be good for cash flow because the company tends to hold onto cash longer.
Total Debt includes: short-term debt, long-term debt, and capital leases.
Total Debt = Short-Term Debt + Long-Term Debt + Capital Leases
Short-term debt and capital leases refer to money the company has borrowed for a term of less than a year. These items can become troublesome when the company’s bills are due and it doesn’t have the money to pay them. PG short-term borrowings were $9.98 billion in 2011. The company generates enough operating cash flow, roughly $13.23 billion, to satisfy any short-term obligations.
Long-term debt is debt obligations such as bonds and notes, which have maturities greater than one year. In 2011, PG accumulated $22.03 billion in long-term debt. Overall, the company has $32.01 billion in debt as of 2011.
Retained earnings record the amount of capital a company has generated over its lifetime, minus dividends and stock buybacks. I usually reference retained earnings before equity because it’s a better measurement for a company’s long-term track record at generating profits. Retained earnings are a cumulative account; each year that the company makes a profit and doesn’t pay it all out as dividends, retained earnings increases. If a company has lost money over time, retained earnings can turn negative and create an “accumulated deficit”.
For example, Microsoft had an accumulated deficit and equity of -$6.33 billion and $57.08 billion, respectively in 2011. The accumulated deficit was the result of the special dividend paid in the second quarter of 2005 and common stock repurchased. However, this won’t hinder the company’s ability to operate, or repay debt given its continuing profitability and strong cash flow.
Debt to Equity
This is a measure of a company’s financial leverage. It’s calculated as:
Debt to Equity = Total Debt / Equity
Ideally, I like the debt to equity to be zero. But realistically anything below 0.60 is relatively good for large companies. PG has management to maintain a debt to equity ratio of 0.52 over the past five years. Some companies, such as Colgate-Palmolive, Philip Morris International, and IBM, have debt to equity exceeding 1. This is perfectly fine because these companies generate plenty of operating cash flow to fund their debt.
Return on Equity (ROE)
This is the amount of net income returned as a percentage of shareholders equity. Return on equity measures a company’s profitability by revealing how much profit a company generates with the money shareholders have invested. It is calculated as:
Return on Equity = Net Income / Equity
PG has maintained a 19.00% ROE from 2007 to 2011. In other words, if I give PG $1, I can expect to receive $1.19 or a 19.00% return on my investment. But this isn’t necessarily true as ROE can be skewed due to debt. Companies such as Colgate-Palmolive and Philip Morris International have a ROE of more than 90%. Just be careful when using this metric to analyze a company’s intrinsic value. The values can often be skewed due to high leveraged debt.
Return on Retained Earnings (RORE)
Since ROE can be skewed by high leveraged debt, I prefer using RORE instead. It is calculated as:
Return on Retained Earnings = Net Income / Retained Earnings
Retained earnings are percentage of earnings not paid out as dividends, but retained by the company to be reinvested in its core business or to pay debt. Hence, this variable excludes debt from the equation, unlike equity, and provides a more accurate calculation in my opinion. P&G averaged a 21.65% RORE over the past five years, which is relative to its 18.49% ROE. In 2010, Colgate-Palmolive had an 82.36% ROE, but its RORE was 15.37%. We can clearly see the difference when leveraged debt is excluded from the calculations. However, there’s no need to worry about Colgate-Palmolive’s finances. The company generates enough cash flow to manage its debt.
Hopefully my post was helpful. In the final post, I’ll go over the cash flow statement, which I believe is the most important of the financial statements. Questions are very welcome! Ask them in the comments and I’ll try my best to answer them. Cheers!
If you missed the previous post, in Part -1, Henry analyzed the Income Statement.
Henry Le blogs about investing, life, and the pursuit of early retirement over at PaperCroc. He is your average investor and strongly believes investing is a great tool to building wealth. Stop by his website and follow his investing journey!