Happy New Year. The calendar year has just finished. Lots of companies will be busy closing the books, and preparing Annual Reports. Do they really understand what their accountants are going to produce?
When building a company, when executing your strategy… Two things are certainties: (1) you want to be able to steer your company financially. So you need, at any given time, to be able to answer questions like: Does revenue grow as planned? Are costs within budget? Do we make net profit? Is the cashflow sufficient? Are debtors paying in time? Do we have an acceptable return on capital invested?
(2) at some point you will need financing, if things go well. We recently refinanced our company, to get access to working capital for growth. We managed to borrow 80% of our monthly turnover, secured by our invoices (Accounts Receivables). Of course there were discussions with banks about performance, solvency and other ratios. For non-financials, which most entrepreneurs are, it might be interesting to have all the relevant information based on an example balance sheet and profit- and loss statement (also called income statement). I will give it a go.
In the attached Excel file I have created an example. Early next year I will put in the definitive Qhuba numbers.
A balance sheet, also known as a “statement of financial position”, reveals a company’s assets, liabilities and owners’ equity (net worth). The balance sheet, together with the income statement and cash flow statement, make up the cornerstone of any company’s financial statements. If you are a shareholder of a company, it is important that you understand how the balance sheet is structured, how to analyze it and how to read it.
The balance sheet is divided into two parts that, based on the following equation, must equal each other, or balance each other out. The main formula behind balance sheets is: Assets = Liabilities + Shareholders’ Equity
It might seems confusing that Equity is on the same side of the Balance sheet as Debts or Liabilities. That is because Assets (“what you have”) is paid for by Equity (“your money”) and Debt (“money you borrowed”): Assets – Liabilities = Equity
This means that assets, or the means used to operate the company, are balanced by a company’s financial obligations along with the equity investment brought into the company and its retained earnings.
Assets are what a company uses to operate its business, while its liabilities and equity represent how you paid for these assets. Owners’ equity (or shareholders’ equity) is the amount of money initially invested into the company plus any retained earnings, and it represents a source of funding for the business.
Types of Assets
- Current Assets
Current assets have a life span of one year or less, meaning they can be converted easily into cash. Such assets include cash, accounts receivable and inventory. Accounts receivables consist of the short-term obligations owed to the company by its clients. Lastly, inventory represents the raw materials, work-in-progress goods and the company’s finished goods.
- Non-Current Assets
Non-current assets are assets that are not turned into cash easily, or have a life-span of more than a year. They can refer to tangible assets such as machinery, equipment, buildings and land. Non-current assets also can be intangible assets, such as goodwill, patents or copyright.
On the other side of the balance sheet are the liabilities. These are the financial obligations a company owes to outside parties. Like assets, they can be both current and long-term. Long-term liabilities are debts and other non-debt financial obligations, which are due after a period of at least one year from the date of the balance sheet. Current liabilities are the company’s liabilities which will come due, or must be paid, within one year. This includes both shorter term borrowings, such as accounts payables, along with the current portion of longer term borrowing, such as the latest interest payment on a 10-year loan or mortgage.
Shareholders’ equity is the initial amount of money invested into a business. If, at the end of the fiscal year, a company decides to reinvest its net earnings into the company (after taxes), these retained earnings will be transferred from the income statement onto the balance sheet into the shareholder’s equity account. This account represents a company’s total net worth. This is purely the Net worth from an Accounting point of view, and has no relation to the value of the company in terms of its earning capacity. In order for the balance sheet to balance, total assets on one side have to equal total liabilities plus shareholders’ equity on the other.
As you can see from the balance sheet above, it is broken into two sides. Assets are on the left side and the right side contains the company’s liabilities and shareholders’ equity. It is also clear that this balance sheet is in balance where the value of the assets equals the combined value of the liabilities and shareholders’ equity.
Analyze the Balance Sheet With Ratios
With a greater understanding of the balance sheet and how it is constructed, we can look now at some techniques used to analyze the information contained within the balance sheet. The main way this is done is through financial ratio analysis.
Financial ratio analysis uses formulas to gain insight into the company and its operations. For the balance sheet, using financial ratios (like the debt-to-equity ratio) can show you a better idea of the company’s financial condition along with its operational efficiency. It is important to note that some ratios will need information from more than one financial statement, such as from the balance sheet and the income statement.
The main types of ratios that use information from the balance sheet are financial strength ratios and activity ratios. Financial strength ratios, such as the working capital and debt-to-equity ratios, provide information on how well the company can meet its obligations and how they are leveraged. This can give investors an idea of how financially stable the company is and how the company finances itself. Activity ratios focus mainly on current accounts to show how well the company manages its operating cycle (which include receivables, inventory and payables). These ratios can provide insight into the company’s operational efficiency.
There are a wide range of individual financial ratios that investors use to learn more about a company.
1. Liquidity Ratios
1.1 Current Ratio (CR)
The current ratio is a financial ratio used to test a company’s liquidity (also referred to as its working capital position) by calculating the proportion of current assets available to cover current liabilities. Or: are there enough assets to pay for short-term debt.
Formula: Current Ratio = Currents Assets/Current Liabilities
In our example: 320.000 / 160.000 = 2
1.2 Quick Ratio
The quick ratio is a liquidity indicator that further refines the current ratio by measuring the amount of the most liquid current assets there are to cover current liabilities. The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficult to turn into cash. Therefore, a higher ratio means a more liquid current position.
In our example: 220.000 / 160.000 = 1,375
1.3 Cash Ratio
The cash ratio is a further refinement, where only cash is taken into account, compared to current liabilities.
The above ratios are not widely used in practice (except by the Dutch Chamber of Commerce). The development of working capital is more interesting. Let’s have a look at what Working Capital is.
Working capital (abbreviated WC) is a financial metric that represents operating liquidity available to a business, organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital.
A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.
Net Working Capital = Current Assets − Current Liabilities
Net Operating Working Capital = Current Assets − Non Interest-bearing Current Liabilities
Usually CFO’s like Koos Boot, former CFO at Wegener , look at the total current assets (excluding cash) less the total non-interest bearing current liabilities. So, cash and bank debt are excluded. They are part of the financing of such working capital and is not part of the capital itself.
1.4 Debtors – Days Sales Outstanding (DSO):
Days Sales Outstanding is a company’s average collection period. How many days does it take your customers to pay you, in relation to your sales. Days Sales Outstanding is calculated as total outstanding receivables at the end of the period analyzed divided by total sales for the period analyzed (typically 90 or 365 days), times the number of days in the period analyzed.
Formula: DSO = Accounts Receivable/(Total Revenue/365)
Of course here you have to take the AR of a certain period (three months, or a year) and compare it to the revenu in the same period, divide by the number of days in that period
Sometimes it needs adjustment for VAT, which are included in the Accounts Receivable, but not in the Revenue and for last batch of invoices, which might not be due.
2. Profitability Indicator Ratios
A general statement: this requires comparing P&L (a number that comes from a certain period) to numbers of the Balance Sheet (at a specific moment), so it might be correct to use Balance Sheet averages, for instance: Balance Sheet at the begin and end of the period.
2.1 Return On Assets
The return on assets (ROA) percentage shows how profitable a company’s assets are in generating revenue.
This number tells you what the company can do with what it has, i.e. how many dollars of earnings they derive from each dollar of assets they control. Return on assets gives an indication of the capital intensity of the company, which will depend on the industry; companies that require large initial investments will generally have lower return on assets.
ROA can be computed as: Net Income/Total Assets
This number doesn’t say everything. A thriving business can still get into trouble, i.e. in a situation of extensive growth, in which the ability to secure external funding comes up short.
Net profit: € 44.700
Interest paid: € 15.000 +
Operating income: € 59.700
Total assets € 560.000
Return on Assets: € 59.700 / € 560.00 * 100% =10,66%
2.2 Return On Equity
Return on equity (ROE) measures the rate of return on the ownership interest of the common stock owners. It measures a firm’s efficiency at generating profits from every unit of shareholders’ equity (also known as net assets or assets minus liabilities). ROE shows how well a company uses investment funds to generate earnings growth.
Formula: ROE = Net Income (after tax)/Shareholder Equity
A business that has a high return on equity is more likely to be one that is capable of generating cash internally. For the most part, the higher a company’s return on equity compared to its industry, the better.
Example: ROE= € 44.700 / € 200.000 * 100% = 22,35%
2.3 Return on capital employed (ROCE)
Return on capital employed ratio, expressed as a percentage, complements the return on equity (ROE) ratio by adding a company’s debt liabilities, or funded debt, to equity to reflect a company’s total “capital employed”. This measure narrows the focus to gain a better understanding of a company’s ability to generate returns from its available capital base.
By comparing net income to the sum of a company’s debt and equity capital, investors can get a clear picture of how the use of leverage impacts a company’s profitability. Financial analysts consider the ROCE measurement to be a more comprehensive profitability indicator because it gauges management’s ability to generate earnings from a company’s total pool of capital.
Formula: ROCE = NOPAT/Capital Employed
As Koos Boot pointed out to me: it might be more useful to look at Economic Value Added of Economic Profit to determine if the company creates value.
He wrote to me: “In that case you compare how much the company earns with its investments (ie total assets minus non-interest bearing debt) compared to what the company must pay on its funding. The latter is both interest and a (fictitious) compensation for equity providers. The latter charge is always higher than the interest for the banks because there is more risk involved. Both items (earnings on assets and capital costs) have to be adjusted for tax effects.
The analysis is used to separate the effects of investment versus funding.
Your understanding NOPAT (net operating profit after taxes) is here also (rightly) called, but not explained.
My experience is that in practice there is little use of ROA, RONA and similar concepts, but more often ROCE is used and then usually together with EVA.
In my experience ROE is rarely used. It is more common among shareholders than companies (and is therefore in itself relevant)
3. Cash Flow Indicator Ratios
3. 1 Operating cash flow
While EBITDA is sometimes called “cash flow”, it is really earnings before the effects of financing and capital investment decisions. It does not capture the changes in working capital (inventories, receivables, etc.). The real operating cash flow is the number derived in the statement of cash flows.
Overview of the Statement of Cash Flows
The statement of cash flows for non-financial companies consists of three main parts:
- Operating flows – The net cash generated from operations (net income and change in working capital).
- Investing flows – The net result of capital expenditures, investments, acquisitions, etc.
- Financing flows – The net result of raising cash to fund the other flows or repaying debt and dividends.
By taking net income and making adjustments to reflect changes in the working capital accounts on the balance sheet (receivables, payables, inventories) and other current accounts, the operating cash flow section shows how cash was generated during the period. It is this translation process from accrual accounting to cash accounting that makes the operating cash flow statement so important.
3.2 Free cash flow can also be calculated by taking operating cash flow and subtracting capital expenditures.
Formula: FCF = Operating Cash Flow – Capital Expenditures
3.3 The free cash flow/operating cash flow
The free cash flow/operating cash flow ratio measures the relationship between free cash flow and operating cash flow.
Free cash flow is most often defined as operating cash flow minus capital expenditures, which, in analytical terms, are considered to be an essential outflow of funds to maintain a company’s competitiveness and efficiency.
The cash flow remaining after this deduction is considered “free” cash flow, which becomes available to a company to use for further expansion, acquisitions, and/or financial stability to weather difficult market conditions. The higher the percentage of free cash flow embedded in a company’s operating cash flow, the greater the financial strength of the company.
Formula: Free Cash Flow (Operating Cash Flow – Capital Expenditure)/Operating Cash Flow
3.4 Working capital ratio
This ratio indicates whether a company has enough short-term assets to cover its short-term debt. Anything below 10 indicates negative W/C (working capital). While anything over 20 means that the company is not investing excess assets. Most believe that a ratio between 12 and 20 is sufficient,
If you have calculated how much capital you have, you do not know whether that amount is high enough. To determine to some extent, working capital is often related to the annual revenue or total assets. The working capital ratio is calculated by dividing working capital by total assets or annual revenue and the result multiplied by 100 percent.
Inventory: € 100.000,=
Debtors: € 100.000,=
Cash: € 20.000.= +
Current assets € 220.000,=
Current account: € 80.000,=
Creditors: € 80.000,= +
Short term debt: € 160.000,=
Working capital: € 60.000,= (+)
Turnover: € 500.000,=
Working capital ratio: € 60.000,= / € 500.000,= 12%
4. Ratios related to debt
Solvency ratios if one of many ratios used to measure a company’s ability to meet long-term obligations. The solvency ratio measures the size of a company’s after-tax income, excluding non-cash depreciation expenses, as compared to the firm’s total debt obligations. It provides a measurement of how likely a company will be to continue meeting its debt obligations.
In practice you will almost always find: Net debt / EBITDA. This is often a covenantratio for bank financing. Net debt is usually all interest-bearing debt minus cash.
In fact it indicates how many times your income your debt can be. This will sound familiar if you consider your personal situation. The bank provides mortgage that will not exceed three times your annual salary.
4.1 Debt-Equity Ratio
To a large degree, the debt-equity ratio provides another vantage point on a company’s leverage position, in this case, comparing total liabilities to shareholders’ equity, as opposed to total assets in the debt ratio. Similar to the debt ratio, a lower the percentage means that a company is using less leverage and has a stronger equity position.
Formula: debt-equity ration = Total Liabilities/Shareholders’ Equity
Often you will see the old solvency ratio Shareholders’ Equity / Total assets. Total assets are often adjusted for non-interest bearing liabilities. These are deducted from the assets (ie a net assets balance).
4.2 Interest Coverage Ratio
To what extent are expenses covered by your operating interest? In short, you can easily pay off interest on your financiers from the realized profit.
Banks establish different standards for different industries. The assumption is that the RF (ICR) must be at least 4. After all, interest rates may vary over time, and you must be able to cover a higher interest rate.
The higher the number, the more security to foreign capital providers can be given. As a result, the interest obligations of the company are met.
Example (based on a dutch BV structure):
Turnover: € 500.000
Cost of sales € 100.000
Salaries € 150.000
Depreciation € 60.000
Other costs € 115.000 –
Operating result € 75.000
Interest costs € 15.300 –
Profit before tax € 59.700
Tax € 15.300 –
Profit after tax € 44.700
Interest coverage ratio € 75.000 / € 15.300 = 5
4.3 Tangible Net Worth
A measure of the physical worth of a company, which does not include any value derived from intangible assets such as copyrights, patents and intellectual property. Tangible net worth is calculated by taking a firm’s total assets and subtracting the value of all liabilities and intangible assets.
Formula: Tangible Net Worth = Total Assets – Liabilities – Intangible Assets
Again, this says nothing about the future earning capacity and is is therefore not widely used. Sometimes banks like to have an old-fashioned view at equity and deduct all intangible assets just to be sure. The outcome is then divided by total assets. If you score above 30% is, one feels (rightly or wrongly) comfortable.
4.4 Capital Base
Since Solvency II banks are looking intently at their clients’ Capital Base (in Dutch: Garantie Vermogen). In our dealings with Deutsche Bank, they used the following definition for Capital Base:
The Capital base comprises share capital, retained earnings, subordinated debts (debts that are only repaid after the bank loans have been repaid) and reinvestment reserves arising from revaluation. Minority interests and Intangible Assets like goodwill are deducted.
Capital Base Ratio: Capital Base/Balance Total
share capital plus
retained earnings plus
subordinated debts plus
passive tax latencies (like reinvestment reserves) minus
Intangible Assets (such as goodwill)
Minority interests minus
Active tax latencies (like Deferred Taxes)
As a percentage of the balance sheet total
The balance sheet, along with the income and cash flow statements, gives an insight into a company and its operations. There are probably many differences per country, per industry and per bank you are dealing with on what is important, and what is not.
Investors have a different view of the world than banks, and both of them have different views than the entrepreneur or executive who is implementing his strategy. In all cases: you have to understand what you are looking at, and you have to make your own choices based on the facts that are important to you. In the end, financial figures might distort the reality as you know it, but if you understand their language, they do not lie.