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The analysis of a balance sheet is a complex process. It not only includes a large number of the information of management, but also these information need to be analysed comprehensively with the income statement, cash flow, accounting policies and explanatory notes.
Firstly, we must know the balance sheet reflects the financial situation of a company at a point in time (the balance sheet date), but the income statement shows the operational results of the company over a period of time.
Now, we should know the basic ledgers of the balance sheet and the income statement. The balance sheet is divided into assets, liabilities and equity. And the assets is divided into current assets and non-current assets. We assume you have known the definition of all ledgers within current assets and non-current assets and the journals record when the transactions occured (if you don’t know it clearly, you can see the details of the balance sheet).
Balance sheet shows the economic resources controlled by the company, existing obligations and the net assets of the required right of the owners, reflecting the economic resources controlled by the company and the assets for redeem the debt in the future. Here, there’re some count methods when analysing the balance sheet. Four main ratios groups:
- Profitability.
Profitability reflects the performance of company and its managers, such as: return on capital employed(ROCE), gross profit percetage and trading profit margin. - Management effciency.
Management effciency reflects the effciency of asset usage: inventory turnover, accounts receivable collection period, accounts payable payment period. - Financial.
Financial reflects financial structure and stability of the company: equity to assets ratio, current and liquid ratios. - Financial.
Financial reflects financial structure and stability of the company: equity to assets ratio, current and liquid ratios.
Balance sheet involves the analysis of the management effciency and the financial. The analysis of the profitability and the investment need to combine the income statement. In fact, it’s not too complex. As long as you’ve understanded the definition and use of accounting ledgers within the balance sheet and the income statement, it’s easy to analyse the four main ratios groups and make the right conclusion of analysis.
Here, we analyse mainly the management effciency and the financial. And according to the result of analysis to improve the management.
Management effciency:
- Inventory turnover.
It insteads the turnover rate of the enterprise. Generally, if it’s commercial enterprise, the more higher, the more better. - Accounts receivable collection period.
The more quicker, the more better. It shows we can regain the cash flow more quickly. - Accounts payable payment period.
It represents a source fo free finance.
Financial:
- Current and liquid ratios.
It shows the short financial situation of the enterprise. For example, is the current assets sufficient to redeem the current debt? Or there’re how much to redeem the current debt when the current assets minus the inventory. We know sometimes there’re some problems in truning the inventory into cash. - Equity to assets ratio.
The equity to assets ratio shows what proportion of total assets is financed by equity, and hence what proportion is financed by loans and non-equity shares.
According to the analysis about the management effciency and the financial, we can make a strategic decision to improve the management of the enterprise. If you want to know more and the details, you can study this book Analysis of Financial Statements (Frank J. Fabozzi Series). The book, so far, is excellent. It’s very current, up to date, and insightful, especially when you’re face the exams or the financial problem.
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