Analyzing the Balance Sheet Using Ratios

LEARNING OBJECTIVE 2

Use ratios to evaluate a company's balance sheet.

We previously introduced the four financial statements. We discussed how these statements

provide information about a company's performance and financial position. Here, we extend

this discussion by showing you specific tools that you can use to analyze financial statements

in order to make a more meaningful evaluation of a company.

Ratio Analysis

Ratio analysis expresses the relationship among selected items of financial statement data.

A ratio expresses the mathematical relationship between one quantity and another. For analysis

of the primary financial statements, we classify ratios as shown in Illustration 2.9.

A single ratio by itself is not very meaningful. Accordingly, in this and the following chapters,

we will use various comparisons to shed light on company performance:

1. Intracompany comparisons covering two years for the same company.

2. Industry-average comparisons based on average ratios for particular industries.

3. Intercompany comparisons based on comparisons with a competitor in the same

industry.

Next, we use some ratios and comparisons to analyze the balance sheet of Best Buy.

Using a Classified Balance Sheet

You can learn a lot about a company's financial health by evaluating the relationship between

its various assets and liabilities.

Liquidity

Suppose you are a banker at Citigroup considering lending money to Best Buy, or you are a

sales manager at Apple interested in selling computers and cell phones to Best Buy on credit.

You would be concerned about Best Buy's liquidityits ability to pay obligations

expected to become due within the next year or operating cycle.

You would look closely at the relationship of its current assets to current liabilities.

Working Capital One measure of liquidity is working capital, which is the difference

between the amounts of current assets and current liabilities (see Illustration 2.11).

Working Capital = Current Assets Current Liabilities

When current assets exceed current liabilities, working capital is positive. When this

occurs, there is a greater likelihood that the company will pay its liabilities.

When working capital is negative, a company might not be able to pay short-term creditors,

and the company might ultimately be forced into bankruptcy.

Best Buy had working capital in 2017 of $3,394 million ($10,516 million $7,122 million).

Current Ratio Liquidity ratios measure the short-term ability of the company to pay its

maturing obligations and to meet unexpected needs for cash.

One liquidity ratio is the current ratio, computed as current assets divided by current

liabilities (see Decision Tools).

The current ratio is a more dependable indicator of liquidity than working capital.

Two companies with the same amount of working capital may have significantly different

current ratios.

What does the ratio actually mean? Best Buy's 2017 current ratio of 1.48:1 means that for

every dollar of current liabilities, Best Buy has $1.48 of current assets. Best Buy's current ratio

increased in 2017. Best Buy's current ratio is very similar to that of hhgregg.

One potential weakness of the current ratio is that it does not take into account the

composition of the current assets.

A satisfactory current ratio does not disclose whether a portion of the current assets is

tied up in slow-moving inventory.

The composition of the current assets matters because a dollar of cash is more readily

available to pay the bills than is a dollar of inventory.

For example, suppose a company's cash balance declined while its merchandise inventory

increased substantially. If inventory increased because the company is having difficulty selling

its products, then the current ratio might not fully reflect the reduction in the company's

liquidity.

Solvency

Now suppose that instead of being a short-term creditor, you are interested in either buying

Best Buy's stock or extending the company a long-term loan.

Long-term creditors and stockholders are interested in a company's solvencyits ability

to pay interest as it comes due and to repay the balance of a debt due at its maturity.

Solvency ratios measure the ability of the company to survive over a long period of time.

Debt to Assets Ratio : The debt to assets ratio is one measure of solvency. It is

calculated by dividing total liabilities (both current and long-term) by total assets. It measures

the percentage of total financing provided by creditors rather than stockholders (see

Helpful Hint).

Debt financing is more risky than equity financing because debt must be repaid at specific

points in time, whether the company is performing well or not.

Thus, the higher the percentage of debt financing, the riskier the company.

The higher the percentage of total liabilities (debt) to total assets, the greater the risk that

the company may be unable to pay its debts as they come due. Illustration 2.13 shows the

debt to assets ratios for Best Buy and hhgregg.

The 2017 ratio of 66% means that every dollar of assets was financed by 66 cents of debt.

Best Buy's ratio is similar to hhgregg's ratio of 69%. The higher the ratio, the more reliant the

company is on debt financing. This means that a company with a high debt to assets ratio has

a lower equity "buffer" available to creditors if the company becomes insolvent. Thus, from

the creditors' point of view, a high ratio of debt to assets is undesirable (see Decision Tools).

The adequacy of this ratio is often judged in light of the company's net income.

Note that while Best Buy and hhgregg relied on debt financing in a roughly equal fashion,

hhgregg went bankrupt.

This is largely explained by the fact that hhgregg's income was insufficient to pay its debt

obligations as they came due.

Generally, companies with relatively stable earnings, such as public utilities, can support

higher debt to assets ratios than can cyclical companies with widely fluctuating earnings,

such as many high-tech companies.

In later chapters, you will learn additional ways to evaluate solvency.

Write a letter to B. P. Palmer that explains

(a) the three main types of ratios;

(b) examples of liquidity and solvency ratios, how they are calculated, and what they measure;

(c) the basis for comparison in analyzing Future Products' financial statements.