How To Read & Analyze The Balance Sheet Like a CFO | The Complete Guide To Balance Sheet Analysis

hey guys in today's video i'm going to show you how to read and analyze the balance sheet like a cfo does so what we'll do is we'll jump back to my computer here and i'm going to show you an example balance sheet for a company called crab cake inc and what we'll do is we'll go over the structure of the balance sheet as well as a couple of accounting definitions and then we'll go over the approach itself how does a cfo approach the balance sheet which can be summed up as saying it's a risk based approach meaning a cfo looks at each line item on the balance sheet and think of all of the risks associated with that line item and then think of ways to hedge against these risks so we'll do all that and then toward the end of the video i'm going to show you a couple of financial metrics that you can apply that can quickly give you an idea of the financial health of the company based on the balance sheet that's the topic of this video today so stick around [Music] if you're new here welcome welcome my name is bill hannah i'm the financial controller i'm a licensed cpa in the great state of new york and i have over 15 years of experience in the field of finance where i started out at pricewaterhousecoopers as an auditor and then i transitioned out to private industry and then i worked my way up from a financial analyst position all the way up to a corporate controller position which is what i do today and this channel is all about giving you the summary or the juice of my experience over the last decade and a half and i do this here in the youtube channel as well as on my website through a blog post an online course and templates so go ahead and check that out as well all right so diving into the balance sheet here this is a balance sheet for a company called crab cake inc and it's for the month ended december 31 2019 and as we all know the balance sheet shows the financial position of the company at a point in time this is as opposed to the income statement which shows the financial uh performance of the company during a period of time so here we're looking at a point in time which is december 31 or december 31st 2019 and the basic structure of the balance sheet is as follows total assets which is 40 million in this case will always equal total liabilities and equity which is saying that uh assets equals liabilities plus orders equity assets is what you owe equals what you own so obviously assets is what you own in the company well you will always equal what you owe which is total liabilities and equities obviously liabilities is something that you owe to third parties and equity it's also something that the company owns but it owes this to the owners of the company right so it's very easy what you own in the company or assets will always equal what you owe which is liabilities and owner's equity all right so let's go over assets real quick so for assets we'll always have current assets and then non-current assets or other assets so basically current assets are those assets that can be converted into cash within 12 months so when we look at current assets it will include cash or cash equivalent uh here we have half a million dollars we have accounts receivable which is always the assumption is that you can always turn it into cash within 12 months because you'll collect your accounts receivable and then inventory which is three million dollars in this case uh and the idea is that all of these components all of these three items on current assets can be converted into cash within 12 months and that's why we call it current right so current means that it can be converted to cash within 12 months and then we'll always have the other assets or non-current assets which is in this case uh property plant and equipment because the idea is that these are an investment in the future of the company this is not something that the company intends to sell and turn into cash and so this is other assets here so the total assets for the company is 14 billion dollars and then we can jump over to the liabilities section so liabilities are also broken down in a similar fashion to assets where we look at current liabilities and then we look at non-current liabilities so current liabilities uh similar concept these are the liabilities or the obligations that are expected to be fulfilled that the company has to fulfill within 12 months and so an example here is accounts payable the expectation that the company will pay its accounts payable within 12 months of course and then you have accrued expenses and these are the uh all of the other expenses of the company hasn't yet booked as payable but based on the accounting principle of the accrual principle the company needs to accrue for any liability or obligation that it hasn't received an invoice for so even though you haven't received receives an invoice for a service or product from a vendor you still need to accrue for it and this is based on the accrual principle right this is one of the principles of accounting the accrual principle so uh accrued expenses 300 000 and then we have deferred revenue 500 000. the first revenue basically uh is you can think of it as prepayments from customers so as a company you're receiving cash from your customers for a future product or service that you will deliver to them in the future but the reason why we record it as a liability is because this becomes an obligation for the company right so you receive cash you record the cash as a debit but then your credit is deferred revenue which is a current liability because this is still an obligation for the company to fulfill uh and so 500 000 in this case is deferred revenue and that will give us a total current liabilities of 8.3 million dollars and then we'll jump over to non-current liabilities and these are the liabilities that we don't expect to pay for the next 12 months so here we have a long-term loan or long-term debt of 3.5 million dollars and that gives us total liabilities of 11.8 million and then after that what's left over is going to be the stockholders or the shareholders equity of 2.2 million which can be you can think of it as subtracting total liabilities from assets so if you take all of the liabilities and pay it off from the assets what's going to be left over here is 2.2 million dollars and this is the what the owners of the company can claim as their equity in the company 2.2 million dollars in this case and then obviously as we said total liabilities and equities 40 million dollars is gonna always equal total assets of 40 million and this is one of the first things you look for when you're analyzing a balance sheet right is total assets equal to total liabilities and equities if they're not equal then you're looking at a balance sheet that has an error in it and you need to have that error looked at first before you can even begin to analyze the balance sheet so the first thing is this number here assets need to equal total liabilities and equities and now that we've seen a quick overview of the balance sheet let's talk about the approach of a cfo how does the cfo approach the balance sheet and we said at the beginning of the video that it's a risk-based approach or what are the risks associated with each line item on the balance sheet so let's dive right back in and look at the risk associated with each of the line items uh beginning from the assets and going down all the way to liabilities all right so starting with current assets the first item here is going to be cash and cash equivalents so a cfo will look at this number and say okay i have half a million dollars in cash i need to look at my current liabilities so look at accounts payable here and i'll see that my balance is 7.5 million dollars which basically is telling me that i need to pay off the vendors 7.5 million dollars over the next uh say 60 to 90 days so i'll look here and say okay where is the money going to be coming from to cover all these accounts payable if i only have half a million dollars in cash basically i look here at accounts receivable and i see that i have a big balance so seven million dollars in accounts receivable this is expected to be collected normally in a course of business uh say between 45 to 60 days so i'm expected to collect this number first so that i'm able to pay off my accounts payable so this is the first thing that the cfo will look at which is the obligations so the cfo looks at the obligations of the company in relation to the cash position of the company to determine whether there's enough cash on hand to cover the obligations that have come right up and then the second thing that the cfo would look at is profitability so we we have we know that the accounts receivable seven million dollars is going to cover um the obligations that the company needs to pay in the next uh say 90 days but then what about profitability is this company profitable meaning is this a cash machine if my cash is running low here and it's half a million dollars am i making enough profits to be able to generate to generate more cash so that i'm hedging against the risk of running out of cash so basically when we look here at the income statement looking for the company's income statement and we see that net income is 120 000 which is adjusted for depreciation with you put back depreciation this is close to 200 000 for one month so this is for the month of december 2019. so i can say okay on a monthly basis i am profitable by about 200k uh which gives me a little bit more comfort uh that um over the course of a year let's say i'm gonna be generating somewhere around two million dollars in profits which will generate more cash to uh improve my cash position so to summarize for the cashier cash equivalent the cfo will be looking at two things obligations and then also looking at profitability which in turn will create cash flow the next item here on current assets is going to be accounts receivable so the cfo would look at two things when it comes to accounts receivable they look at the balance and they'll say all right it's 7 million dollars so i need to see an aging schedule of the 7 million dollars so the aging schedule is going to show you the breakdown of this 7 million dollars in terms of what the customer owe by bucket so the first bucket is going to be current accounts receivable or you know the accounts receivable that the customer is not late on paying yet and then it's going to show you then the breakdown from 30 days 60 days 90 days uh so this way you can get an idea of like how much of this number is aged and that can give you an idea on how much of this number uh can be expected to be bad debt basically the customer is never gonna pay this number so the older the accounts receivable the more likelihood that you're not gonna collect it so that's why it's important to look at an aging schedule of accounts receivable and then the second thing that the cfo will look at is the day's sales outstanding uh so basically a day sales outstanding is a financial statement or a balance sheet metric that will show us um how far or how long it takes uh so here we have day sales outstanding which is the number of days it takes to convert sales to cash which basically takes the accounts receivable balance divided by credit sales and then multiply it by the number of days in the period and to apply this to our example here if we take um the accounts receivable balance which is uh seven million dollars divided by credit sales four million dollars which we can see here in the balance sheet or the income statement rather if we switch over to the income statement we have sales of four million dollars so we take that number and we uh plug it here so we have 7 million ar divided by credit sales um 4 million dollars times 31 days this happens to be a month with 31 days then that gives us a result of 54 days so 54 days so this is saying that the company takes on average 54 days to convert its sales into cash uh this number is a little bit on on the higher end you want this number to always be uh somewhere around 30 to 45 days um you know if it goes up to 60 days then it's a little bit above average above 60 days then that would be a bad signal so these are the two things that the cfo would look at for accounts receivable uh first is the aging schedule and then they will look at this sales outstanding or dsl the next item in our list is inventory and basically when a cfo looks at inventory they're looking at a balance of three million dollars in this case and you want to make sure that none of it is nearing expiration or obsolescence so if you have three million dollar three million dollars worth of inventory it doesn't mean that all of it is sellable right maybe some of it is not you're not you're not going to be able to sell so if you have inventory especially if it's like a food inventory and a big chunk of it is a food products that are nearing expiration or going to expire very soon uh so this is a risk here so if you if you're looking at an aging schedule of inventory you can tell by bucket how much of this inventory needs to be moved quickly in order not to be written off or not to lose money on it so a cfo would want to look at a breakdown of what makes the three million dollars in this case to determine how much risk is associated with this inventory how much of it needs to be moved quickly so now we've covered uh all of the items in current assets so the next item here is non-current assets or other assets and we have here property plant and equipment and when a cfo is looking at this balance of 3.5 million dollars they're asking themselves a question of is this entire balance appropriate to be booked in a balance sheet meaning is any of this obsolete like if this is machinery or equipment are we using all of it or some of it is obsolete and needs to be uh written off uh so this is the risk here when you look at this number uh is to know the composition no look at a breakdown of the assets that are included here and determine whether all of them are in use all of them have a future economical life for the company um so this balance is appropriate otherwise if it's not if a part of it needs to be written off then that that's a hit to the p l and that will reduce this number here on the balance sheet all right so now that we've covered assets let's look at liabilities and the first item in current liabilities is going to be accounts payable and when a cfo looks at this number here the balance 7.5 million dollars they think of two things in terms of risk when it comes to accounts payable so the first thing they think of dpo or days payable outstanding which is basically the amount of time that the company takes on average to pay uh to pay its obligations to vendors so each company has a unique cycle of payment sometimes it's a quick cycle of 30 days uh sometimes it's maybe 90 days or 120 days when it's a like a bigger supply chain when you have vendors for your materials so basically the longer the better in this case and the cfo be looking to measure the dpo and the dpo uh days payable outstanding the formula for it is purchases on credit divided by the account accounts payable balance and take that and multiply it by the number of days in the period and that will give you the dpo and typically you want that number to be as as long as possible so that you want to shrink your cycle of receiving from your customers and make this cycle as long as possible so you have an advantage and this is like a cash flow advantage when you collect quickly and then pay off on the longer duration of time so dpo is the first thing to look at and then the second thing is going to be aging so you know similar to when we talked about accounts receivable when also when you look at accounts payable we want to look at the aging of the composition of the 7.5 million dollars to determine how much of it is current and how much of it is aged because the risk here is that if if a lot of this balance is aged meaning that we owe this for the past let's say maybe six months or so this is a sign of trouble right so if the company has a lot of accounts payable that is aged or that is uh past due it means that the company isn't able to collect and time from its customers and pay off its vendors so that's why it's really important to look at aging that will give you a quick idea obviously when you look at the aging schedule you want as much as possible that 7.5 million dollars to be sitting in the current section of the aging schedule are not being past due so this is what the cfo would look at when it comes to accounts payable the next item is going to be accrued expenses and we have 300 thousand dollars and we said before the accrued expenses is what the companies accruing for in terms of liabilities that haven't received the company haven't received an invoice from a vendor yet so what the cfo would look at here is he would ask for a schedule of this number here just to determine whether the company is appropriately accruing for everything that it owes so only when you see a breakdown of the number that's when you can make that determination so a schedule here will give you an idea and then the next item is going to be deferred revenue so uh cfo would look at this number and think okay you know this 500 000 is received in advance from customers for future services or products um you know i need to know whether the company is going to be able to make good on this um on this obligation so you know the you know the cfo would want to look at and see what the customer is paying for um let's say it's paying for a product and then we'll ask a question okay this is a product that we have on hand this is is this something that we need to manufacture from scratch are we going to be able to make good on this obligation here and so you know you need to know what's um you know what's included in this number here and again this is usually going to be a schedule that you can obtain the company should keep a schedule of all of the prepayments that are received from customers so this covers pretty much the section current liabilities now we come to non-current liabilities and the cfo will look here and see that the company has a long-term debt of 3.5 million and so the first question is to ask for a breakdown of this number uh to see just to see the maturity right so you want to see the breakdown by maturity date of you know when do we expect to pay off this number is this made up of loans that are like three year or five year or ten year loan so basically then you can plan in the future um you know how you're going to pay off this loan is similar to when you own a house and or a property and you want to know how long is the the mortgage right is it a 10-year 20-year 30-year mortgage it's the same thing here if you have a long-term debt uh first thing you want to know is how long will it take to pay off or what is the maturity date um of this loan so you come to total liabilities and it's 11.8 million dollars and there are a couple of financial metrics or kpis that you want to be using here to make sure that the company financial health is not something that is in jeopardy so the first thing you want to compare is total liabilities uh you want to compare that to equity and this is a financial metric here that is called a debt to equity ratio which is the relative proportion of shareholders equity in debt used in financing the company's assets so the formula for it is liabilities divided by equity and if we apply this here uh liabilities is 11.8 million dollars divided by equity which is 2.2 million dollars and will give us a result here that is 5.4 uh so this number 5.4 um you know is saying that the company is using 5.4 times more debt than stock uh to finance its business um you know this could be a sign of too much leverage but it might be also the company taking advantage of low interest rates so there are two sources of financing for the company is either raising debt in this case which is the long-term debt or selling stock which is equity and so uh each one of them has a cost to the company and it's up to the company to determine which one is cheaper uh if the interest relate interest rates are low in an environment where the feds are lowering the interest rate uh then it makes sense for the company to raise more money from debt over financing and so in this case here you look at this metric and you can determine the debt to equity ratio the other financial metric to look at here is the servicing of the loan itself which is the interest coverage ratio so this is measuring how many times can a company cover the interest payment from earnings in a given period and so basically you take the earnings or ebit in this case earning before interest and tax divided by the interest expense and so in this case it's 250 000 which we can get here from the income statement when you take the um you know ebit which is earnings before interest and tax 250 000 divided by 80 000 which is the interest expense again that's from the income statement here as well eighty thousand dollars of interest expense um and the result is 3.1 and so this is saying that the company can cover its interest payment three times or 3.1 times over its earnings and so this is good so the company has makes enough earnings to cover its interest by a factor of three so this is a good sign that the company is in fact is able to service its interest um on the actual loan there are a few other important ratios such as the liquidity ratios uh quick and current ratios that are used by cfos to analyze the balance sheet and also there are financial leverage ratios such as the debt to capital ratio and uh debt to asset ratio as well as the financial leverage ratio and these are all important ratios that the cfos use to analyze the company i'm gonna leave a link to this file down below in the description uh in excel so you can download it and look at the balance sheet the income statement and the actual ratios that are used here so you can find a description you can find a link in the description down below so the link in the description below will lead you to a product on my website to purchase which is really inexpensive and it includes the excel file that we discussed today with its balance sheet income statement and financial metrics formula and interpretation and also an actual pdf summary one page summary of the of the metrics that we looked at today so you can keep it as a handy reference for the future the reason why this is a paid product versus a free giveaway which sometimes i give in this channel is because this this template took a lot of time for me to put together and test and make sure that it's correct and accurate and also because when you buy a product through this channel you're also supporting the channel and making sure that i'm able to give you the content or the free content that i put out every week that's it for this video if you liked it and you learned something new from it give it a big fat thumbs up and share this video with someone that you think might benefit from it and i'll see you in the next one [Music] you

Channel: The Financial Controller

Views: 200,288

Rating: 4.9607844 out of 5

Keywords: how to analyze the balance sheet, balance sheet analysis, how to read the balance sheet, how to be a financial analyst

Id: DMv9JC_K37Y

Length: 21min 31sec (1291 seconds)

Published: Sat Jan 23 2021