Common-size Balance Sheet and Related Financial Ratios

Examining a company’s balance sheet can reveal information about its liquidity and solvency at the time the balance sheet is prepared, as well as the economic resources under the company’s control. Recall that liquidity is defined as the company’s ability to meet its short-term financial commitments. In other words, analysis of liquidity concentrates on the company’s ability to liquidate assets into cash to cover operating expenses.

On the other hand, solvency refers to a company’s ability to meet its financial obligations over the longer term. As such, solvency emphasizes the company’s financial framework and its capacity to service long-term debts.

The main tools of analyzing balance sheets are common-size analysis and balance sheet ratios.

Common-Sizing the Balance Sheet

Common-size balance sheets are valuable for analyzing the composition of a company’s balance sheet both over time (time-series analysis) and in comparison with other companies within the same industry (cross-sectional analysis).

Two primary methods for common-sizing the balance sheet are vertical common-size analysis and horizontal common-size analysis.

The vertical common-size analysis states each balance sheet item as a percentage of total assets. In contrast, the horizontal common-size analysis reflects quantities on the balance sheet regarding a base-year value of choice. However, the vertical common-size analysis is the more popular of the two methods.

Example: Vertical Common-size Analysis (Time-Series Analysis)

$$ \begin{array}{l|r|r}
&  & \textbf{Common−} \\
& & \textbf{size} \\
&\textbf{Dec 31, 2016} & \textbf{balance-} \\
\textbf{Assets}& \textbf{(\$)} & {\textbf{sheet (%)} } \\ \hline
\text{Current Assets} & & \\ \hline
\text{Cash and cash equivalents} & 100,000 & 0.8 \\ \hline
\text{Short-term marketable securities} & 1, 234,678 & 9.7 \\ \hline
\text{Accounts receivable} & 52,000 & 0.4 \\ \hline
\text{Inventory} & 1, 170,356 & 9.2 \\ \hline
\text{Total current assets} & 2, 557,034 & 20.0 \\ \hline
\text{Property, plant, and equipment} & 6, 834,190 & 53.6 \\ \hline
\text{Intangible assets} & 3, 370,041 & 26.4 \\ \hline
\text{Total assets} & 12, 761,265 & 100.0 \\ \hline
\text{Liabilities and shareholders’ equity} & & \\ \hline
\text{Current liabilities} & & \\ \hline
\text{Accounts payable} & 3, 825,396 & 30.0 \\ \hline
\text{Total current liabilities} & 3, 825,396 & 30.0 \\ \hline
\text{Bonds payable} & 3, 771,894 & 29.6 \\ \hline
\text{Total liabilities} & 7, 597,290 & 59.5 \\ \hline
\text{Total shareholders’ equity} & 5, 163,975 & 40.5 \\ \hline
{\text{Total liabilities and shareholders’} \\ \text{equity}} & 12, 761,265 & 100.0
\end{array} $$

An analysis of data in the table above reveals that property, plant, and equipment, at 53.6%, make up the lion’s share of the company’s assets. The company does not have much cash and cash equivalents (0.8%), and most of its debt is in the form of accounts payable (30.0%). Also, there is no working capital as current assets (20.0%) are less than current liabilities (30.0%).

Example: Vertical Common-size Analysis (Cross-Sectional Analysis Analysis)

Emma Stone is analyzing two companies in the electronics industry to assess their financial health as shown on their balance sheets. She has prepared the following vertical common-size balance sheets for Sony and Panasonic (hypothetical values):

$$\begin{array}{l|c|c}
\hline & \textbf{Sony} & \textbf{Panasonic} \\ \hline
\textbf{ASSETS:} & \textbf{31 March 2023} & \textbf{31 March 2023} \\ \hline
\text{Current assets:} & & \\
\text{Cash and cash equivalents} & 6.2 & 4.5 \\
\text{Short-term marketable securities} & 12.7 & 48.0 \\
\text{Accounts receivable} & 5.3 & 9.1 \\
\text{Inventories} & 1.5 & 1.2 \\
\text{Other current assets} & 3.9 & 2.5 \\
\textbf{Total current assets} & 29.6 & 65.3 \\
\text{Long-term marketable securities} & 47.1 & 3.0 \\
\text{Property, plant, and equipment, net} & 10.2 & 10.5 \\
\text{Goodwill} & 2.0 & 15.2 \\
\text{Acquired intangible assets, net} & 0.8 & 4.5 \\
\text{Other assets} & 25.3 & 2.9 \\
\textbf{Total assets} & 100.0 & 100.0 \\
\text{LIABILITIES AND SHAREHOLDERS’}\\
\text{EQUITY:} & & \\
\text{Current liabilities:} & & \\
\text{Accounts payable} & 14.0 & 3.5 \\
\text{Short-term debt} & 3.5 & 4.0 \\
\text{Current portion of long-term debt} & 1.8 & 0.5 \\
\text{Accrued expenses} & 7.2 & 2.9 \\
\text{Deferred revenue} & 2.1 & 13.5 \\
\text{Other current liabilities} & 0.0 & 2.7 \\
\textbf{Total current liabilities} & 28.6 & 27.1 \\
\text{Long-term debt} & 26.5 & 32.4 \\
\text{Deferred revenue non-current} & 0.9 & 4.6 \\
\text{Other non-current liabilities} & 11.2 & 7.5 \\
\textbf{Total liabilities} & 67.2 & 71.6 \\
\textbf{Total shareholders’ equity} & 32.8 & 28.4 \\
\textbf{Total liabilities and shareholders’}&&\\
\textbf{equity} & 100.0 & 100.0 \\
\hline
\end{array}$$

Based on the common-size balance sheet data for Sony and Panasonic, what insights can be drawn about the liquidity, cash, and marketable securities, accounts receivable, inventories, and capital structure of these two companies?

Solution

Liquidity: Both companies have a significant portion of their assets in current assets, indicating liquidity. Sony has 29.6% of its assets in current assets, while Panasonic has a higher proportion at 65.3%. This suggests that Panasonic might have a better ability to meet short-term obligations compared to Sony.

Cash and Marketable Securities: Sony has a higher percentage of cash and cash equivalents (6.2%) compared to Panasonic (4.5%). However, Sony has a lower allocation in short-term marketable securities (12.7%) than Panasonic (48.0%). This indicates that Panasonic is holding more liquidity in cash, while Sony is investing more in short-term securities.

Accounts Receivable: Panasonic has a higher percentage of accounts receivable (9.1%) compared to Sony (5.3%), which could imply that Panasonic extends more credit to its customers or takes longer to collect payments.

Inventories: Both companies have a small portion of their assets in inventories, with Sony at 1.5% and Panasonic at 1.2%, suggesting efficient inventory management.

Capital Structure: The total liabilities to total assets ratio differs between the two companies, with Sony having 67.2% and Panasonic having 71.6%. This indicates that Panasonic has a higher level of leverage compared to Sony, suggesting a greater reliance on debt financing in its capital structure.

Shareholders’ Equity: Sony has a slightly higher proportion of shareholders’ equity (32.8%) compared to Panasonic (28.4%), suggesting that Sony has a slightly stronger equity position.

Balance Sheet Ratios

Ratio analysis can assist with the conduct of time series and cross-sectional analysis of a company’s financial position.Balance sheet ratios are those ratios that involve balance sheet items only. In a vertical common-size balance sheet, each line item represents a ratio, as it expresses a balance sheet figure as a percentage of total assets. Additionally, other balance sheet ratios are used to compare one balance sheet item to another.

Balance ratios are classified into: (i) liquidity ratios, which measure a company’s ability to meet short-term obligations; and (ii) solvency ratios, which measure financial risk, financial leverage and a company’s ability to satisfy its long-term and other obligations.

Liquidity Ratios

$$ \begin{array}{c|c|c}
\textbf{Ratio Name} & \textbf{Calculation} & \textbf{Indication} \\ \hline
\text{Current Ratio} & \frac{\text{Current assets}}{\text{Current liabilities}} & {\text{A company’s} \\ \text{ability to meet its} \\ \text{short-term obligations} } \\ \hline
{\text{Quick Ratio} \\ \text{(Acid Test)} } & \frac{ \text{Cash}+\text{Marketable securities}+\text{Receivables}}{\text{Current liabilities}} & {\text{It satisfies the} \\ \text{same purpose as} \\ \text{the current ratio} \\ \text{but is considered a} \\ \text{stricter measure as} \\ \text{inventory is} \\ \text{excluded.} } \\ \hline
\text{Cash Ratio} & \frac{\text{Cash}+\text{Marketable securities}}{\text{Current liabilities}} & {\text{Test a company’s} \\ \text{ability to meet its} \\ \text{short-term} \\ \text{obligations using} \\ \text{highly liquid} \\ \text{assets.}}
\end{array} $$

Solvency Ratios

$$ \begin{array}{l|c|c}
\textbf{Ratio Name} & \textbf{Calculation} & \textbf{Indication} \\ \hline
\text{Long term debt-to-equity} & \frac{\text{Total long term debt}}{\text{Total debt}} & {\text{Financial leverage} \\ \text{and financial risk} } \\ \hline
\text{Debt-to-equity} & \frac{\text{Total debt}}{\text{Total equity}} & {\text{Financial leverage} \\ \text{and financial risk} } \\ \hline
\text{Total debt} & \frac{\text{Total debt}}{\text{Total assets}} & {\text{Financial leverage} \\ \text{and financial risk}} \\ \hline
\text{Financial leverage} & \frac{\text{Total assets}}{\text{Total equity}} & {\text{Financial leverage} \\ \text{and financial risk}} \end{array} $$

Issues with Ratio Analysis

The effectiveness of cross-sectional financial ratio analysis can be constrained by variations in accounting practices. Furthermore, comparability can be hindered by the lack of uniformity in a company’s operational activities. To circumvent this limitation, diversified companies active in multiple industries can employ industry-specific ratios for distinct business segments can enhance comparison.

Conducting ratio analysis involves considerable judgment. One critical aspect of this judgment is recognizing the limitations of any given ratio. Additionally, it requires judgment to determine whether a ratio indicates a long-term trend or merely a short-term situation. For instance, a drawback of the current ratio is its susceptibility to changes in end-of-period financing and operational decisions that can impact the amounts of current assets and liabilities

Question 1

The following balance sheet information is given for company XYZ.

$$ \textbf{Company XYZ Balance Sheet} \\
\begin{array}{l|r}
\text{Assets} & {\text{Dec } 31, 2016(\$)} \\ \hline
\text{Current Assets} & \\ \hline
\text{Cash and cash equivalents} & 100, 000 \\ \hline
\text{Short-term marketable securities} & 1,234, 678 \\ \hline
\text{Accounts receivable} & 52, 000 \\ \hline
\text{Inventory} & 1,170, 356 \\ \hline
\text{Total current assets} & 2,557, 034 \\ \hline
\text{Property, plant, and equipment (PPE)} & 6,834, 190 \\ \hline
\text{Intangible assets} & 3,370, 041 \\ \hline
\text{Total assets} & 12,761, 265 \\ \hline
\text{Liabilities and shareholders’ equity} & \\ \hline
\text{Current Liabilities} & \\ \hline
\text{Accounts payable} & 3,825, 396 \\ \hline
\text{Total current liabilities} & 3,825, 396 \\ \hline
\text{Bonds payable} & 3,771, 894 \\ \hline
\text{Total liabilities} & 7,597, 290 \\ \hline
\text{Total shareholders’ equity} & 5,163, 975 \\ \hline
\text{Total liabilities and shareholders’ equity} & 12,761, 265
\end{array} $$

The current ratio for company XYZ is closest to:

1. 0.34.
2. 0.67.
3. 1.20.

Solution

The correct answer is B.

$$
\text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}}=\frac{2,557,034}{3,825,396}=0.67 $$

Question 2

To convert a regular balance sheet into a common-size balance sheet, each line item is stated as a percentage of:

1. Total assets.
2. Total equity.
3. Total liabilities.

Solution

The correct answer is A.

Making a common-size balance sheet requires stating each line item as a percentage of total asset.