Assessing a Company’s Balance Sheet: Essential Metrics and Evaluation

A company’s balance sheet provides a snapshot of its assets and liabilities, showing what it owns and owes at a specific time. Evaluating balance sheets is essential for making informed investment decisions, as it reveals the company’s financial stability. Key metrics like working capital, asset performance, and capitalization structure help investors assess its financial health and the quality of their investment.

Analyzing the Cash Conversion Cycle (CCC)

The cash conversion cycle is a key indicator of the adequacy of a company’s working capital position. Working capital is the difference between a company’s current assets, such as cash and current liabilities, such as payables owed to suppliers for raw materials. Current assets and liabilities are short-term in nature, meaning they’re usually on the books for less than one year.

The cash conversion cycle is an indicator of a company’s ability to efficiently manage two of its most important assets–accounts receivable and inventory. Accounts receivable is the total money owed to a company by its customers for booked sales.

Key Components of the Cash Conversion Cycle (CCC)

Days sales outstanding is the average number of days it takes a company to collect payment from their customers after a sale is made. The cash conversion cycle uses days sales outstanding to help determine whether the company is efficient at collecting from its clients.

The cash conversion cycle calculation also calculates how long it takes a company to pay its bills. Days payables outstanding represents the average number of days it takes a company to pay its suppliers and vendors.

The third component of the CCC includes how long inventory sits idle. Days inventory outstanding is the average number of days that inventory has been in stock before selling it.

Calculated in days, the CCC reflects the time required to collect on sales and the time it takes to turn over inventory. The cash conversion cycle calculation helps to determine how well a company is collecting and paying its short-term cash transactions. If a company is slow to collect on its receivables, for example, a cash shortfall could result and the company could have difficulty paying its bills and payables.

The shorter the cycle, the better. Cash is king, and smart managers know that fast-moving working capital is more profitable than unproductive working capital that is tied up in assets.

How to Calculate the Cash Conversion Cycle

$\begin{aligned} &\text{CCC} = \text{DIO} + \text{DSO} – \text{DPO}\\ &\textbf{where:}\\ &\text{DIO} = \text{Days inventory outstanding} \\ &\text{DSO} = \text{Days sales outstanding} \\ &\text{DPO} = \text{Days payables outstanding} \\ \end{aligned}$​CCC=DIO+DSO−DPOwhere:DIO=Days inventory outstandingDSO=Days sales outstandingDPO=Days payables outstanding​

1. Obtain a company’s days inventory outstanding (DIO) and add it to the days sales outstanding (DSO).
2. Subtract the company’s days payables outstanding (DPO) from the result obtained in the first step.
3. Use the formula CCC = DIO + DSO – DPO to understand the cash conversion cycle’s efficiency.

The fixed asset turnover ratio can tell investors how effectively a company’s management is using its assets. The ratio is a measure of the productivity of a company’s fixed assets with respect to generating revenue. The higher the number of times PP&E turns over, the more revenue or net sales a company’s generating with those assets.

It’s important for investors to compare the fixed asset turnover rates over several periods since companies will likely upgrade and add new equipment over time. Ideally, investors should look for improving turnover rates over multiple periods. Also, it’s best to compare the turnover ratios with similar companies within the same industry.

Measuring Efficiency With the Fixed Asset Turnover Ratio

The fixed asset turnover ratio measures how much revenue is generated from the use of a company’s total assets. Since assets can cost a significant amount of money, investors want to know how much revenue is being earned from those assets and whether they’re being used efficiently.

Fixed assets, such as property, plant, and equipment (PP&E) are the physical assets that a company owns and are typically the largest component of total assets. Although the term fixed assets is typically considered a company’s PP&E, the assets are also referred to as non-current assets, meaning they’re long-term assets.

The amount of fixed assets a company owns is dependent, to a large degree, on its line of business. Some businesses are more capital intensive than others. Large capital equipment producers, such as farm equipment manufacturers, require a large amount of fixed-asset investment. Service companies and computer software producers need a relatively small amount of fixed assets. Mainstream manufacturers typically have 25% to 40% of their assets in PP&E. Accordingly, fixed asset turnover ratios will vary among different industries.

How to Calculate the Fixed Asset Turnover Ratio

$\begin{aligned}&\text{Fixed Asset Turnover}=\frac{\text{Net Sales}}{\text{Average Fixed Assets}}\\&\textbf{where:}\\&\text{Net Sales}=\text{Gross sales, less returns, and allowances}\\&\text{Average Fixed Assets}=\frac{\text{NABB}+\text{Ending Balance}}{2}\\&\text{NABB}=\text{Net fixed assets’ beginning balance}\end{aligned}$​Fixed Asset Turnover=Average Fixed AssetsNet Sales​where:Net Sales=Gross sales, less returns, and allowancesAverage Fixed Assets=2NABB+Ending Balance​NABB=Net fixed assets’ beginning balance​

1. Locate net sales on the company’s income statement.
2. To find net sales, subtract returns and allowances from gross sales if necessary.
3. Calculate the average fixed assets by adding the beginning and ending balances of net fixed assets and dividing by two.
4. Divide net sales by average fixed assets to obtain the fixed asset turnover ratio.

The fixed asset turnover ratio can tell investors how effectively a company’s management is using its assets. The ratio is a measure of the productivity of a company’s fixed assets with respect to generating revenue. The higher the number of times PP&E turns over, the more revenue or net sales a company’s generating with those assets.

It’s important for investors to compare the fixed asset turnover rates over several periods since companies will likely upgrade and add new equipment over time. Ideally, investors should look for improving turnover rates over multiple periods. Also, it’s best to compare the turnover ratios with similar companies within the same industry.

Analyzing Profitability With the Return on Assets Ratio

Return on assets (ROA) is considered a profitability ratio, meaning it shows how much net income or profit is being earned from its total assets. However, ROA can also serve as a metric for determining the asset performance of a company.

As noted earlier, fixed assets require a significant amount of capital to buy and maintain. As a result, the ROA helps investors determine how well the company is using that capital investment to generate earnings. If a company’s management team has invested poorly with its asset purchases, it’ll show up in the ROA metric.

Also, if a company has not updated its assets, such as equipment upgrades, it’ll result in a lower ROA when compared to similar companies that have upgraded their equipment or fixed assets. As a result, it’s important to compare the ROA of companies in the same industry or with similar product offerings, such as automakers. Comparing the ROAs of a capital intensive company such as an auto manufacturer to a marketing firm that has few fixed assets would provide little insight as to which company would be a better investment.

Formula and Calculation of the Return on Assets Ratio


$\begin{aligned} &\text{ROA} = \frac{ \text{Net Income} }{ \text{Average Total Assets} }\\ \end{aligned}$​ROA=Average Total AssetsNet Income​​

1. Locate net income on the company’s income statement.
2. In many ROA formulas, total assets or the ending period total assets figure is used in the denominator.
3. However, if you want to use average total assets, add total assets from the beginning of the period to the ending period value of total assets and divide the result by two to calculate the average total assets.
4. Divide net income by the total assets or average total assets to obtain the ROA.
5. Please note that the above formula will yield a decimal, such as .10 for example. Multiply the result by 100 to move the decimal and convert it to a percentage, such as .10 * 100 = 10% ROA.

The reason that the ROA ratio is expressed as a percentage return is to allow a comparison in percentage terms of how much profit is generated from total assets. If a company has a 10% ROA, it generates 10 cents for every one dollar of profit or net income that’s earned.

A high percentage return implies well-managed assets and here again, the ROA ratio is best employed as a comparative analysis of a company’s own historical performance.

The Impact of Intangible Assets

Numerous non-physical assets are considered intangible assets, which are broadly categorized into three different types:

Unfortunately, there is little uniformity in balance sheet presentations for intangible assets or the terminology used in the account captions. Often, intangibles are buried in other assets and only disclosed in a note in the financials.

The dollars involved in intellectual property and deferred charges are typically not material and, in most cases, do not warrant much analytical scrutiny. However, investors are encouraged to take a careful look at the amount of purchased goodwill on a company’s balance sheet—an intangible asset that arises when an existing business is acquired. Some investment professionals are uncomfortable with a large amount of purchased goodwill. The return to the acquiring company will be realized only if, in the future, it is able to turn the acquisition into positive earnings.

Conservative analysts will deduct the amount of purchased goodwill from shareholders’ equity to arrive at a company’s tangible net worth. In the absence of any precise analytical measurement to make a judgment on the impact of this deduction, investors use common sense. If the deduction of purchased goodwill has a material negative impact on a company’s equity position, it should be a matter of concern. For example, a moderately leveraged balance sheet might be unappealing if its debt liabilities are seriously in excess of its tangible equity position.

Companies acquire other companies, so purchased goodwill is a fact of life in financial accounting. However, investors need to look carefully at a relatively large amount of purchased goodwill on the balance sheet. The impact of this account on the investment quality of a balance sheet needs to be judged in terms of its comparative size to shareholders’ equity and the company’s success rate with acquisitions. This truly is a judgment call, but one that needs to be considered thoughtfully.

The Bottom Line

The efficient management of key asset types is crucial for maintaining a strong balance sheet. Understanding how to read and analyze these financial statements lets you assess a company’s strength and make better investment decisions, helping build a robust and well-informed portfolio.