The term comparative balance sheet analysisstands for the study of the trend of the same items, or computed ratios, in two or more balance sheets of the same business enterprise on different dates. It is also the study of the trend of propor- tions extracted from B/S figures, as of the different dates, and used to create a pattern of the entity’s financial behaviour.
Comparative balance sheet analysis is most comprehensive when based on a bal- ance sheet model that remains invariable between time periods, thus making comparisons possible. Also, it is most desirable that successive yearly balance sheets represent the financial condition of an enterprise at the same point in the natural business year cycle. To be successful in a comparative B/S study, the ana- lyst must realize that:
● Financial figures must be strictly comparable, and
● He or she should always find out why they are not comparable, if it so happens.
This calls for appropriate modelling of assets and liabilities, starting with their classification in the manner discussed in section 2, keeping that classification steady. It also requires a balance sheet model which more or less remains invari- ant. Box 13.1 presents as an example the different chapters of a consolidated B/S.
The theme of Box 13.2 is critical balance sheet ratios to be targeted in an analysis.
The strategic aspect of A&L modelling is a direct after-effect of the fact that a com- pany’s balance sheet represents its financial state, complemented by its profit and loss calculations (see section 5). Both are important to all of its stakeholders: the shareholders, bondholders, management, employees, regulators, and investors.
Tactical aspects, on the other hand, are mainly concerned with the:
● Mechanics of modelling
● Use of the construct for predictive or evaluative purposes
● Risks with incorrect entries to the B/S, whether because of error or fraud, and
● Risks taken with models because of their imperfect fit with real-life per- formance.
Good news first. As we have already seen in Part 3, models written for analysis and simulation have the major advantage of making mental processes explicit.
They help to expose inconsistencies in these mental processes, and make possible rethinking of variables and patterns. They also contribute to determining future implications ahead of time.
Box 13.1 A consolidated balance sheet.
ASSETS
● Current assets
Cash and cash equivalents Short-term investments Accounts receivable Other receivables
Prepaid expenses and other current assets
● Longer-term assets
Property and equipment at cost, net
Investments including available-for-sale securities Goodwill and other intangible assets, net
Other assets LIABILITIES
● Current liabilities Accounts payable
Accrued expenses and other liabilities Accrued personnel costs
Deferred income taxes
● Longer-term liabilities Bond issues
Longer-term loans
Irreversible commitments
● Stockholders’ equity Preferred stock Paid-in capital
Unrealized gains on available-for-sales securities Cash flow hedges, net
Retained earnings
In this sense, models developed for balance sheet presentation and those written for analysis can provide a rich source of information on financials, including latent problems. The risk involved derives from simplification, which comes with abstraction. Seen independently from one another, each of the financial ratios shown in Box 13.2 is too weak in terms of provided information for deci- sion purposes. But these ratios can present a more complex pattern when taken in unison, provided that:
● Their meaning is clear
● Their computation is fairly standardized, and
● We are confident in the way they have been recorded or estimated; in short, in their accuracy.
Let’s take a closer look into a ratio providing investor information which falls at the P&L side. Earnings per share (EPS) is one of the time-honoured criteria, and quite often analysts look at the price of a stock as 10, 20, 30 times or more earn- ings per share. Both the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASC) issued new standards for com- puting EPS, which primarily deal with the denominator used in its calculation,
Box 13.2 Critical balance sheet ratios
● Annualized Revenues per Employee
● Working capital
● Acid test (current ratio), CA/CL
● Book value per share
● Assets/liabilities test (A/L), with proxy capitalization
● Cash per share
● Days of inventory
● Debt to capitalization
● Earnings per share
● Inventory turns
● Quick ratio
● Sales to total assets
● Return on sales
● Return on equity
● Working capital
since always on the numerator is net income (see section 5 on the difficulty of estimating it properly).
Earnings per share has been classically employed as a metric for stock valuation.
More recently, however, two value-added metrics were introduced: EPS Change (year-to-year) and Consensus EPS. Earnings per share and its add-ons are calcu- lated not only on an annual basis but also quarterly, based on the company’s financial reporting, or at shorter intervals as information becomes available.
This may help provide better focus; on the other hand, add-ons make the com- putation more complex. Under Financial Accounting Standards 128 (FAS 128), the computation becomes simpler, but at the same time FAS 128 requires two EPS statistics, and the spread between the two figures can be wide:
● FAS 128 substitutes basic earnings per share (BEPS) for primary earnings per share (PEPS).
BEPS is net income available to common shareholders divided by the weighted average number of common shares outstanding. The other figure is fully diluted earnings per share (FDEPS) which, generally, will be the same or higher than the pre- viously calculated figure referred to as diluted earnings per share (DEPS). Inversely:
● DEPS will be higher than FDEPS when stock prices rise at the end of the period.
DEPS continues being calculated using the if converted method for convertible securities, and treasury stock method for options and warrants. But between FASB and IASB the specifics of this calculation diverge, and moreover the impact varies by company.
An added complexity is provided by the proliferation of metrics due to the policy entities follow in retained earnings. Growth companies typically pay no divi- dends, therefore two further metrics, dividend rate and dividend yield, are not important to them, but they are used with companies paying dividends, a growing breed. Just as important are cash flow measurements. Two metrics applicable in this connection are:
● Cash flow/share
● Price/cash flow.
Strictly speaking, these are not balance sheet items, but they are critical issues to analysts and investors, and the place to find information about them is the balance
sheet and income statement. This brings back into perspective the question of which values are written in the B/S and P&L. Or, more precisely, how these have been computed. The principle is that what matters is fair valuewhich, as we have already seen, is market value established by a willing buyer and willing seller under other than fire sale conditions.