Intro to Finance: Financial Statement Analysis - Balance Sheet, Assets Liabilities Equity Working Capital

What This Is

A balance sheet is a financial statement that presents a company's assets, liabilities, and equity at a specific point in time. It provides a snapshot of a company's financial position and is essential for understanding a company's liquidity, solvency, and profitability. For example, Apple's balance sheet as of 2022 reported total assets of $384 billion, total liabilities of $343 billion, and total equity of $41 billion.

Key Formulas & Symbols

• Current Ratio = Current Assets / Current Liabilities where Current Assets = cash, accounts receivable, inventory, and prepaid expenses, Current Liabilities = accounts payable, short-term debt, and accrued expenses.
• Quick Ratio = (Current Assets - Inventory) / Current Liabilities where Inventory is excluded from current assets to better reflect a company's ability to pay short-term debts.
• Debt-to-Equity Ratio = Total Debt / Total Equity where Total Debt = long-term debt, short-term debt, and other debt obligations, Total Equity = common stock, retained earnings, and other equity components.
• Working Capital = Current Assets - Current Liabilities where Working Capital is a measure of a company's liquidity and ability to meet short-term obligations.
• Asset Turnover Ratio = Sales / Total Assets where Sales is the revenue generated by a company, Total Assets = all assets on the balance sheet.
• Return on Equity (ROE) = Net Income / Total Equity where Net Income is the profit earned by a company, Total Equity = common stock, retained earnings, and other equity components.
• Capital Structure = Total Debt / (Total Debt + Total Equity) where Capital Structure is a measure of a company's financing mix.

Step-by-Step Calculation

1. Calculate the current ratio by dividing current assets by current liabilities.
2. Calculate the quick ratio by dividing current assets minus inventory by current liabilities.
3. Calculate the debt-to-equity ratio by dividing total debt by total equity.
4. Calculate working capital by subtracting current liabilities from current assets.
5. Calculate the asset turnover ratio by dividing sales by total assets.
6. Calculate the return on equity (ROE) by dividing net income by total equity.

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
• Correction: Use market value for WACC to reflect the actual cost of capital.
• Mistake: Confusing IRR and NPV ranking.
• Correction: IRR is the rate at which the NPV equals zero, while NPV ranking is based on the difference between the NPV and zero.
• Mistake: Not considering taxes when calculating WACC.
• Correction: Taxes should be considered when calculating WACC to reflect the actual cost of capital.

Exam / CFA Tips

• Tip: Be careful with the order of operations when calculating WACC.
• Tip: Use the correct formula for calculating the weighted average cost of capital (WACC).
• Tip: Consider the impact of taxes on WACC when calculating the cost of capital.

Quick Practice Problem

A company has $100 million in cash and $50 million in accounts payable. What is the company's current ratio?

Answer: 2, because $100 million (current assets) / $50 million (current liabilities) = 2.

Last-Minute Cram Sheet

• The current ratio is a liquidity measure, not a solvency measure.
• The quick ratio is a more conservative measure of liquidity than the current ratio.
• The debt-to-equity ratio is a measure of leverage, not a measure of liquidity.
• Working capital is a measure of a company's liquidity and ability to meet short-term obligations.
• The asset turnover ratio is a measure of efficiency, not a measure of profitability.
• Return on equity (ROE) is a measure of a company's profitability.
• The capital structure is a measure of a company's financing mix, not a measure of liquidity.
• The WACC is a measure of the cost of capital, not a measure of profitability.