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

Hey guys, in today's video I'm going to show you how to

read

and

analyze

the

balance

sheet

like a CFO does. What we'll do is go back to my computer here and I'll show you an example.

balance

sheet

for a company called crab cake inc and what we'll do is 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 summarized by saying that it is a risk-based approach, which means that a CFO looks at each balance sheet item and thinks about all the risks associated with that item and then thinks of ways to protect against these risks so we'll do all that and then towards the end of the video I'll show you a couple of financial metrics that you can apply that will quickly give you an idea of ​​the financial health of the company based on the balance sheet.

The topic of this video today, so stick around if you're new here, welcome, welcome, my name is Bill Hannah, I'm the financial controller, I'm a certified public accountant in the great state of New York and I have over 15 years of experience. in the finance field where I started at Pricewaterhousecoopers as an auditor and then transitioned to the private industry and then moved up from a financial

analys

t position to a corporate controller position which is what I do today and this channel goal is giving you the summary or the juice of my experience over the last decade and a half and I do it here on the YouTube channel and on my website through a blog post, an online course and templates, so go ahead and check out.

That's fine too, so digging into the balance sheet here, this is a balance sheet for a company called Crab Cake Inc and it's for the month ending December 31, 2019 and as we all know, the balance sheet shows the financial position of the company at a given time, this is unlike the income statement, which shows the financial performance of the company over a period of time, so here we are looking at a moment in time which is December 31 or December 31, 2019 and the basic structure of the balance sheet is as follows: total assets, which are 40 million, in this case they will always be equal to the total liabilities and capital, which means that the assets are equal to the liabilities plus orders, capital assets are what you owe equals what you own, so obviously assets are what you own.

Well, the company will always be equal to what it owes, which is the total of liabilities and shares, obviously, liabilities are something that it owes to third parties and capital is also something that the company owns, but it owes it to the owners of the company, so it's very easy. What you own in the company or the assets will always be equal to what you owe, which are the owner's liabilities and equity. Okay, so let's go over assets real quick, 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.

Here we have half a million dollars. We have accounts receivable, which is always supposed to be possible. convert it to cash within 12 months because you will collect your accounts receivable and then the inventory, which in this case is three million dollars, and the idea is that all of these components, all of these three elements of current assets, can be converted in cash within 12 months. 12 months and that's why we call it ordinary law. So current means that it can be converted into cash within 12 months and then we will always have the other assets or non-current assets which in this case are property, plant and equipment because the idea is that it is an investment in the future of the company. company, this is not something that the company intends to sell and convert into cash, so this is other assets here, so the total assets of the company are 14 billion dollars and then we can jump.

Let's go to the liabilities section so that liabilities are also broken down similarly to assets, where we look at current liabilities and then we look at non-current liabilities, so current liabilities, a similar concept, these are the liabilities or obligations what they are expected to be. fulfilled that the company has to fulfill within 12 months, so an example here is accounts payable, the expectation that the company will pay its accounts payable within 12 months, of course, and then it has accrued expenses and these are all other expenses the company has not yet accounted for as payable, but under the accrual principle accounting principle, the company must accumulate any liability or obligation for which it has not received an invoice, so even if you have not received, you receive an invoice for a service or product from a supplier you still need to accrue for it and this is based on the accrual principle, this is one of the accounting principles, the accrual principle, so the accrued expenses It's 300,000 and then we have deferred revenue 500,000.

The first revenue you can basically think of as advance payments from customers, so as a business you receive cash from your customers for a future product or service that you will deliver to them in the future. , but the reason we record it as a liability is because this becomes an obligation for the company, so you receive cash, you record the cash as a debit, but then your credit is deferred revenue, which which is a current liability because it is still an obligation that the company must fulfill, etc., 500,000. In this case it is deferred income and that will give us a total current liability of 8.3 million dollars and then we will move on to non-current liabilities and these are the liabilities that we don't expect to pay over 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 a total liabilities of 11.8 million and Then what will be left over will be the shareholders or the shareholders' equity of 2.2 million, which could be you.

We can think of it as subtracting the total liabilities from the assets, so if you take all the liabilities and pay them out of the assets, what will be left here is $2.2 million and this is what the owners of the company can claim like your equity in the company 2.2 million dollars in this case and then obviously as we said the total liabilities and shares of 40 million dollars will always equal total assets of 40 million and this is one of the first things what you look for when analyzing a balance sheet. The right side of the sheet is total assets equal to total liabilities and shares, if they are not equal then you are looking at a balance sheet that has an error and you need to check that error first before you can even begin to

analyze

the balance sheet, so that the first thing is this number here, assets should equal total liabilities and shares 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?

At the beginning of the video I said it's a risk-based approach or what are the risks associated with each line item on the balance sheet, so let's dive back in and look at the risk associated with each of the line items, starting from the assets and going down to get to the liabilities, so starting with the current assets, the first item here is going to be cash and cash equivalents, so a CFO will look at this number and say, "Well, I have half a million dollars in cash and I need to look at my current liabilities, so I look at the accounts payable here and I'll see that my balance is $7.5 million, which basically tells me that I need to pay suppliers $7.5 million in the next, let's say, 60 to 90 days, so I'll look here and say: Where is the money coming from to cover all these accounts payable if I only have half a million dollars in cash?

Basically, I look here at the accounts receivable and I see that I have a big balance, like this than seven. million dollars in accounts receivable, this is expected to be collected normally in the course of business, say 45 to 60 days, so I am expected to collect this number first so I can pay my accounts payable, so this is The first thing the CFO will look at is liabilities, so the CFO analyzes the company's obligations in relation to the company's cash position to determine if there is enough cash available to cover the obligations that have arisen and then The second thing the CFO would consider is profitability, so we know that the accounts receivable of $7 million will cover the obligations the company must pay in the next 90 days, but what about profitability?

This company is profitable, which means it is an ATM. If my cash is running out here and it's half a million dollars, am I making enough profit to be able to generate more cash to protect against the risk of running out of cash? Basically, when we look at the company's income statement and see that the net income is 120,000, which is adjusted for depreciation and reset for depreciation, this is about 200,000 for a month, so this is for the month. December 2019. So I can say that it is good on a monthly basis. I have a profitability of about 200,000, which gives me a little more comfort.

Over the course of a year, let's say I'll make about two million dollars. in profits which will create more cash to improve my cash position, so to summarize for cashier cash equivalent the CFO will look at two things, liabilities and then also profitability which in turn will create Cash Flow. The next item here on current assets. they're 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 okay it's 7 million dollars so I need to see an expiration schedule of the 7 million dollars, so the aging schedule will show you the breakdown of this 7 million dollars in terms of what the customer owes by segment, so the first segment will be current accounts receivable or you know accounts receivable that the customer is not yet behind on paying. and then it will show you the breakdown of 30 days 60 days 90 days, this way you can get an idea of ​​how much of this number is aged and that can give you an idea of ​​how much of this number can be expected to be bad debt, basically, The customer will never pay this number, so the older the accounts receivable, the greater the likelihood that you will not collect them, which is why it is important to look at one accounts receivable aging schedule and then the second.

What the CFO will consider is the sales pending for the day, so basically the sales pending for the day is a financial statement or a balance sheet metric that will show us how far or how long it takes, so here we have the sales pending of the day, which are the number of days it takes to convert sales into cash, which basically takes the accounts receivable balance divided by credit sales and then multiplies it by the number of days in the period and to apply this to our example here if we take the accounts receivable balance. which is seven million dollars divided by credit sales, four million dollars, which we can see here in the balance sheet or income statement.

If we switch to the income statement, we have sales of four million dollars, so let's take that number and plug it in here, so we have 7 million ar divided by credit sales, that is 4 million dollars multiplied by 31 days, This turns out to be a month with 31 days, so that gives us a result of 54 days, that is, 54 days, so this says that the company assumes an average of 54 days to convert its sales into cash uh, this number is a little high on the high end, you want this number to always be around 30 to 45 days, you know, if it goes up to 60 days, then it's a little bit above the average above 60 days, then that would be a bad sign, so these are the two things that the CFO would consider for accounts receivable.

First, the aging schedule, and then they'll look at pending sales or the next item on our list. It's inventory and basically when a CFO looks at inventory, in this case they're looking at a balance of three million dollars and you want to make sure that none of that is about to expire or is obsolete, so if you have three million dollars, worth three million dollars. of inventory doesn't mean that everything can be sold, right, maybe some of it isn't, you won't be able to sell it, so if you have inventory, especially if it's like food inventory and a big part of it is food products that are at about to expire or expiring very soon, so this is a risk, so if you are looking at an inventory aging program, you can know by cube how much of this inventory should be. moved quickly so as not to be canceled or lose money, so a CFO would want to see a breakdown of what makes up the three million dollars in thiscase to determine how much risk is associated with this inventory, how much of it needs to be moved quickly, so now we have covered all the elements of current assets, so the next element here is non-current assets or other assets and we have here properties, plant and equipment and when a CFO is analyzing this $3.5 million balance they are wondering if this whole balance is appropriate to be posted on a balance sheet, that is, if any of this is obsolete, such as if it is machinery or equipment, are we using all of it or is part of it obsolete and in need? be written off so this is the risk here when you look at this number is knowing the composition not looking at a breakdown of the assets that are included here and determining if they are all in use they all have a future economic life for the company um for what this balance is appropriate otherwise if it's not if a part of this needs to be written off then that's a hit to the p l and that will reduce this number here on the balance sheet so now that we've covered the assets let's look at the liabilities and The first item in current liabilities is accounts payable and when a CFO looks at this number here, the balance of $7.5 million, he thinks of two things in terms of risk when it comes to accounts payable, so The first thing you think of is dpo or days payable outstanding, which is basically the amount. of time that the company takes on average to pay its obligations to suppliers, so each company has a unique payment cycle, sometimes it is a quick cycle of 30 days, sometimes it can be 90 days or 120 days when It's about a larger supply. chain when you have suppliers for your materials, so basically the longer the better in this case and the financial director will look to measure the dpo and the dpo uh days payable outstanding, the formula is credit purchases divided by the balance of the accounts per pay from the account and take that and multiply it by the number of days in the period and that will give you the dpo and usually you want that number to be as long as possible to reduce the receiving cycle of your customers and make them This cycle is as long as possible. as long as possible to have an advantage and this is like a cash flow advantage when you collect quickly and then pay over a longer period of time, so the first thing you need to consider is dpo and then the second thing will be aging, so it's similar to when we talk about accounts receivable, when we also, when we look at accounts payable, we want to look at the age of the composition of the 7.5 million dollars to determine what part is current and what part is aged due to The risk here is that if much of this balance is overdue, meaning we owe it for the past, say maybe six months or so, this is a sign of trouble, so if the company has a lot of accounts payable that are expired or that it is expired, it means that the company cannot charge the time of its clients and pay its suppliers, that is why it is very important to observe the aging, which will give you a quick idea, obviously, when you look at the schedule of expiration.

You want, to the extent possible, that the $7.5 million that is in the current section of the aging schedule not be expired, so this is what the CFO would look at when it comes to accounts payable. pay, the next element will be the accumulated expenses. and we have 300 thousand dollars and we said before that accrued expenses is what companies accumulate in terms of liabilities that they have not received, the company has not yet received an invoice from a supplier, so what the CFO would look at here is him . I would ask for a schedule of this number here just to determine if the company is adequately accruing everything it owes so only when you see a breakdown of the number is when you will be able to make that determination so a schedule here will give you an idea and then the The next item will be deferred revenue, so the 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, you know, I need to know if the company is going to be able to to fulfill this obligation so you know the CFO would want to look and see what the customer is paying, let's say they're paying for a product and then we'll ask a question, okay? it's a product that we have on hand this is something that we need to manufacture from scratch we're going to be able to fulfill this obligation here and so you know you need to know what it is, you know, what's included in this number here and again, this is usually going to be a schedule. that you can get.

The company must maintain a schedule of all advance payments received from customers, so this pretty much covers the current liabilities section. Now we come to the non-current liabilities and the CFO will look here and see that the company has long-term debt of 3.5 million, so the first question is to ask for a breakdown of this number, to see just the maturity correct, so you want to see the breakdown by expiration. The date of you know, when do we expect to pay? This number is made up of loans that are like three-year, five-year, or ten-year loans, so you can basically plan ahead.

You al

read

y know how you are going to pay. Paying off this loan is similar to when you own a home or property and want to know how long the mortgage lasts. Is it a 10 year mortgage? 20 years 30 years? It's the same here if you have a long mortgage. -Term debt, the first thing you want to know is how long it will take to pay it off or what the maturity date is for this loan, so you get to the total liabilities and it's $11.8 million and there are a couple of financial metrics or kpis . which you want to use here to make sure that the financial health of the company is not something that is in jeopardy, so the first thing you want to compare is total liabilities, you want to compare that to equity and this is a financial metric here.

It's called the debt-to-equity ratio, which is the relative proportion of shareholders' equity in debt used to finance the assets of the company, so the formula is liabilities divided by equity and if we apply this here, the liabilities are 11.8 million dollars divided by capital, which is 2.2. million dollars and it will give us a result here that is 5.4 uh, so this number 5.4 um, you know, it says that the company is using 5.4 times more debt than equity, uh, to finance its business, um You know, this could be a sign of too much leverage. but it could also be that the company is taking advantage of low interest rates, so there are two sources of financing for the company: in this case, it is increasing debt, which is long-term debt, or selling shares, which They are actions, and each one of them.

It has a cost to the company and it is up to the company to determine which is cheaper. If interest-related interest rates are low in an environment where the feds are lowering interest rates, then it makes sense for the company to raise more money. from debt over financing, so in this case, here you look at this metric and you can determine the debt-to-equity ratio. The other financial metric to consider here is the servicing of the loan itself, which is the interest coverage ratio, so it measures how many times a company can cover interest payments from profits in a given period, so basically you take the earnings or ebit, in this case the earnings before interest and taxes are divided by the interest expense, so in this case it's 250,000 that we can get here. from the income statement when you take the ebit, which is earnings before interest and taxes, 250,000 divided by 80,000, which is the interest expense again, that's also from the income statement here eighty thousand dollars of interest expense and the result is 3.1 and this means that the company can cover its interest payment three times or 3.1 times more than its profits and this is good, so the company has made enough profits to cover its interests by a factor of three, so this is a good sign that the company can in fact pay its interest on the actual loan.

There are some other important ratios such as liquidity ratios, quick and current ratios that CFOs use to analyze the balance sheet and there are also financial leverage ratios. such as debt-to-equity ratio and debt-to-asset ratio, as well as financial leverage ratio, and these are all important ratios that CFOs use to analyze the company. I will leave a link to this file below in the description. in Excel so you can download it and see the balance sheet, income statement, and the actual ratios that are used here so you can find a description. You can find a link in the description below to the link in the description below to take you to it. to a product on my website to buy that is really affordable and includes the Excel file we discussed today with its balance sheet income statement and the formula and interpretation of the financial metrics and also an actual one page PDF summary of the metrics what do we use.

I reviewed it today so I can keep it as a useful reference for the future. The reason why this is a paid product instead of a free gift that I sometimes give on this channel is because this template took me a long time to put together and test and make sure it is correct and accurate and also because when you buy a product from Through this channel you are also supporting the channel and ensuring that I can give you the content or free content that I publish every week. That's all for this video, if you liked it and learned something new, give it a big thumbs up and share this video with someone you think would benefit and I'll see you in the next one.